NFMAMAGNY Symposium Municipal Fiscal Stress Bankruptcy and Pensions

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NFMA/MAGNY Symposium Municipal Fiscal Stress, Bankruptcy and Pensions David Nowakowski – Director, Credit Strategy

NFMA/MAGNY Symposium Municipal Fiscal Stress, Bankruptcy and Pensions David Nowakowski – Director, Credit Strategy April, 2011 Read RGE’s full report: “States of Despair Part 1: Muni Stress—Past, Present and Future” By David Nowakowski and Prajakta Bhide, Feb, 2011 1

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Roubini Global Economics To start a free trial or for more information – [email protected] com www. roubini. com [email protected] com Tel: 212. 645. 0010 | [email protected] com / [email protected] com Tel: +44 (0) 207 420 2800 2

U. S. Consumption and Output Source: Tim Duy at http: //www. roubini. com/us-monitor/259995/will_the_fed_scale_up_qe 2

U. S. Consumption and Output Source: Tim Duy at http: //www. roubini. com/us-monitor/259995/will_the_fed_scale_up_qe 2 • The financial crisis has resulted in a “balance-sheet recession” • The recession may be over, but the damage will take the better part of a decade to heal • Zero interest rates (QE + ZIRP), massive fiscal stimulus, global imbalances and bigger-than-ever too-big-to-fail banks will need exit strategies. Is there a plan? 3

Fiscal Controls Have Been Poor Spending has far outpaced revenues 4

Fiscal Controls Have Been Poor Spending has far outpaced revenues 4

Fiscal Problems Are Bad, Will Get Far Worse Annual Average Open Interest (futures and

Fiscal Problems Are Bad, Will Get Far Worse Annual Average Open Interest (futures and options combined) • The recession left a big hole in state and local government finances. • Cyclical improvement underway, and budget gaps were handled (mainly with one-off measures). • Structural problems are demographics, chronic revenue/spending imbalances, and the state “entitlements”: pensions and other benefits. • This will result in massive spending pressure, leading to deficits. 5

Debt Growth Will Lead To Insolvency If Not Tackled State and Local Governments Will

Debt Growth Will Lead To Insolvency If Not Tackled State and Local Governments Will Be Bad, Uncle Sam Worse • • • Given current range of revenues, Debt/GSP of > 50% is probably unsustainable Unlike 2008 -10, Washington will be less able (and eventually unable/unwilling) to help We won’t get to the right-hand side: there will either be a crisis, or a solution 6

Muni’s Hardly Default? Oh Yes, They Do! Source: RGE, Hempel (1964, 1971) • Unlike

Muni’s Hardly Default? Oh Yes, They Do! Source: RGE, Hempel (1964, 1971) • Unlike U. S. Treasuries, State and Local governments have a long history of going bust • The worst episode saw a quarter of the market go bust, with abysmal recovery values • However, the bigger picture that emerges is an ability to withstand severe economic shocks, with investors made whole in a large number of cases 7

Revenues Recover Slowly, Transfers Turned Off Debt/GSP is small compared to Sovereign Debt Problems;

Revenues Recover Slowly, Transfers Turned Off Debt/GSP is small compared to Sovereign Debt Problems; Deficits < 1% of GDP State and Local debt levels are not exceptional in a historical context Higher Leverage is offset by lower interest rate costs (thank you Alan and Ben) Federal Transfers have cushioned the blow, but 2012 -2013 will hurt States’ problems will make cities’ and counties’ finances harder too Revenue bonds are a large part of total debt. Usually riskier, these may now be safer if they are ringfenced from cyclical forces 8

Revenues Recover Slowly Most Sources of Revenue Held Up, But Cyclical Nature Of Revenues

Revenues Recover Slowly Most Sources of Revenue Held Up, But Cyclical Nature Of Revenues Is Evident % Change, Y/Y • Property Taxes may (finally) decline in 2011 • Income and Sales taxes are rebounding • Increase in poverty and unemployment, combined with demographics mean that spending needs rose • Balanced Budget Laws meant that, absent fiscal transfers, State and Local governments acted like “ 50 Little Hoovers” 9

Pension Funds and Other Benefits “States shortchanged their pension funds in good times and

Pension Funds and Other Benefits “States shortchanged their pension funds in good times and bad” – Pew Center Study 10

Pension Funds and Other Benefits When is a trillion not a trillion? As an

Pension Funds and Other Benefits When is a trillion not a trillion? As an illustration, assume 40 years of payments grow at 4% per year, totaling US$ 16 trillion Discounted at 8% liabilities have a present value of US$ 3. 5 trillion – a $1 trillion unfunded gap Discounted at 30 -y UST rate of 4. 5%, the burden becomes $6 trillion $3. 5 trillion unfunded! If local government and utility liabilities are added, and new retirees or employees continue to earn benefits, the totals will be higher still Will the pension assets’ return on investment be 8% in a New Normal environment? 11

State Debt Metrics – Nowhere Near “EM levels” Most Sources of Revenue Held Up,

State Debt Metrics – Nowhere Near “EM levels” Most Sources of Revenue Held Up, But Cyclical Nature Of Revenues Is Evident • • • State and Local budget gaps are serious, but debt levels and interest service are nowhere near unmanageable levels Incentive to default is low The problem is the will to raise taxes and cut spending in the face of high unemployment and voter resistance RGE’s view is that some delay is warranted, but longer-term the choice is clear: reform or crisis It’s not just Detroit: Atlanta, Phoenix, Denver, Chicago, Portland, Dallas also show signs of strained finances 12

Debt and Fiscal Metrics: “No Greece In America’s Engine” The Eurozone’s solvency problems are

Debt and Fiscal Metrics: “No Greece In America’s Engine” The Eurozone’s solvency problems are an order of magnitude larger than State and Local fiscal issues 13

Credit Fundamentals: Governments Trump Corporates Though ratings agencies have been known to be wrong

Credit Fundamentals: Governments Trump Corporates Though ratings agencies have been known to be wrong before…. Source: Moody’s (used with permission) • Muni ratings centered around A, while most corporates BBB; States are mostly Aa-Aaa • HY ratings for corporates result of competition, buybacks, LBOs, risk of bankruptcy and liquidation; munis don’t take such risks and raise revenues “at will” • However, certain muni sectors are much more like corporates

A New Paradigm – What To Expect For Muni Defaults? RGE’s View: In a

A New Paradigm – What To Expect For Muni Defaults? RGE’s View: In a more strained environment the muni market will not return to its past state • The long period of leverage is closing; de-leveraging happens partly through defaults • Predicting defaults by looking at recent history is useless. The current picture is deteriorating as well, even as the cyclical indicators are picking up. Looking at non-muni sectors to gauge what will happen: • Over a 5 -year period, 1% of IG bonds and 20+% of junk bonds usually default • Applying those to the $3+ trillion municipal bond market translates to $100 bn in defaults through 2015. That is a small number! • Losses would likely be further limited by high recovery values (80% for most), both on fundamental strength of credit and assets, as well as superior legal protection • Overall credit metrics are not strained, so cascading defaults unlikely (for a while). Another recession, before we’re even out of the previous one, could be a different story. • Household and mutual fund ownership is dominant (67%) low leverage and not likely to cause contagion to financial system. But economic problems, and effects of austerity are underestimated. • Tail risks need to be priced in, and muni investors need to stop relying on monoline guarantees and history of 0. 1% default rates. That said, at present this sector is CHEAP!

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