Category Archives: State & Local Finance

Large, established toll road systems are better positioned for the next recession

Source: Maria Matesanz, Eriq Alexander, Kurt Krummenacker, Moody’s, Sector In-Depth, July 17, 2018
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Large road systems will experience more stable traffic and revenue trends in a recession than smaller or less well established systems, based on our analysis of their performance during and after the last recession. From a financial and operational standpoint, we expect larger toll roads to maintain steady traffic growth and performance with minimal negative credit effects associated with typical traffic and toll revenue drops seen during recessions. We define large, established toll roads as those that operate multiple assets and have been in operation more than 15 years….

Most states adopt timely fiscal 2019 budgets amid strong revenue growth

Source: Matthew Butler, Nicholas Samuels, Emily Raimes, Timothy Blake, Moody’s, Sector In-Depth, July 16, 2018
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Growth in state tax revenue was robust in fiscal 2018 and positioned many states to carry an operating surplus into fiscal 2019, which for all but four states began on July 1. Likely aided by the strong revenue performance, all but two states began fiscal 2019 with an adopted budget in place, which is a departure from the past few years when several states entered the new fiscal year without an enacted budget.

The “Privatization” of Municipal Debt

Source: Ivan T. Ivanov – Federal Reserve Board, Tom Zimmermann – University of Cologne, July 12, 2018, Paper prepared for: Brookings Municipal Finance Conference July 17, 2018

State and local governments in the U.S. have substantially increased their reliance on private bank loans in the aftermath of the Great Recession. Using loan-level data on bank lending to U.S. municipal governments, we document that these loans have high effective debt priority and are likely to allow borrowers additional debt capacity. Specifically, banks loans to municipalities are highly collateralized, include additional seniority and guarantee provisions, and have short maturities. Consistent with the idea that financially weak borrowers are more likely to resort to higher priority debt, banks’ assessments indicate a non-trivial fraction of municipal borrowers to be high risk. Last, we show that exogenous adverse income shocks lead to a significant increase in bank financing in the debt structure of municipalities. These results suggests that the reliance of municipalities on private debt is likely to increase in an environment of eroding fiscal positions.

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View MacNaught’s slides
Colin MacNaught (BondLink)

The Retail Sales Tax in a New Economy

Source: John L. Mikesell – Indiana University, Sharon N. Kioko – University of Washington, presented at the Brookings Institution’s 7th annual Municipal Finance Conference, July 16-17, 2018

For the second half of the 20th century, the retail sales tax was the largest single source of tax revenue to state government and the second largest source for local governments. Born out desperation during the Great Depression, the retail sales tax became the single largest source of tax revenue for the states by 1947. While consumption is an indispensable measure of household ability to pay, the U.S. retail sales tax fails to fully capture that measure in its taxable base. As a result, the tax is not economically neutral, horizontally equitable, robustly revenue-productive, or simple to collect. Since its adoption, political, social, and economic forces have created a tax that is both “too broad” or “too narrow”. We explore patterns of change and their impact on the retail sales tax. Specifically, we explore how changes in consumption, policy, and technology, particularly the internet, have made the retail sales tax less neutral, equitable, administrable, and productive. We also examine which policy options have been successful and what policy changes should be encouraged.

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View Gordon’s slides
Tracy Gordon (Urban Institute)

Budget Processes and the Great Recession: How State Fiscal Institutions Shape Tax and Spending Decisions

Source: Kim Rueben, Megan Randall, Aravind Boddupalli, Urban Institute, July 16, 2018

As states enter the 2019 fiscal year, most have passed budgets on time and are finally logging tax revenues at pre-Great Recession levels, arguably exhibiting the highest degree of fiscal health since the recession’s 2009 trough. While many states have seen notable annual revenue growth over the last five years, in as recently as 2017 ten states struggled to pass a budget on time. In October, 2017, for example, Connecticut Gov. Dan Malloy approved the state’s two-year $40.2 billion budget more than 100 days after the fiscal year began. Representing a strong bipartisan effort, the package included spending cuts, new taxes and fees, and new fiscal controls meant to stabilize the state’s financial future. These controls included strengthening revenue and spending limits and specifying how money should be deposited into a rainy day fund – the assumption being that additional fiscal controls would help the state move toward a more sustainable fiscal path.

What evidence, however, shows that fiscal institutions, such as those adopted by CT, help states respond to unexpected fiscal or economic pressures? Following up on previous literature, new data and the magnitude of states’ fiscal challenges during the Great Recession make this an important time to reexamine the role of budget rules in determining state fiscal health and helping states weather fiscal uncertainty.

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View Watkins’ slides
Ben Watkins (State Board of Administration, Florida)

The impact of Dodd-Frank on credit ratings and bond yields: The municipal securities’ case

Source: Craig L. Johnson, Yulianti Abbas, and Chantalle E. LaFontant, Indiana University, April 2018

We empirically test the reputation and disciplining hypotheses on the potential impact of Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) on Standard & Poor’s (S&P) state government credit ratings and bond yields. Our empirical findings indicate that S&P ratings after Dodd-Frank are higher and more stable, as evidenced by fewer total rating changes. We find fewer overall negative rating actions, fewer rating downgrades, and more rating upgrades. We also find that after Dodd-Frank bond yields are lower and that Dodd-Frank impacted bond yields through credit ratings. The impact of Dodd-Frank on bond yield is significant across all rating classes. Our findings are consistent with the disciplining hypothesis, and we find no support for the reputation hypothesis.

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View Goodfield’s slides
Ashton Goodfield (Deutsche Asset Management)

What Went Wrong?: The Puerto Rican Debt Crisis and the “Treasury Put”

Source: Robert Chirinko, Ryan Chiu, Shaina Henderson, University of Illinois at Chicago, June 2018

What went wrong? Why did seemingly rational bond investors continue to purchase Puerto Rican debt with only a modest risk premium, even though the macroeconomic fundamentals were dismal? Given gloomy macro economic fundamentals and relatively low risk premia, investors were either stunningly myopic or Puerto Rican debt was implicitly insured by the U.S. Treasury. The rational investor model rules out the former hypothesis.

This project examines the latter hypothesis, which we label the “Treasury Put.” The expectation of a federal bailout was perfectly reasonable given past behavior by the Federal Government, especially the prior bailout of the city of New York. Evaluating the Treasury Put hypothesis with a minimal set of assumptions is possible given two fortuitous features – a unique characteristic of Puerto Rican bonds and a “seismic shock.” Puerto Rico issued both uninsured and insured general obligation bonds. These bonds were issued on the same day and, in many cases, with the exact same maturity. These features allow us to compute accurately the risk premia on Puerto Rican bonds. The second feature was the non-bailout of the city of Detroit in 2013 that effectively extinguished the Treasury Put. Puerto Rican risk premia were stable before the Detroit bankruptcy and bracketed by the risk premia on Corporate Aaa and Baa bonds. However, after the Detroit bankruptcy, risk premia rose dramatically, thus documenting the existence of a sizeable Treasury Put and a significant misallocation of capital to Puerto Rico.

presentation slides

Analyzing the Interplay Between Public-Pension Finances and Governmental Finances: Lessons from Linking an Economic Model to a Pension Fund Model

Source: Yimeng Yin -The Nelson A. Rockefeller Institute of Government, Don Boyd – Center for Policy Research, The Rockefeller College, University at Albany, July 11, 2018, Paper prepared for: Brookings Municipal Finance Conference July 17, 2018

…. Research suggests that the real world differs from these assumptions, in some ways that mean the assumptions may understate risks, and in other ways that mean the assumptions may overstate risks. Investment returns may not be normally distributed and may not be independent over time. Perhaps more important, investment returns and tax revenue may be correlated: a poor economy may cause investment returns to fall short of expectations, and may also cause tax revenue to fall short. The resulting increase in required employer contributions may cause additional fiscal pressure if increases come when tax revenue is low.

We address these issues, focusing on the correlation between tax revenue and the economy, by building a small macroeconomic model that can generate internally consistent stochastic scenarios of growth in real gross domestic product (GDP) and returns from stock and bond investments. ….

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View Quinby’s slides
Laura Quinby – Center for Retirement Research, Boston College

Present consequences of unfunded pension liabilities and ways forward

Source: Jeffrey Cheng and David Wessel, Brookings Institution, July 16, 2018

Note: This paper will be presented at the 2018 Municipal Finance Conference on July 16 & 17, 2018.

State governments with large unfunded pension liabilities are paying more to borrow from capital markets than are other states, according to Chuck Boyer of the University of Chicago Booth School of Business.

In the paper, “Public pensions, political economy and state government borrowing costs,” to be presented at the 2018 Municipal Finance Conference at Brookings this week, Boyer argues that markets view states with large pension deficits as riskier investments. His evidence suggests that states are already paying for municipal government’s unfunded pension liabilities in the form of higher borrowing costs. He asks two questions: 1) how are state governments’ borrowing costs affected by unfunded pension obligations? and 2) do states with political constraints face higher borrowing costs?

Boyer constructs a panel dataset using each state’s Comprehensive Annual Financial Reports for the period 2005 to 2016. He focuses on balance sheet variables—revenues, expenses, assets, and liabilities—to capture a state’s financial health and credit default swap (CDS) spreads – the premium paid to protect buyers from an issuer defaulting – to measure borrowing cost. The author reasons that CDS reflects market sentiments better than market yields because CDS are more liquid, and because they are standardized, whereas market yields may be affected by additional features of a particular bond.

Public pensions, political economy and state government borrowing costs
Source: Chuck Boyer, University of Chicago Booth School of Business, current draft: July 11, 2018

I find that public pension funding status has a robust and statistically significant relationship with state borrowing costs, as measured by credit default swap spreads. A one standard deviation increase in the net pension liability to GDP ratio is related to an 18 basis point increase in CDS spreads. This effect is most pronounced among states with constitutional protection for pension liabilities, suggesting the markets perceive these legal protections as material. I also find suggestive evidence that states with more powerful unions pay higher borrowing costs. Results are robust to using spreads from the underlying bonds themselves. These findings highlight the fact that states are already paying for potential future pension problems through higher borrowing costs.

Related: presentation slides

When Needed Public Pension Reforms Fail or Appear to Be Legally Impossible, What Then? Are Unbalanced Budgets, Deficits and Government Collapse the Only Answer?
Source: James E. Spiotto, Chapman Strategic Advisors, May 30, 2018

The problem of underfunded public pensions confronts a number of states and local governments in the United States. In the past, numerous public employers in the United States have agreed to pension benefits that now appear challenging to afford given current revenues and the increased cost of providing governmental services. Further, this challenge has been exacerbated by past failures to set aside sufficient moneys to meet the pension benefits obligations incurred to date. All of this is occurring on the heels of the Great Recession of 2007, followed by an anemic recovery, and at a time many states and local governments are faced with an aging infrastructure that must be attended to and increased demands for basic public services (sanitation, water, streets, schools, food inspection, fire department, police, ambulance, health and transportation) that must be met. Because the public pension underfunding problem pits the requirement of meeting pension obligations against the need to provide for essential public services, all citizens have an interest in the fair and equitable solution to the dilemma.

Unfortunately, a just and effective method of resolving unaffordable public pension obligations has been elusive for some public governmental employers and employees. This is due in part to promised pension benefits costs exceeding the government’s ability to pay and the failure to fund promptly the incurred obligations. In some cases, solving the problem has been complicated by the lack of any ability to adjust or modify pension benefits to those that are sustainable and affordable to the fullest extent possible without adversely affecting the funding of essential public services. This paper will provide a review of some legal and practical obstacles that have been making needed pension reform and balancing the budget difficult, if not impossible, and will suggest possible new approaches to the problem that have not yet been tried. …..

Related: presentation slides

U.S. Public College And University Fiscal 2017 Median Ratios: Lower-Rated Entities Continue To Face Financial Stress

Source: S&P Global Finance, July 16, 2018
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The credit quality of most rated U.S. public colleges and universities was relatively stable in fiscal 2017, except for lower-rated schools, whose credit issues continued. Enrollment and demand metrics were favorable across higher-rated categories and as a sector, although schools in the ‘BBB’ and speculative-grade categories generally saw theirs weaken.

U.S. Not-For-Profit Private Universities’ Fiscal 2017 Median Ratios: Competition And Affordability Continue To Be Main Credit Risks
Source: S&P Global Finance, July 16, 2018
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Despite the sector facing continuous challenges in the areas of competition and affordability, S&P Global Ratings’ key median indicators for U.S. not-for-profit private universities in fiscal 2017 were relatively flat as compared with those from a year earlier, reflecting the sector’s continued ability to withstand medium-term pressures.