Market Memo: Municipalities under more fiscal stress than states

(The following views were issued on June 28 by a municipal fund bond manager. I offer them here as food for thought. MS)

When it comes to state budgets, it’s a new fiscal year but the same old story: Days away from the start of a new fiscal year, at least eight state legislatures are extending current sessions or meeting in special session to try and hammer out a budget agreement by July 1. New York already has missed its budget deadline — its 2011 fiscal year started April 1. That brings to 9 the number of states that have entered or are in danger of entering the new fiscal year without a budget in hand, matching last year’s total that missed their deadlines.

And like last year, the issues behind this year’s showdown are the same: revenue and taxes. Hit hard by the recession and slow to participate in the recovery, many states suffered declines in virtually every revenue source — the Census Bureau estimates collective state revenues fell a record $67 billion for the 12 months ended June 30, 2009. Federal stimulus aid has helped, but the bulk of it runs out this year. And states are reluctant to close the gap through tax increases for fear of making their economies worse. Tax hikes that are being discussed tend to be limited in nature, such as on tobacco — not broad income tax increases. Finally, having taken the scalpel to spending the year before, they’re also finding it politically problematic to undergo another round of radical budget surgery. States face a cumulative shortfall of $89 billion for the coming fiscal year, the National Conference of State Legislatures estimates.

That’s the bad news. The good news is that as the state budget drama plays out in the press, the headline news will be worse than the underlying news. There are signs revenue is stabilizing — in this year’s first quarter, states reported their first year-over-year increase in revenue since 2008’s third quarter. Debt service payments among all states also continue to be current, with state revenues coming in at levels that are more than sufficient to cover scheduled payments on general obligation (GO) bonds, the most frequently issued and generally lowest-risk form of bonds issued by states. GO bonds generally rank high on a state’s incoming revenue pecking order. Moreover, a lot of fiscal challenges confronting states are more long-term in nature, such as pensions and infrastructure, and they have time to work it out.

Stringent credit analysis key

The news isn’t as good on the local government front. We share some of the concerns about potential default that have been expressed in recent articles in the financial press. While we don’t wish to remark on specific issues because circumstances vary widely, we believe local governments most vulnerable to a potential default share common characteristics — poor demographics and subpar fiscal management. Areas with older, declining, less educated populations that typically struggle with a dwindling tax base have seen their situation worsen in the wake of the longest and by many measures steepest recession of the post-World War II era. This is a bit of generalization, of course. Fiscal woes and mismanagement isn’t limited to declining areas. Many boomtowns in the Sunbelt also are suffering fiscal crises, in part because they relied too heavily on residential growth and failed to diversify their tax base. Then came the collapse of the housing market, which undermined a key source of revenue growth.

Dislaimers:
Views are as of June 28, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
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