Financial Crisis: Who will Bailout the State and Local Governments?

The continual Illinois corruption scandals have created not only ignominy to the Land of Lincoln, but have now placed a negative ranking from Standard and Poor on its credit. If Illinois vies with other states for the title of most corrupt, it has plenty of company when it comes to financial disaster.

Although building for years, the impending collapse of state and municipal finance has been hastened by the growing financial crisis. The year 2008 will go down as one of the most turbulent years in the history of financial markets. Long established companies such as Lehman Brothers, Fannie Mae, Freddie Mac, and Citigroup have imploded. Large retailers like Circuit City have already filed for bankruptcy and, without federal help, huge companies like General Motors will join the parade.

Yet with all the turbulence in the private economy, there has been much less media attention on the coming bankruptcy of some municipalities and perhaps even some states. Many of us are taught in college finance classes that the yield on municipal bonds always has to be lower than U.S. Treasury securities, largely due to their exemption from federal income taxation. This normal pricing of municipal bonds no longer exists. Municipal bond yields, the last couple of months, are consistently higher than U.S. Treasuries. This tells us that the credit markets perceive great risk in lending to America's cities. The perceived ability to pay back principal is now the operating rule in the credit markets.

As of this writing, Triple-A rated, Tax-Exempt General Obligation Bonds are yielding over 5% while the 30 Year Treasury Bond yields around 3%.This suggests that many communities and some states as well may be in distinct danger of default.

There’s a general pattern as to where the biggest problems lie: in those states and communities where public employee unions wield all but unlimited power. This is not so much the fault of unions – the purpose of every union is to gain higher wages for its workers – but in many states and cities there is no counterforce to their influence. This becomes a vicious circle. Local politicians overpay unionized government workers who make campaign contributions and organize "get out the vote" drives to make sure the politicians keep overpaying them.

The most recent famous example is the California city of Vallejo filing for Chapter 9 bankruptcy. George Will writes:

Joseph Tanner, who became city manager after this municipality of 120,000 souls was mismanaged to the brink of bankruptcy, stands at a white board to explain the simple arithmetic that has pushed Vallejo over the brink. Its crisis -- a cash flow insufficient to cover contractual obligations -- came about because (to use figures from the 2007 fiscal year) each of the 100 firemen paid $230 a month in union dues and each of the 140 police officers paid $254 a month, giving their respective unions enormous sums to purchase a compliant City Council.

So a police captain receives $306,000 a year in pay and benefits, a police lieutenant receives $247,644, and the average for firefighters -- 21 of them earn more than $200,000, including overtime -- is $171,000. Furthermore, police and firefighters can store up unused vacation and leave time over their careers and walk away, as one of the more than 20 who recently retired did, with a $370,000 check. Last year, 292 city employees made more than $100,000. And after just five years, all police and firefighters are guaranteed lifetime health benefits.

The recent news out of the state of California is no better. The L.A. Times reports that California's budget deficit could reach $41 Billion by 2010. Can California continue to pay 3600 prison guards over $100,000 a year? It would be wrong to single out California. Many other places are on pace for financial ruin.

Massachusetts is another state where unions have hijacked the political process for the benefit of their members. Last year, The Boston Globe reported how lucrative rent-seeking can be:

Nearly one in 10 Massachusetts State Police officers made more than the governor last year, with 225 officers topping the $140,535 annual salary of the state's chief executive.Four of the 2,338 state troopers were paid more than $200,000, and 123 others were paid more than $150,000, the salary of the governor's Cabinet secretaries, according to payroll information obtained by the Globe under the state public records law.

And that brings me back to my home state of Illinois. We not only face an immediate cash flow crisis but also must confront an underfunded public pension fund deficit of more than $50 Billion, and the Blagojevich scandal has held up a needed $1.4 billion short-term bond offering. Chicago Public Radio reports the Illinois pension deficit is "larger than the state’s annual budget." There is a clause in the Illinois State Constitution that prevents any state or local government worker's pension from being cut. Will a federal bankruptcy judge have to come in and void a section of the Illinois State Constitution?

When the major credit rating agencies failed to accurately price in the risk of subprime mortgages, questions about their rating standards are now becoming quite important. If you can't trust Moody’s, Standard and Poor’s, and Fitch, what should you be looking for if you want to own municipal bonds?

In the coming years, many municipalities and state governments will need to deal with the conflict between those who pay taxes and those who consume them. Government workers' salaries come from the taxpayers: which means government workers aren't net taxpayers. Cheap and easy credit might no longer be available to help pay for overpaid government workers.

This situation can be resolved in two ways. As in a bankruptcy proceeding, states and cities can work with unions to control costs and reduce obligations. Or they can – as Wall Street and Big Three have done – come to Washington, DC to beg. Once that happens, the long-term credibility of Washington’s debt will need to rise to record levels, with implications that are almost too horrific to contemplate.

Steve Bartin is a resident of Cook County and native who blogs regularly about urban affairs at http://nalert.blogspot.com. He works in Internet sales.