Are State And Local Governments Ready For An Economic Slump? by Erik Larson & Joseph Rosenblum
What do you get when you increase leverage, mix in volatile revenues, and reduce financial and operational flexibility? A recipe that leaves some state and local governments unprepared for the next recession.
Most state and local governments are still high-quality issuers considered to be in good financial health, but others have met obstacles in their attempts to get on firmer footing. Trends in leverage and financial reserves highlight growing credit risk for some tax-backed issuers. And that argues for a sharper focus on credit research in municipal portfolios.
States Face Hurdles Meeting Reserve Goals
Since the recession, many state and local governments have done an admirable job in balancing their operating budgets; as revenues have recovered, expense growth has been limited. But other governments have faced major challenges—failing to translate the most recent economic expansion into improved reserves.
Average state government reserve levels as a percentage of expenditures are marginally lower than they were in 2008.
They were just 8.9% of expenditures in 2016, according to the National Association of State Budget Officers (NASBO) estimate. That’s lower than the levels prior to the previous recessions: 10.4% in 2000 and 11.5% in 2006 (Display).
Insufficient Funding, Bleak Returns Hurt Bottom Line
Balance sheets overall show a drastic increase in financial leverage since 2008. Much of that increase comes from higher pension and healthcare liabilities.
Insufficient pension funding and bleak investment returns have increased the unfunded liabilities of many state and local governments—particularly those that started the recession with big pension liabilities. And for those issuers who were underfunded to start with, pension costs and leverage have jumped sharply.
According to the US Federal Reserve’s Financial Accounts of the United States, state and local governments’ overall liabilities increased by 17% to US$5.5 trillion between 2008 and 2015, while the net pension liability component increased by 30% to US$1.7 trillion (Display).
Are “Bad Actors” to Blame for Liability Spike?
Most local governments have behaved responsibly, but a relative few have allowed their liabilities to get out of hand. Indeed, of the US$793 billion increase in total governmental liabilities, Chicago and Illinois alone accounted for approximately 19.5%, up US$155 billion from fiscal year 2008 to 2015. But they are only the worst of the bad actors.
A closer look at the liability problem provides some perspective on who else is driving the increase. We found that 20 issuers with the fastest-growing leverage ratios accounted for about 60% of the total liability increase—that’s US$482 billion of the US$793 billion total increase in state and local liabilities.
We also identified approximately 80 large governments whose total liabilities in aggregate increased by 100% from 2008 to 2015, while their net pension liabilities increased by 547%. (To be fair, the increase in pension liabilities on financial statements is partially due to new accounting treatments requiring the proper recognition of net pension liabilities.)
Likewise, NASBO reserve-level data show that just a handful of states—Alaska, North Dakota, Louisiana, Connecticut and Kansas—account for most of the decline in the average year-end reserve balance.
So, it’s fortunate that the number of issuers with high leverage is limited; the number of states with reserves that remain below prerecession levels is also limited. But pension asset returns are likely to stay low, which means many municipal issuers will need to increase their pension and healthcare contributions as a percent of spending in the years ahead.
Governments Vulnerable to Economic Dips
The good news is that most state and local governments are still considered high quality. But growing fixed costs make some issuers more vulnerable to economic downturns, which could make their bonds’ market prices more volatile.
We don’t see an impending recession on the horizon, but think that credit research can help investors take a closer look at their exposures to general-obligation bond issuers whose market rates don’t provide enough compensation for higher risk.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.