AMERICA : STATES OF DISTRESS / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

America: States of distress

By Hal Weitzman and Nicole Bullock

Published: August 8 2010 20:14

By Tuesday, the state of Illinois is supposed to send Michael Kuzniewski a cheque for $1.5m. He is not holding his breath.

As superintendent of education for Illinois’ high school district 201, Mr Kuzniewski oversees the teaching of 9,000 pupils in Chicago’s western suburbs. The district has an annual budget of $100m – of which $35m comes from the state.

Cash-strapped Illinois, however, is five months behind on paying its bills. It still owes the district $3.6m from the last academic year and – because it hopes to cut $300m from its schools budget this year – the state cannot say how much it might hand over.

So Mr Kuzniewski has been forced to wield the axe. District 201 pupils who go back to high school on August 23 will find 22 per cent fewer teachers and 44 per cent fewer teacher aides. They will have five (longer) classes a day rather than six. They will also need fewer credits to graduate.

“We don’t have a lot of options,” he says. “Every district in the state is in the same situation.”

Illinois – the “Land of Lincoln” and adopted state of President Barack Obama – may be in its worst financial predicament yet but it is not alone. The recession has savaged US states’ tax receipts. District 201 provides a potent example of the devastating effect of their financial problems on public services across swaths of America. The experience is also telling for nations such as the UK that, to redress their own budgetary problems, are starting to implement sharp cuts in what government provides.

Illinois has a budget deficit this year of more than $12bn – half of its total operating budget. The state is at least 153 days behind on paying its bills: by the end of June, it owed service providers $4.7bn – a figure that is now nearer $6bn, according to the state comptroller’s office.

Illinois is not alone. In the past few years, states have had to close hundreds of billions of dollars of budget gaps, collectively, according to the national conference of state legislatures. All but one, Vermont, must agree a balanced budget annually.

The hope is that fiscal 2010, which ended on June 30, represents the revenue trough. Most states expect tax income to rise this year. But the recovery is tempered by the extent of recent declines and the waning influence of federal stimulus funds. Some are already facing new gaps and are predicting that deficits will persist until 2013.

In response, states have employed cost-cutting measures. New Jersey slashed its education budget. Idaho cut aid to low-income elderly people and the disabled. Mississippi eliminated more than 100 jobs in its only state-run training facility for juvenile delinquents. Illinois released prisoners early – until public opposition forced an about-turn.

There has also been financial sleight-of-hand. Minnesota has moved some of this year’s school funding bill to the next financial year. Arizona has sold buildings and leased them back. States have considered selling advertisements on vehicle licence plates and imposing taxes on fizzy drinks.

The woes of California being wrestled with by governor Arnold Schwarzenegger have received the most attention. Yet in some ways Illinois’s position is worse: the hole in its public pension fund is relatively bigger, it has received a string of downgrades on its bonds in recent months and investors have demanded higher yields than on Californian paper.

Shortfalls in public pension funds are the heart of the matter. State pension deficits are estimated to total at least $1,000bn, according to the Pew Center on the States, a think-tank. Illinois’ pension funds – which pay out to retired teachers, state workers, university staff, judges and politicians – are funded at less than 40 per cent, the lowest proportion of any US state. The gap between assets and liabilities was about $71bn by last September, the most recent available figures.

The unfunded liability could by now have grown to $80bn – more than twice the state’s total annual budget, says Ralph Martire, executive director of the Center for Tax and Budget Accountability, a think-tank.

Some say the shortfall is even bigger. Joshua Rauh, of Northwestern University’s Kellogg School of Management, notes that states generally assume their investments will generate 8 per cent returns a year. “It’s an economic fallacy,” he says. “It would be like taking money from your savings account, putting it into the stock market and then writing down the cost of your mortgage.”

Using a rate of 3.6 per cent – what US Treasuries were yielding in June – Prof Rauh recalculates Illinois’ pension hole at $145bn – about $30,000 for every household in the state.

Illinois’ pension gap has worsened as a result of the downturn, but this is a longstanding problem. The state began skipping contributions in the 1970s. By 1995 it faced unfunded liabilities of $17bn and sketched out a 50-year plan to re-fund the system but skipped contributions in the early years.

Liabilities built up: by mid-2008, before the full financial crisis hit, the pot was only 54 per cent funded. As Mr Matire puts it: “We’ve basically been borrowing against the pension system and writing IOUs to that.”

Unfunded pensions are a central reason the state cannot pay its bills to institutions such as high school district 201. Interest payments on much of the money Illinois borrows to fund pension contributions come out of its general fund – the same pool that pays for elementary education, keeping the peace and fixing potholes.

As the unfunded portion of the fund grows, so does the annual payment Illinois is required to make – putting stress on the general fund and crowding out other spending.

The cuts in district 201 point to the longer-term effects. If educational standards decline in an area where, Mr Kuzniewski says, many pupils aspire to well-paying blue-collar jobs, Illinois may struggle to produce a workforce that will attract investment. Employers already complain that high school graduates lack literacy and numeracy skills. Ron Bullock, owner of Bison Gear, an industrial motor-maker based near Chicago, says half of those applying to his company fail a basic mathematics test.

If the pension problem was chronic before the downturn, it is now critical. Revenues to the state have plummeted. Billions have been wiped off the value of pension funds. Illinois has been hard hit by the decline in manufacturing. The need for welfare services is greater than ever. “The recession peeled back a lot of what Illinois has been papering over for years,” says Susan Urahn, managing director of the Pew Center.

Yet the state continues to cling to the scheme it outlined in 1995, maintaining it will re-fund the pension system by 2045. It is not clear how long it and others can continue on this path. The assets in Illinois’ public pension funds will pay for benefits only until 2018, says Prof Rauh, or until 2022 if the state uses future contributions to pay for current pensioners.

Another 30 states will have run out of money to pay pensions by 2030, Prof Rauh calculates. Tax revenues will not cover payments, so the federal government is likely to come under pressure for a bail-out whose cost could be more than $1,000bn, he says. Washington had a glimpse of the future last week, when the Senate approved $26bn of federal aid to cash-strapped states.

Some observers try to compare Illinois to Greece. Such parallels are overdrawn, however. Fears over sovereign default in Europe certainly spilt into the US market; but, while most municipal bond experts predict an uptick in defaults, they are more likely to be by hospitals and housing developers than states.

For states, default would carry a huge stigma. With cuts leaving money for debt servicing, investors appear to feel safe enough. In spite of recent credit downgrades by Fitch, and Standard & Poor’s, Illinois raised $900m in capital markets last month. In a roadshow covering the US, Europe and Asia, officials and bankers convinced investors – nearly one-third of them non-US – that Illinois would always pay its bondholders.

The selling point was that the state requires itself to make bond payments before all other bills. It also offered a hefty premium to comparable US Treasuries – as much as 3.25 percentage points on debt due in 2035. Corporate bonds with similar ratings were paying lower yields. The Illinois bonds have since rallied.

While the markets still have the appetite, the state continues to borrow. It issued $3.5bn in debt last year to pay its pension contributions and plans another $4bn bond for this year’s payment. However, this moves debts around rather than tackling long-term problems.

The state slashed $1.4bn from the current year’s budget, but cost-cutting alone is no solution. Illinois is not, in fact, profligate. Although it is the fifth biggest state by both economy and population, it ranks 45th in state spending as a percentage of gross state product and 46th in its combined state and local tax burden as a proportion of income.

So, like other states, it is likely to need to increase revenue too. Proposals therefore focus either on raising income taxes sharply and expanding the sales tax base; or on reforming the pension system. Illinois recently passed legislation raising the state workers’ retirement age from 60 to 67, the most extreme of a number of such moves by several states. The measure is the first serious attempt to tackle the growing pension hole but applies, like those introduced by other states, only to new staff.

Many observers worry, however, that simply changing the rules for new employees is insufficiently radical given the scale of the problem, since it only stems the growth of liabilities. Legal experts in Illinois are therefore debating the constitutionality of changing rules for those who have been paying into the system for years.

Pat Quinn, Illinois’ Democratic governor who is running for re-election in November, wants to raise state income tax from 3 per cent to 4 per cent. Some analysts fear this will not be enough. Politically, the choices are so unpalatable that for decades Illinois’ leaders have avoided them. This was highlighted last month at the corruption trial of Rod Blagojevich, the former governor being prosecuted on corruption charges, including an alleged attempt to sell Mr Obama’s vacated Senate seat.

Robert Greenlee, former deputy governor, testified that his ex-boss was so reluctant to discuss budgetary issues that, when the budget director arrived for meetings, Mr Blagojevich would hide in the toilet.

BUDGETS UNDER PRESSURE

Can a US state default on its debt? Years of budget shortfalls in the run-up to the financial crisis and fears this year of sovereign default in European countries have made this a pressing question, writes Nicole Bullock.

Provisions in the US constitution that protect the independence of the 50 states also make them ineligible to seek protection under the federal bankruptcy code from creditors, says James Spiotto of law firm Chapman and Cutler.

For most of the previous century, most dutifully paid their debts, the ups and down of the economy notwithstanding. But default and debt repudiation are not unprecedented.

Debt has long been a part of the history of Arkansas, for example. In the 1800s, it sold bonds to capitalise the state banks. When the Panic of 1837 – a banking crisis that precipitated a recession – hit, it defaulted. Arkansas sold further bonds to build railways but, upon running into trouble after the civil war, amended its constitution to repudiate $17m worth of debt. A round of borrowing for a highway system in the 1920s resulted in a similar outcome. The state defaulted once again when the Great Depression hit.

Arkansas is not alone. In the 1860s in the financial and social turmoil that followed the civil war, numerous states and municipalities failed to pay their debts. “The reasons for repudiations range from official misconduct to the carpetbagger era in the South ... to railroads and real estate,” says Mr Spiotto.

This period led the states to pass statutory provisions prioritising debt service and creating a legal obligation to pay debts. That laid the ground for years of very low defaults. Since the 1930s, when Arkansas ran into trouble, defaults in the $2,800bn municipal bond market, which counts more than 50,000 issuers across the country, have been a fraction of what investors have endured in the corporate market.

With the depth and breadth of the current downturn, however, some observers have begun to question how long this can last.

Many argue that access to cheap funding in the federally subsidised ”muni market” is too important for states to risk it by reneging on their debt again. Officials know their tax receipts would never be enough to support the workings of government and infrastructure expenses, the latter typically funded with municipal bonds. Indeed, states such as Illinois are willing to dock payments to schools but keep servicing their debt.

But according to Matt Fabian of research group Municipal Market Advisors: “The risk is that the current financial crisis begins to break down that sensibility, as it has among mortgage and corporate borrowers, leading to a more adversarial relationship between issuer and lender.”

Copyright The Financial Times Limited 2010