Bad Boy Cities and States Test Fiscal Limits

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Illinois' reputation as the incorrigible outlaw of state finance has continued to grow throughout the fall. In mid-October, a fiscal study group co-chaired by former Federal Reserve Chairman Paul Volcker issued a stinging assessment of the state's finances which argued that Illinois is effectively insolvent.

But what is perhaps more startling is that other states and many municipalities have increasingly employed the same kinds of gimmicks as the Prairie State to create the illusion that they are balancing their books. Although this maneuvering fools fewer and fewer people as the long fiscal downturn drags on, some states and cities act as if there are no consequences to their extended fiscal games. Perhaps they imagine another Washington bailout of local governments, like the 2009 stimulus, is inevitable.

One of Illinois' greatest problems, for instance, is that it has not been able to afford its pension system for years. Rather than reform it by reducing its costs, however, Illinois has borrowed money to finance the system. But Illinois is hardly alone. These kinds of pension borrowing have become common throughout state and local finance despite general agreement that they are risky and often accomplish little except to kick the funding problem down the road.

In the last 25 years states and cities have issued more than 3,000 pension bonds, racking up some $60 billion in obligations. Most worrisome, perhaps, is that the practice of funding pensions through debt grew more common after the fiscal meltdown of 2008. In the wake of those woes, pension borrowings increased from about $1.6 billion in 2009 to $3.8 in 2010 to $5.2 billion last year.

States originally argued that these pension bonds were good financial practice because they could borrow at about 5 percent and project earning 8 percent annually on that money in the markets. But pension systems have rarely lived up to their lofty investment expectations. A 2010 study by the Center for State and Local Government Excellence estimated that the vast majority of these borrowings have turned out to be a drain on governments.

New Jersey, for instance, borrowed $2.7 billion in 1998 for its pension system, projecting the money would earn 8 percent annually. Since then the state's pension system has achieved less than half that projected return. Meanwhile, Jersey must spend $10 billion in principal and interest to pay back that original borrowing, whose costs will weigh on its budget for another 18 years.

Borrowings have played a role in some of our most spectacular municipal meltdowns in part because pension funds invested the money aggressively to earn more on the principal than they would pay back in interest. In 2007 Stockton, Ca., borrowed $125 million hoping to reduce its spiraling annual retirement costs. The city promptly lost a quarter of that money in the 2008 market crash. When it filed for bankruptcy earlier this year Stockton, which pays among the richest pension benefits in California, listed $29 million in annual pension payments plus $7 million more annually to pay off its retirement borrowing on a general fund budget of merely $168 million.

The fate of Oakland, Ca., which issued among the earliest pension bonds in the mid-1980s, should have long ago persuaded responsible budgeters to avoid them. Over the years the city has used a succession of debt offerings rather than contributions from its budget to finance pensions, but with disastrous results. The city lost $225 million in bad investments from capital it raised in a 1997 pension borrowing, but still Oakland borrowed another $213 million this summer to roll over that previous debt. The city had dug itself such a deep hole over the years that, "We have no option" except borrowing, the city's treasury manager said. She didn't explain how Oakland will be able to pay back the current borrowing, or what happens if investors suddenly stop buying the city's debt.

The pension borrowings are a subset of a much larger problem: increasing use of debt by states in the midst of a sustained downturn. A 2011 study by the Congressional Research Service noted that states have relied much more on debt in the current downturn than in the recession of 2001. State debt has reached 70 percent of revenues, compared to 60 percent in the recession earlier in the decade. Many states, the report said, seemed to "suffer from a so-called ‘fiscal illusion' that makes debt (or federal grants) appear to be ‘cheaper' than using general fund [tax] revenues" to fix budget problems.

States and cities have had to find ways around their own constitutional restrictions on debt to pile on the borrowing. Arizona used a series of gimmicks to close its budget gaps with debt, relying on borrowed money to finance 17 percent of its budget between 2007 and 2011. The state sold its government buildings in an elaborate deal in which the new ‘owners' were nothing more than bondholders who bought what's known as certificates of participation which paid the owners what the state called "rent" rather than debt repayments. That allowed the state to get around limits on borrowing. Arizona also sold off projected revenues from its state lottery for the next two decades to borrow $450 million to cover a budget shortfall in 2010.

Arizona, however, has one of the strictest debt limits of any state. Officially, its state debt load is just $2,188 per resident, one of the lowest among the states. But the Goldwater Institute in Phoenix estimates true state debt at more than $10,000 per citizen thanks to budget gimmicks like rollovers of state budget obligations from one year to the next. Such gimmicks don't get you out of trouble; they merely intensify it. That's why despite its seemingly low debt load, Arizona was recently rated by the financial website 24/7 Wall St. as one of the country's most mismanaged states, thanks largely to its enormous budget deficit relative to state GDP.

Governors and mayors justify these maneuvers as an alternative to steep budget cutting during downturns, but governments rarely unwind these gimmicks and pay off the debt when times get good. New York State is still repaying debt from the bonds it issued when the state sold Attica prison to itself during Mario Cuomo's governorship in the early 1990s. The state has continually refinanced the debt and extended the term of the borrowing rather than repay it.

Today's fiscal stunts will echo down through the decades. School districts around the country, for instance, have taken to funding their building and repair projects by issuing what's known as capital appreciation bonds which don't require any repayments for 20 years, but are extremely expensive to pay off over their 40-year life. One school district in California, Poway, borrowed $105 million to finish a construction project but didn't want any new debt payments on its balance sheet in the immediate future so it issued these CABs. Final tab to repay the debt over 40 years: $1 billion. Other districts in Southern California have similarly loaded up on CABs.

Some budget stunts are far riskier, as elected officials bet that some higher authority (their state legislature or even Washington) won't let them fail no matter how irresponsibly they government themselves. City council members in insolvent Harrisburg, Pa., for instance, rejected a rescue plan from the state because they didn't like its terms and instead threw themselves into bankruptcy, somehow hoping for a better deal there. A judge promptly threw the city right back out again.

In Detroit, unions and city council members have rejected a financial oversight plan from the state and are trying to put themselves into bankruptcy even as the city runs out of cash. Mayor Dave Bing, who supports the state rescue, has whittled the city's budget deficit down by several hundred million dollars but knows that the Motor City's decades of fiscal mismanagement make it impossible for the city to pay its way out of its enormous financial problems alone. In frustration, Bing recently observed that city workers who've tried to resist concessions that the state is demanding from them think they are ‘entitled' to their jobs and benefits no matter how deep Detroit's fiscal problems go.

One of the principal differences between bankruptcy in the private and public sectors is that governments that become insolvent don't get liquidated. But in Michigan, some state legislators are now proposing that perhaps it's time to disband municipal Detroit government and break the city up into a series of smaller communities that might better govern themselves.

Perhaps elected officials in other places might behave more responsibly if more of them faced the threat of being forced to close up shop and give way to a new government.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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