The Credit Crisis and the States: Only Getting Worse

I think I need a drink.

Yesterday at TPC, a panel of experts looked at what the credit mess means for state and local governments. The answer is: Nothing good. I felt like I was watching the final minutes of the Super Bowl with a room full of New England Patriots fans.

A big part of the problem, the panelists agreed, is that cities, states, and counties are getting whipsawed by the shaky bond market in some surprising ways.

The basic issue is pretty straight-forward. The mortgage meltdown is driving down housing values, which in turn are slashing real estate-related revenues —a major source of income for local government. Not only are property taxes sagging, so are transaction fees, which Chris Hoene of the National League of Cities points out is another big money-maker for local government. The evidence is the housing decline is nowhere near bottom, and since property tax revenues lag changes in values, it might be years before those revenues turn back up.

To make matters worse, many local governments are spending a fortune trying to maintain foreclosed, empty houses.

States have their own problems. Not only is the economic slowdown squeezing tax revenues, but their options for balancing budgets (which they are required to do by law) are far more limited today than in past recessions. In the 2001 slump, states could cut aid to cities and counties, which remained relatively flush since house prices–and property taxes–stayed strong.

Seven years ago, states also borrowed their way out. As my TPC colleague Kim Rueben points out, in the wake of Enron’s collapse, investors were frantically looking for high-quality paper, and munis provided it. Even foreign buyers flocked to tax-free bonds, although they had no use for the tax-exemption.

This time, it is very different. Buyers are fleeing munis, even though yields exceed that of taxable Treasuries. Part of the problem is the meltdown of bond insurers (for reasons unrelated to the muni debt they are insuring).

There may be fundamental reasons for the nervousness of bond buyers, as well. High real estate assessments in the face of falling prices are renewing talk of property tax caps. That could constrain revenues for years after the housing market recovers, making it harder for local governments to repay bonds.

Equally troubling, the credit market crisis threatens state and local government investments. Plummeting interest rates are slashing yields on their short-term debt. Worse, some states, including Florida, have gotten hammered on their own investments of subprime paper and it would not be surprising if others take big losses as well. Given that many states have pension liabilities for their public employees that far exceed their assets, big bond market losses in their retirement funds could turn a problem into a catastrophe. It is, in short, not a pretty picture.