Local Governments on the Local Governments on the Brink?Brink?

Rick MattoonSenior Economist and Economic AdvisorFederal Reserve Bank of Chicago

Economic Development in Rural WisconsinOctober 26-27Wausau, WI

Presentation outlinePresentation outlineIssues and trends facing local

governmentsIssues in credit markets

This time was differentThis time was differentContext—the 2001 recession put state

governments under significant stress, however the nature of the recession (the tech bubble) had money being reallocated from tech to real estate.

The ensuing increase in property values and boom in new development helped property tax oriented municipalities. Many municipalities also create impact fees and other development related taxes to further capture the gains from the real estate boom.

This time was differentThis time was differentThis recession has seen deep adjustments in

property values. The question is does this translate into declining property tax collections?

Why does this matter? Property tax is still the largest source of local revenues and historically has been a predictable and growing base. However since the 1970s tax revolts, other revenue sources, particularly fees have grown in importance. Also in some states locals can have sales taxes and income taxes. Lots of heterogeneity in local tax bases

For farm areas…the opposite problem…rising farm land values although might not translate into revenues if special exemptions and treatment are common

5

Home Building And PricesSingle Family Housing Market (millions of units, annual rate)

Home Price Indexes (Q1-2000=100)

PermitsStarts

Aug-2011

Case-Shiller Composite 20 Price IndexFHFA Purchase Only Price IndexLoan Performance Home Price Index

Jun-2011

The adjustment processThe adjustment processIt isn’t fast. Lots of communities use

moving averages or irregular assessment cycles for calibrating taxable values. Leads to confusion…the market value of my house is X but the assessed value is Y.

Some communities can simply adjust the tax rate to adjust for the declining value

If this isn’t possible, eventually revenues will decline. For example, the National League of Cities 2010 survey reported an expected decline of 1.8% in property tax collections after years of gains

National League of Cities National League of Cities 20112011

How are they coping?How are they coping?Personnel cutsDelaying/canceling infrastructureCutting basic servicesDrawing down reserves, not much on the

revenue side other than some fee increases

Biggest wildcard…state aid—in Wisconsin, 2011-13 budget cuts direct state aid by 7% ($48 million) and categorical aid by $136 million

Spending pressures include public safety and infrastructure costs, employee related healthcare costs, pensions

How are they coping…reserves are How are they coping…reserves are significant and could act as a buffersignificant and could act as a buffer(ending balances as a percentage of expenditures, NLC)(ending balances as a percentage of expenditures, NLC)

What else might they do?What else might they do? Never waste a crisis Michael Pagano, Dean UIC School of Public

Administration◦ Reform tax structure—link tax base to the

underlying engines of economic growth—particularly taxes on income and wages

◦ Broaden sales tax base to reflect consumers tastes for consuming services

◦ Restructure property tax particularly to reflect growing number of tax-exempt properties. Non-profits consume city services

◦ Consider regional tax authority—minimizes border wars and some services might be better provided at a regional level

◦ Using pricing more effectively—fees should reflect cost of services

What about muni-bond What about muni-bond market and debt issuancemarket and debt issuance2 schools of thought—Armageddon

vs a tempest in a teapotMeredith Whitney—defaults will be in

the hundreds of billions. Even Nouriel Roubini expects elevated (but not systemic) problems with defaults of $100 billion over the next five years

As a benchmark, S & P muni bond index ($1.27 trillion in debt) reported $2.65 billion in defaults in 2010 and $2.9 billion in 2009.

The Tempest in the Teapot The Tempest in the Teapot SchoolSchoolHistoric performance suggests defaults are rare

(600 bankruptcy filings since the Great Depression) and even when they occur bond holder recovery has been above 80%, much better than private sector

Most of the defaults are in no-rated issues and tend to be single-purpose governments—sewer systems, housing projects, etc.

Lots of legal protections and state interventions to prevent either a default or a Chapter 9 filing

Stigma of filing is high and this alone helps prevent filings

Debt levels as a percentage of expenditures aren’t that exaggerated and the term of debt issuance seems matched to the life of the bonds.

Further evidenceFurther evidence Much of the poor performance of the muni market at the end

of 2010 and into 2011 is because of reasons other than a change in the underlying credit-worthiness of issuers.

Examples◦ BABs (Build America Bonds) flooded the market at the end

of the year…might have overloaded the market for muni bonds even if these are taxable

◦ Extension of Bush tax cuts—less need for wealthy to shelter income

◦ Rally in equity markets—repositioning portfolios◦ Still able to issue…just at higher costs…Illinois Pension

bonds ($3.7 billion in March) high rate (ranging from 4.96% for five year maturities to 5.877% for bonds maturing in 2019). This was estimated at almost 2 full points above market for A1 issuers. This was also above the interest rate offered on last years’ pension bond offering of $3.47 billion at 4.42% (five year maturities).

◦ End of mono-line insurers

Finally, the muni market rallied even after the S & P downgrade of the U.S.

What might change this What might change this picture?picture?The dreaded off-balance sheet liabilities

◦ Pensions and OPEB◦ Rating agencies might start treating this as a

binding obligation of the government so governments with large unfunded liabilities might get taken to task

◦ Reported liabilities are probably understated (Novy-Marx and Rauh). GASB rules allow for unrealistic discount rate

◦ Path to full funding is very difficult, according to N-M and R, Wisconsin’s real liability is $56.2 billion which represents 3.7 years of state revenue. Milwaukee’s unfunded liability ($3.4 billion) works out to $14,853 per city household. (Good news Chicago’s is $41,966)

◦ OPEB is even worse…pay as you go for the most part

ConclusionConclusionMunicipal finances are under

significant stress, particularly for property tax reliant towns.

Other forms of aid from state or feds seem unlikely

Slow climb out for housing market will keep the pressure on for a while

Special risks will be pension and OPEB funding, federal tax reform such as capping the deduction for home mortgages