Why State Finances Are Worse Than We Thought

In a report issued Thursday to her clients, banking analyst Meredith Whitney warns that current state finances are much worse than people think. According to Whitney’s report, future deficits need to be closed through tax increases or cuts in spending on social services. Worse still, Whitney warns that debt levels are in fact significantly higher than official estimates.

Whitney’s report, which covers 25 of the largest states in the U.S., shows that state governments have raised annual outlays from $1.5 trillion to nearly $2.2 trillion, an increase of $700 billion in spending, while tax receipts have risen $300-400 billion, to $1.4 trillion. Throughout the recession, spending has continued to rise even though state income has remained flat.

Forty-six states must balance their budgets for the fiscal year ending this month, but on average, taxes will fall 36% short of revenue. So states are receiving money from the federal government through the American Recovery and Reinvestment Act, which has given out $480 billion in grants and contracts since it was passed in 2009. But that money still wasn’t enough, and the stimulus is set to expire this month, so states have had to dip into emergency funds created from prior surpluses, as well as increase their issuance of General Obligation bond securities, incurring long-term debt in order to keep the state operating in the short term. Today, debt service takes up half of Nevada’s budget, 40% of Michigan’s, and over 20% of the budgets of Arizona, California, Connecticut, Ohio, and Illinois.

Another problem Whitney notes is that pension costs are rising so quickly that they are stealing money from other programs, thus ensuring future tax increases and spending cuts. And this is with states already shortchanging pension funds, covering only 77% of their liabilities instead of 100% or more as they did in better economic climates. To fully pay pension costs, states would have to add $700 billion a year to their budgets.

But wait, there’s still more bad news: states have even more liabilities than we know about. Pension and Other Post-Employment Benefits (OPEB) liabilities didn’t legally have to be reported until 2008, and since that time, figures have usually been reported as being lower than they actually are because states tend to overestimate future returns on retirement investments.

But Whitney’s biggest concern is Revenue Bonds, which back government projects like subsidized housing, toll roads, and land acquisitions. The bonds are supported by the inflow of cash from the projects and are not guaranteed by the state government, so unlike General Obligations bonds, they can default if the cash flow falls short of the interest payments, so investors will have to restructure them, incurring great financial losses themselves. Whitney counts this as the equivalent to default. Today, Revenue Bonds total $2.7 trillion, almost twice the total for General Obligation bonds.

With such bleak news coming from such a well-respected financial authority, it’s got a lot of people quite worried. However, Robin Prunty, S&P Senior Director in the Public Finance Ratings Group, has stepped in to alleviate some of the fears caused by Whitney’s somewhat sensationalist report. In an interview with CNBC, Prunty said:

We don’t envision a municipal market crippled by widespread defaults or bankruptcies. We believe, moreover, that fundamental credit performance throughout the market—as measured by default rates relative to debt in the market—will remain mostly stable.

And while Prunty admits that states are facing difficult budgetary concerns, as Whitney outlined, there has also been a steady trend of revenue growth in the last few months, though he still projects large state deficits and the need to decrease spending.

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