Thursday, December 1, 2011

First Greece, then California?

We know that Greece is in trouble. But what of California? It too is a sovereign entity within a monetary union. Chapter 9 bankruptcy, the provision that covers local governmental entities, is not available for state governments; under the US Constitution they fall outside the jurisdiction of such Federal legislation. And it's large -- 12% of the US economy, much larger than Greece is within the EU. So it may be Too Big To Fail -- perhaps we need to create the term "SIPEs" for "Systemically Important Political Entities" (cf. SIFI).

We would first need basic data. I've outlined what I know and what I think we need to know below. This is a work in progress, so will read choppily until such time as I rewrite in one sitting from beginning to end. Oh, and conclusions are at the very bottom.

1. What is the total volume of California bonds "at risk"?
State finances are potentially complex -- there can be taxes that are legally earmarked for the repayment of specific bonds, e.g. highway bonds matched against gasoline taxes all covering highway maintenance separate from the general budget. So the first approximation would be General Obligation Bonds (or their equivalent), that are backed only by the full faith and credit of the state government.
  • A quick google search suggests that about $80 billion are outstanding. (See "Seeking Alpha" from January 2010; the California State Treasurer gives the December 2011 General Obligation Bond total as $72 billion.) If so, then the amounts are really pretty small: with the GDP of California at about $1.8 trillion, it comes to 4% of state GDP, while Greece's (gross) debt is 116% of GDP.
  • In addition the state has contingent liabilities. The big item is likely unfunded pension obligations, rumored at about $500 billion. If we use $600 billion as a total, then debt is 1/3rd of GDP. But it's not clear that the bond market factors that in, since the need to lay out cash is down the road and the amount fluctuates with the stock market.
  • On 30 November 30 year Treasuries had a yield while California bonds of roughly the same maturity traded at 4.5% according to, or nearly a 2% premium despite their more favorable tax status -- indeed, for someone in the top income tax bracket, that would be the same as 7.6% on a US Treasury bond, a very stiff premium.
2. Who holds these bonds? Are they held by individuals who for various reasons might have a hard time "dumping" them? For example CALPERS, the state pension fund and the world's largest institutional investor, may hold so many bonds that it is unrealistic to think that they would "dump" them and be forced to book a loss. Or bond holders might be widely dispersed and typically hold only a few. In the former case, this would mute any crisis.
  • My hunch is that debt however is in fact widely held, albeit almost entirely within the state of California because state debt is tax exempt and marketed within states, for example there are mutual funds restricted to California bonds. Furthermore, it is likely held by a combination of individuals and pension funds, not banks (licensed or shadow) and so would not have some of the spillover observed with sovereign debt in the EU.
3. What is the maturity of the debt? In general, the government will refinance debt by rolling it over when it comes due. So a crisis could be accentuated if there is a current deficit that would have been debt financed, and maturing debt that would have been rolled over. More generally, a non-crisis gradual increase in borrowing costs to match perceived risk only affects new debt; the longer the average maturity, the longer it takes for an increase in interest rates to increase the average interest rate on state debt and hence the share of tax revenues needed just to pay interest.
  • I have no information though the unfunded pension liabilities are long-term so my hunch is that only $20 billion is short-term -- a drop in the bucket in US financial markets, even in their current stressed state (or should that be "states currently stressed"?). But that's not so small relative to general revenues in California, which I think are on the order of $75 billion.
  • Floating rate debt accentuates the impact any any short-run issues. Ditto bank loans. In January 2010 (Seeking Alpha) there was $5.5 billion in floating rate notes and $6 billion in bank loans. So at that point it was over 10% of all general state debt. 
4. What of other debt? -- there is likely seasonality in tax receipts and (perhaps less so) in expenditures. How is that financed? -- bank loans? The private sector analog is "working capital".
  • See above -- old data. So I don't know.
5. To what extent is California an "open" economy? -- the greater the share of trade, the smaller an impact a decline in expenditures would have.
  • I'm sure California is more "open" than Greece, in that it has never been an independent nation. However it is large and physically remote from the rest of the US economy so the short-run multiplier might be pretty big.
  • Greece is small, with a population of 11 million, while California has 37 million.
6. How large is the government? Again, parts of the government may be funded by taxes that can't be tapped to cover general budget items -- a debt crisis might not affect those areas at all.
CA state-level GDP is about $1.8 trillion, state and local government is about $0.2 trillion or about 11% of the economy. However there is no breakdown for the state government vs local governments. Furthermore it is not clear whether transfer payments are included (normally they would not be) and how these are handled within the state fiscal system.
  • My recollection from a year or so ago is that current expenditures at the state level are about $100 billion, but that the budget was not unified and reporters in Sacramento felt that no one really had a comprehensive grasp, certainly not those in the state legislature. But this means that the state government only accounts for 5% or so of the economy.
  • In contrast, for Greece we are talking about the central government, which has total expenditures of 47% of the economy and an overall budget shortfall of roughly 8% of GDP. That is very different in scale from a state government in the US, even if we lump city and country governments and the many semi-independent school, water, sewage, transit, port and other units in with the state.
7. How interrelated is government? To what extent would a debt crisis at the state level impede the operations of local government, which probably employs far more people? Most state governments transfer significant amounts of funds to local governments, particularly in support of public education. Is that the case for California?
  • My guess is that the state directly employs relatively few people, indirectly many. In normal times local school systems might have the ability to tide over a temporary shortfall in funds. I very much doubt that's true now.
  • However, under the California constitution education has seniority over debt service; it may be therefore that if crunch turns into default, in the first instance bondholders would be left holding the bag, not state employees. In the second instance, I suspect that the axe would fall on a great many, and that education would be affected through indirect channels.
8. Would Federal-level "automatic stabilizers" mute the impact?
  • My hunch is that state employees fall outside the unemployment insurance and pension guarantee systems. Furthermore, unless I'm mistaken unemployment insurance, medicaid and various other social safety nets are actually administered by, and operate in part with funds from, the state level. So they could suffer from spillover effects that would magnify the more narrow state government component.
9. What of contagion?
  • I think it quite realistic to think that local governments would have a hard time issuing bonds, even if they themselves are fiscally sound. After all, potential purchasers can always purchase Treasuries if they want long-term bonds, though for tax reasons they are imperfect substitutes. (Interest income on state obligations is not subject to either state or Federal income taxes, whereas Federal bonds typically are exempt from state taxes but not Federal taxes.)
10. What of contagion?
  • If California runs into trouble, then surely Illinois also would. And local governments therein (Chicago?). Sipes! (Structurally important political entities!)
11. How big an adjustment?
  • At least one mitigating factor is that the numbers I know are smallish. A current budget shortfall of $25 billion is 1.4% of California's GDP. Add in pension shortfalls of $500 billion and (spread over several years) we get a rather bigger number, but one that is still far below the 8% structural deficit in Greece. Of course this is in the context of a continuing recession and a continuing drop in real estate prices and high level of foreclosures that may mean revenues will continue to fall rather than stabilize.
  • Furthermore, the political system is byzantine, not Greek. Because of the referenda system, the legislature has limited powers; it could take a long while to change the state constitution, even if the will is there, because of the mechanics involved.
12. Should we worry?
  • I can't answer that question. But I don't think it can be brushed aside -- though Dani Rodrik concludes that in a November 2011 blog post. Part of the answer would be whether there is any trigger. What is clear is that the underlying structure is not fiscally sustainable. Will it however generate a "crisis"? Or a slow increase in interest rates on state debt and other pressures that will lead to a non-traumatic resolution? I certainly hope the latter, but wonder whether that is politically realistic. After all, the potential for Europe's current problems was fairly clear before the Euro was launched -- Martin Wolf of the Financial Times wrote about it in the early 1990s.
  • Nevertheless, the numbers above seem pretty small, under $100 billion, not factoring in cities, counties, school districts and other bond issuers within the state that may well be tarred and feathered by what goes on in Sacramento. If a crisis developed, but were limited to California -- a big if -- then it would not be big enough to affect the US as a whole.
  • In the late 1970s, before heading off to graduate school, I worked on Wall Street on Eurodollar syndicate loans to Latin America, and served as a representative of Japanese banks to the IMF organized restructuring of Jamaica's debt in 1980. (I didn't stick around to be part of the team for Brazil and other borrowers.) That was horrific in its impact on the average Jamaican, and the economy has never fully recovered. But a default by a US state would be quite different; once Jamaica began running out of US dollars, importing food and oil became problematic, as no foreign party would accept Jamaican currency. That issue would not be relevant for a subnational entity (and is not relevant in the EU -- incomes in Greece may have fallen, but if someone has a job, the euros they earn have held their value). It's important to keep that limit on the downside in mind, for Greece and for California.

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