California is Spain: A Debt Crisis Looms for the Golden State

This is front page news in the New York Times today, and, as a California resident, it’s alarming:

[M]any state and local governments have so much debt — several trillion dollars’ worth, with much of it off the books and largely hidden from view — that it could overwhelm them in the next few years. “It seems to me that crying wolf is probably a good thing to do at this point,” said Felix Rohatyn, the financier who helped save New York City from bankruptcy in the 1970s. Some of the same people who warned of the looming subprime crisis two years ago are ringing alarm bells again. Their message: Not just small towns or dying Rust Belt cities, but also large states like Illinois and California are increasingly at risk. Municipal bankruptcies or defaults have been extremely rare — no state has defaulted since the Great Depression, and only a handful of cities have declared bankruptcy or are considering doing so. But the finances of some state and local governments are so distressed that some analysts say they are reminded of the run-up to the subprime mortgage meltdown or of the debt crisis hitting nations in Europe. Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis . . .

To get a feel for the approaching crisis, and the desperate measures that some states are already taking, the New York Times article offers Illinois as an example. Illinois has taken up an extraordinary form of gambling, and has lost so far, digging itself an ever deeper hole:

Few workers with neglected 401(k) retirement accounts would risk taking out second mortgages to invest in stocks, gambling that the investment gains would be enough to build bigger nest eggs and repay the loans. But that is just what Illinois, which has been failing to make the required annual payments to its pension funds for years, is doing. It borrowed $10 billion in 2003 and used the money to invest in its pension funds. The recession sent their investment returns below their target, but the state must repay the bonds, with interest. The solution? Illinois sold an additional $3.5 billion worth of pension bonds this year and is planning to borrow $3.7 billion more for its pension funds.

This, of course, is a formula for the state’s ruination. And other states are lining up for a similar course to ruination. They, too, are choosing not to make their annual payments into their state pension funds, which means that to get themselves caught up they’ll be borrowing the money down the road, at bond interest rates of 8% (or more).  Isn’t that crazy?:

Many governments are delaying payments to their pension funds, which will eventually need to be made, along with the high interest — usually around 8 percent — that the funds are expected to earn each year. New York balanced its budget this year by shortchanging its pension fund. And in New Jersey, Gov. Chris Christie deferred paying the $3.1 billion that was due to the pension funds this year.

And the clear rumblings of a crisis are already underway:

“Most financial crises happen in unpredictable ways, and they hit you when you’re not looking,” said Jerome H. Powell, a visiting scholar at the Bipartisan Policy Center who was an under secretary of the Treasury for finance during the bailout of the savings and loan industry in the early 1990s. “This one isn’t like that. You can see it coming. It would be sinful not to do something about this while there’s a chance.” So far, investors have bought states’ bonds eagerly, on the widespread understanding that states and cities almost never default. But in recent weeks the demand has diminished sharply. Last month, mutual funds that invest in municipal bonds reported a big sell-off — a bigger one-week sell-off, in fact, than they had when the financial markets melted down in 2008. And hedge funds are already seeking out ways to place bets against the debts of some states, with the help of their investment banks.

And the New York Times says this of another key analyst:

Meredith Whitney, a bank analyst who was among the first to warn of the impact the subprime mortgage meltdown would have on banks, is warning that she sees similar problems with state and local government finances. “The state situation reminded me so much of the banks, pre-crisis,” she said this fall on CNBC.

So here’s the bottom line (I’m paraphrasing the key points toward the end of the New York Times article):

  • Investing in state bonds, like investing in the housing market in the mid-2000s, is widely considered a safe thing to do. This complacency may prove to be a formula for an unpleasant shock.
  • Just as the banks got into trouble with fishy accounting, so the states are engaged in fishy accounting practices now, as with the way they’re accounting for their pension fund obligations.
  • High bank ratings prior to the banking crisis distorted the true condition of the banks; so today high bond ratings are distorting the actual condition of states right now. And high state ratings make money cheaper for states to borrow than it ought to be. In other words, interest rates may not be reflecting accurately the risk that adheres to the investor who lends money to states.
  • One reason the market may be distorted is because investors are betting that the federal government, in a crisis, will bail out failing states. In other words, we are in a “too big to fail” narrative again, and the state bond investor is assuming that the taxpayer will, in a crisis, ultimately pick up the tab.

Isn’t all this depressing? The next decade could be very, very turbulent as governments around the world struggle to get a handle on their debts—from Spain to California. This bodes well for far-right Tea Partier politics and investment strategies, doesn’t it?

I generally roll my eyes at alarmist scenarios, but maybe Sarah Palin and gold really will be better horses to bet on this decade than, say, Jerry Brown and the Golden State (California).

About Santi Tafarella

I teach writing and literature at Antelope Valley College in California.
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3 Responses to California is Spain: A Debt Crisis Looms for the Golden State

  1. Pingback: California Budget Crisis Watch: As Jerry Brown Assumes the Governorship, Education Braces for Big Spending Cuts | Prometheus Unbound

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