Fate of the States: The New Geography of American Prosperity

by Meredith Whitney

  The Orange County Precedent

  On December 6, 1994, Orange County made history by becoming the largest municipality ever to declare bankruptcy. Before that time, municipal bankruptcies had been rare. Not since the 1920s and ’30s had U.S. muni investors faced the prospect of defaults on general-obligation bonds by a major bond issuer like Orange County, the sixth-largest county in the country. At the time, the Orange County bankruptcy was seen as an anomaly. The county was a victim of newfangled financial instruments known as derivatives and of the reckless behavior of one man—county treasurer Robert Citron—who played the derivatives market in a failed attempt to boost revenues in the midst of recession. Experts in public finance didn’t see the Orange County bankruptcy as a precedent or even as a red flag, given that bondholders wound up being repaid in full. This line of thinking had some merit, but the reality is that bondholders would not have been repaid in full had it not been for a bailout by the state of California. Because the municipal-bond market had responded to the Orange County bankruptcy by punishing all California issuers with higher interest rates, it was actually cheaper for California to bail Orange County out than to continue to pay higher borrowing costs. Eighteen years later, California is in no position to bail anyone out.4

  November 2011: Jefferson County, Alabama

  The Jefferson County Commission filed for the largest municipal bankruptcy in U.S. history in 20115—$4.2 billion in unpaid debt, more than double the size of Orange County’s once-record bankruptcy filing. Jefferson County’s finances were sunk by a water-and-sewer project that, thanks to graft and engineering blunders, never actually got built despite the county’s borrowing and spending billions. Following the 2008 housing-market crash and subsequent loss of triple-A ratings by Financial Guaranty Insurance Company (FGIC) and XL Capital Assurance (companies that insured the bonds), the interest on Jefferson County’s variable-rate sewer warrants soared. After struggling for years, the county could not support the tentative deal reached with creditors in September 2011 to immediately begin increasing sewer rates by 8.2 percent annually from their current rate for the first three years. The county’s bankruptcy filing resulted in a loss to creditors, higher tax rates for local taxpayers, a dramatic cut in services ranging from police to litter cleanup, and a loss of access to the credit markets. “People are desperate to think of anything they can to get the money,” local businessman David Sher told the New York Times.6

  The money won’t be coming from the state of Alabama, whose legislature is dealing with a $140 million budget deficit of its own and has so far refused pleas for a bailout akin to Orange County’s. “In areas outside Jefferson County, the feeling is why should we ‘bail them out’ for their poor financial management, for their bribery and kickbacks and for what was a seedy, nefarious indebtedness,” Alabama state senator Arthur Orr, a Republican from Huntsville, told the Stateline news service.7 States just have too many budget problems of their own. In New York, for example, Governor Andrew Cuomo has warned municipalities considering bankruptcy not to expect a lifeline from the state. “Some of them are saying, ‘Well, we should look to the state for effectively a bailout,’” Cuomo told an upstate New York talk-radio station in September 2012. “We are not in the position of being an underwriter for local governments . . . and I don’t believe we should.”8

  June 2012: Stockton, California

  The Jefferson County bankruptcy was more rooted in the water-and-sewer fiasco than in any fallout from the recession or the housing crash. The Stockton bankruptcy, on the other hand, is a perfect example of how the housing boom and bust subverted municipal budget making. It also foreshadows more bankruptcies to come. With 292,000 residents, Stockton is the largest U.S. city ever to file for Chapter 9 protection under the bankruptcy code. It’s also one of California’s grittier cities—the TV biker drama Sons of Anarchy is filmed there—which made Stockton a most unlikely beneficiary of the housing boom. Yet between 2001 and 2006 average home prices in Stockton tripled to $400,000, thanks in large part to a surge in subprime mortgage lending. Flush with new tax revenue, city officials increased spending from $160 million in 2003 to over $200 million in 2007.9 Along the way, the city made some dreadful fiscal decisions—including the back-loading of debt and the granting of overly generous pension deals to city employees. According to the Wall Street Journal, even though California state law requires public employees to contribute between 7 percent and 9 percent of their salary to their pension, Stockton actually agreed to pay workers’ contributions for them.10 To top it all off, Stockton rolled the dice in 2007 on pension-obligation bonds, borrowing $125 million in the bond market only to lose $25 million in the stock-market crash. When the real-estate market crashed too—the average Stockton home price fell 58 percent between 2006 and 2011—the city simply could not reduce spending fast enough to pay its bills. By the time it filed for bankruptcy, Stockton had already cut staff 25 percent in its police department and 30 percent in its fire department.11 Stockton now has the tenth-highest rate of violent crime in the country, according to Stockton city manager Bob Deis. “We have the second-lowest police staffing levels in the country for a large city,” Deis wrote in a Wall Street Journal op-ed, “and often Stockton Police can respond only to ‘in-progress’ crimes.”12

  The city is now locked in an expensive legal battle—as of September 2012, Stockton had spent $4.9 million on lawyers—with two bond-insurance companies that want Stockton to suspend all payments into the CalPERS state-employee pension system and redirect those monies toward bond repayment. The city won a court battle with public-employee unions that objected to the city’s postbankruptcy decision to cut all health benefits to retirees while it reorganizes. Says Deis: “We are trying to be responsible in dealing with our creditors, but in the process we cannot destroy a community and its hope for the future.”13

  July 2012: Mammoth Lakes, California

  The city of Mammoth Lakes decided to seek Chapter 9 bankruptcy protection after losing a $43 million lawsuit against a real-estate developer, Mammoth Lakes Land Acquisition. The tourist town backed out of the agreement once it realized that the development would thwart city plans to lengthen a runway at the local airport in order to accommodate larger commercial jets. The developer sued the town for breaching the development agreement that was supposed to allow the company to build homes, airplane hangars, and other commercial buildings near the Mammoth Yosemite Airport. The judgment totaled nearly three times the Mammoth Lakes annual budget, a budget already $2.8 million in the red for fiscal year 2011–12.14

  July 2012: San Bernardino, California

  A story not unlike Stockton’s, San Bernardino’s bankruptcy stemmed from budgetary mismanagement coupled with rising pension and debt costs. Despite having trimmed its public workforce by 20 percent since 2008, San Bernardino faced escalating budgetary pressures due to rising costs associated with the city’s union contracts. Facing a $46 million budget gap and $157 million in unfunded pension and health-care obligations, San Bernardino filed for Chapter 9 protection in July 2012. City Attorney James Penman defended the mayor and city council, claiming budget officials had falsified fiscal reports, hiding deficits over a sixteen-year period.15

  In the cases of both Stockton and San Bernardino, the housing boom encouraged politicians to grant excessive pay and benefits to employees and the bust made those pay and benefit increases untenable. Other municipalities in California are flirting with Chapter 9 bankruptcy as rising pension and health-care costs are beginning to push them over the edge. Atwater, a small California city facing a $3 million deficit, recently declared a “fiscal emergency.” (Under California law, before cities can declare bankruptcy they must declare a fiscal emergency and agree to mediation with creditors.) Other municipalities facing mammoth budget deficits include Chicago ($298 million), Los Angeles ($216 million), and the School District of Philadelphia ($218 million).16

  When a municipality such as Stockton or San Bernardino declares bankruptcy, the lar
gest and first-in-line creditors are state pension funds (though pensions’ first-in-line status is now being challenged by Stockton’s bond insurers). The irony of course is that it is the retiree obligations that forced these communities into bankruptcy. When San Jose residents voted to cut pension benefits in order to preserve basic social services, the city set a precedent that will be closely watched by other municipalities looking for a way out. Stockton is another potential precedent setter, as it is trying to use Chapter 9 to force bondholders to accept not only less interest but also a reduction in principal. Stockton is the first American city to try this since the 1930s, and what’s so scary to those in the municipal-bond community is that market insiders said something like this simply just couldn’t happen. Well, it’s happening.

  There’s no right or wrong in all this. A government worker rightly feels entitled to the pension and benefits he or she was promised. A taxpayer rightly feels entitled to the essential social services like quality education, safe streets, clean water, and all the other things his tax dollars are supposed to support. The bondholder certainly believes he has the right to be paid back principal and interest in exchange for the municipality’s borrowing his investment dollars. It almost doesn’t matter whose claim is most worthy. Just as the private sector eventually realized that businesses could not survive unless radical changes were made to their retirement programs, the public sector is now slowly coming to the same conclusion. Once a state chooses to reform its pension plans, great improvements in fiscal health can be achieved. But the longer states wait to make changes, the greater risk there is that states will run out of money to pay their pensioners. There are a few basic ways to reform pensions, many of which have already been tested by states like Rhode Island. In 2012 Rhode Island took its funded-pension ratio from 48 percent to over 60 percent, reduced its unfunded liability by roughly $3 billion, and thereby saved the state over $4 billion over the next twenty years.17 Reforms were made with bipartisan support because both Democrats and Republicans understood that in order to save funding for public services, the state needed concessions from unions on pensions and cost-of-living adjustments for both current and future retirees. Rhode Island is a great success story, and more cities and states are following its lead.

  Chapter 10

  The Way Forward

  Back in December 2010 I was pilloried in the financial press when I went on 60 Minutes and warned that there would be fifty to a hundred large municipal-bond defaults. A producer for the CBS news show had been hounding me for weeks, begging me to appear in a segment about the looming state and municipal budget crisis. Steve Kroft had already interviewed New Jersey governor Chris Christie and Illinois state comptroller Dan Hynes, and despite some initial misgivings, I agreed to speak with Kroft about all that was at stake economically. It was a wide-ranging interview. When he asked about municipal-bond defaults, I told him that they were coming and that investors would be wise to ignore conventional wisdom. “When individual investors look to people that are supposed to know better,” I told Kroft, “they’re patted on the head and told, ‘It’s not something you need to worry about.’ It’ll be something to worry about within the next twelve months.”1

  Muni bond defaults did increase 400 percent in 2011, to $25 billion from $5 billion in 2010, according to the Distressed Debt Securities newsletter.2 But for the record, I never said those fifty to a hundred defaults would all happen in 2011, which was how my critics spun the story. Kroft had not even asked me for a time frame. He wanted to tell the story of the state and local budget crisis, and what I told him was that the crisis would become a big deal—“something to worry about”—within twelve months.

  Twelve months after the 60 Minutes story aired, I wasn’t the only one worrying. A headline from the December 20, 2010, issue of Businessweek blared: “New Govs Take Office Amid Historic Budget Crisis.”3 Time Magazine, January 20, 2011: “Can Drastic Measures Save the Cash-Strapped States?”4 Associated Press, January 15, 2011: “Year Ahead Looms as Toughest Yet for State Budgets.”5 Bloomberg News, January 19, 2011: “U.S. Mayors Say City Bond Defaults Likely Amid Strain.”6 A January 10, 2011 National Journal story asked, “Is [California’s] budget crisis even solvable?”7 In December 2012 Detroit became the latest city to flirt with bankruptcy. Given the scope of Detroit’s fiscal problems—a $327 million deficit and $12 billion in accumulated debt8—the city’s best hope is probably a state takeover and the appointment of an emergency manager. “It is likely the only option to avoid bankruptcy, as the city’s expenses continue to outpace revenue,” city council president Gary Brown wrote in an e-mail to constituents.9

  The truth is, more municipalities are debating whether to follow the lead of Stockton, Mammoth Lakes, and San Bernardino and simply walk away from their financial debts in favor of maintaining police, firefighters, low student-to-teacher ratios, and the like. These are tough questions. How bad does it have to get for voters to stand up against the diminished public services they’re getting for their hard-earned tax dollars? When do people say “no more” to skyrocketing crime rates because the police force had to be cut in order to afford a retired chief’s $200,000-a-year pension? How long before taxpayers refuse to honor their obligations to the bond investors who loaned their communities money? At what point do Americans turn against their own teachers, police officers, and other public servants, arguing that an employee’s negotiated right to a generous pension simply cannot take precedence over safe streets or a child’s right to a quality education?

  For some, defaulting may turn out to be the least bad option. It’s not unlike what happened in the housing market, when underwater homeowners dropped mortgage payments from the top to the bottom of their bill-paying priority list. Municipal bankruptcies, writes Michael Corkery of the Wall Street Journal, “are reminiscent of the strategic defaults seen during the financial crisis when many homeowners, overwhelmed with spiraling debts, mailed house keys to lenders and stopped paying their mortgages—a trend know as ‘jingle mail.’” The stigmas that once surrounded mortgage default and now municipal bankruptcy have faded. Even the rating agencies acknowledge they might have to change how they evaluate default risk for muni bonds. As the chief credit officer for public-sector ratings at Moody’s said, “As the stigma around bankruptcy erodes, we are revisiting our long held assumption about the willingness of some cities to repay debt.”10

  Truth be told, that willingness was always in doubt. In 1994 Orange County became the largest municipal bankruptcy in U.S. history, and anyone who followed the Orange County story knew how little obligation voters felt toward general-obligation bondholders. Before the state stepped in with its bailout, James Lebenthal—founder of New York muni-bond firm Lebenthal & Co.—took a film crew with him to Orange County to interview locals about their perceived obligations to investors. Lebenthal said afterward that he was “distressed” to discover that most Orange County residents felt no moral obligation to approve a sales-tax hike in order to repay what was owed on the county’s debt. “I don’t know who will make up the deficit,” one woman told Lebenthal, “but I really don’t think it should be the citizens.”11

  Defaults and bankruptcies are important stories, but they remain mere symptoms of and sideshows to something much bigger and more important. A geographic sea change is occurring in the United States, with economic power shifting away from longtime coastal strongholds—states still hung over from the housing bust—and toward the more “fiscally attractive” central corridor. These so-called flyover states contributed 25 percent of U.S. GDP in 2011, up from 23 percent in 1999. A two-percentage-point increase may not sound like a lot, but it’s huge—$300 billion in GDP.12

  With such a large head start in the recovery, the central corridor should continue to drive the U.S. economy for years and even decades to come. Some of this has to do with the commodities boom and the fact that these states are embracing energy production at a time when states like California and New York are saying no. In fact, fol
ks in other parts of the world would be glad if more U.S. states followed New York and California’s lead. “We Europeans are currently paying up to four or five times more for natural gas than the Americans,” said Harald Schwager, an executive board member for European chemical maker BASF. “Of course, that means increased competition for all the European manufacturing sites.” BASF’s solution: Invest more in the United States.13

  Along with cheap energy, the central corridor is benefiting from the boom in agriculture. And while agriculture has historically been quite cyclical, demand for U.S. crops is stronger than ever. And more global too. Urbanization, modernization, and population growth in the third world have dramatically increased global food demand. In order to meet demand, U.S. grain exports are expected to increase 28 percent by 2021, according to the U.S. Department of Agriculture.14 The economic impact back home is already significant, as corn prices have soared from two dollars to seven dollars a bushel since 2006. A report from the Chicago Federal Reserve in August 2012 showed a 15 percent increase in farmland prices over the prior twelve months across Iowa, Illinois, Indiana, Wisconsin, and Michigan. A similar report from the Kansas City Fed showed a 26 percent gain. While agriculture these days employs a lot fewer people today than it did a hundred or even fifty years ago, higher land values do enrich communities and bolster consumer spending. “I’ll probably upgrade a couple tractors myself,” Minnesota farmer Gerald Tumbleson said back in 2007, when the corn boom first started to take off. “I’ll use a little more fertilizer this year too.”15 No wonder spending growth tracks 30 percent higher in the central corridor versus the coasts. Higher land prices and more consumer spending are good for state and local tax receipts too. It’s a virtuous circle: More jobs, more spending, and more housing demand beget a larger tax base and better public services—which attracts new jobs and pushes home prices ever higher.