“It’s getting late early out here.” —Yogi Berra
Over the last few years, our municipal fixed income research team has communicated a number of consistent themes, two of which are:
1) The aggressive budget cuts following the 2008 financial crisis shored up state and local government financial operations but masked long-term challenges facing government as the economy normalized; and
2) Long-term suboptimal economic growth ultimately leads to financial strains for governments as the natural inflation rate of government services outpaces the growth of the economy and tax base.
State Budget Delays on the Rise
Here we examine the cases of Illinois and Pennsylvania, two states that are in the news today for late budgets. In our opinion, aggressive budget actions necessitated by the financial crisis were not sustainable in the long-run and, combined with pension issues in these states, are key causes for the current deadlocked budget debates. We further believe that the situation in Illinois and Pennsylvania is a harbinger of things to come in the municipal market.
It’s fairly common for state governments to struggle over budget negotiations. Disagreements between state legislators and governors over topics of taxation, pension reform and program funding, however, have escalated to new levels. Seven years after the recession, state budget delays are growing and investor uncertainty and anxiety is increasing. New governors are often looking for political and economic reform measure wins in their first administrations, thus compounding the potential for political gridlock and delay. In particular, Illinois and Pennsylvania face serious financial problems and have yet to pass their state budgets, three months into their respective fiscal years. With both their executive and legislative bodies holding onto their core ideological beliefs, the potential remains for additional delays and economic costs to local governmental agencies and investors alike.
In Illinois, Republican Governor Rauner and the Democratic-controlled legislative body continue to spar over the state budget. Rauner was elected in November 2014 in a blue state and is trying to deliver on the proposed fiscal reform measures that helped get him elected. Serious problems facing the state include the lost revenue from expiration of personal and corporate tax hikes that ended in January 2015, a growing pension liability and unpaid vendor bills. All told, the state faces a budget deficit in excess of $3 billion. On one hand, Rauner seeks broad changes, including property tax freezes, an overhaul of workers compensation rules and term limits for lawmakers. Conversely, the state legislature seeks to fill the budget gap with new revenues (i.e., taxes). The level of political discord has escalated concerns about how state governmental agencies will operate without a budget in place.
Similarly in Pennsylvania, deep divides exist between newly elected Democratic Governor Tom Wolf and the Republican legislative majorities. Wolf wants to boost education spending and raise the sales and personal income tax rates, while the legislature remains opposed to tax hikes. With regard to pension reform, the governor is opposed to a new state pension plan that would resemble many characteristics of private sector 401k plans. As the budget morass continues, many social services agencies and schools remain uncertain about their own finances in the absence of state aid.
Despite these budgets stand-offs, most essential programs governing the health and safety of residents continue to be funded. Additionally, social service programs such as unemployment compensation, senior and disability care, and Medicaid and Medicare services have been funded so far. The concern rests in programs that require legislative approval for funding. School districts, for example, require line-item approval for state aid. In Illinois, Rauner has approved such funding but, in Pennsylvania, similar legislation has not yet been approved.
From a municipal bond credit perspective, state general obligation debt is legally protected even in the face of a budget impasse, but appropriation and local debt that relies on a component of state funding is at greater risk. And, while traditional reasoning may conclude that education funding (K-12) is essential and that state appropriated debt service will approved in separate line items, the political acrimony in many states has put previously logical conclusions in question.
Finding a Silver Lining
When we author an arguably pessimistic commentary, we feel an obligation to inform our readers that there is a third consistent and more optimistic theme. Municipal credit is idiosyncratic and generally has a lower correlation of credit risk across issuers versus the corporate market. In other words, you can have two adjacent issuers with vastly different credit profiles. With more than 50,000 issuers to choose from, it is possible to build a portfolio of stable credits, even in an overall negative environment.
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