The Next Big Risk to Economic Recovery: State and Local Government Bankruptcies
Will governmental units be the next group to face mass-bankruptcy?
As the economy continues to show no signs of recovery by any meaningful measurement, the financial meltdown and the mortgage foreclosure crisis is now impacting our governmental units at all levels, particularly the local levels, which also includes public school districts.
To understand this situation, it is important to understand how most municipal units are funded. Cities, counties, townships and public school districts rely on the taxable value of the real estate in their communities for their primary source of revenue. This is executed through the form of a millage, and each parcel of property is taxed based on the millage rate. When economic times are good, signified by vibrant real estate markets (both residential and commercial), governmental units perform well because their revenue stream is intact, and it typically grows each year.
However, most governmental units pay a premium for its labor force, typified by collective bargaining agreements, defined benefit pension plans, and health care plans whose costs are rising at a rate double that for inflation. Most companies, whether public or privately held, have been well on their way to increasing efficiencies and cutting costs in an effort to remain competitive in the new global economy. Municipal units, on the other hand, don’t have the same pressures as companies do, as their business is based on providing services for its residents. Up until recently, the 20th century-based HR costs of a municipality were sustainable, as tax bases were stable and members of each community were at near full employment.
Then, three things happened: 1) the automotive industry collapsed in the United States, resulting in the loss of millions of jobs in its supply chain; 2) the Fannie Mae/Freddie Mac crisis occurred (but was not addressed in a meaningful way); and 3) massive job losses led to the highest home mortgage foreclosure rate in our history.
Why are these events relevant to municipal governments? Most of their operating revenue is derived from property taxes. As homes go into foreclosure, their value plummets, dragging down the taxable valuation of a community. Second, now these units must figure out how to operate with a massive decrease in revenue (10-30%), without the taxing power to raise more revenue (many units are in a structural budgetary imbalance). This begs the question as to what city services should be cut to balance the budget? The rating agencies are watching closely, as most of the units are limited by statute as to what they can do to balance their budgets. Certainly, the uncompetitive human resources compensation model of most governmental unions (very similar to that of the UAW) is unsustainable, as the tax base cannot support huge, unfunded mandates in the future.
The savvy governmental units will be the ones who convert their HR and pension cost to a more realistic cafeteria-based defined contribution plan, combine services offerings with neighboring communities to share costs, partner with various neighborhood groups for parks and recreation activities, and find new ways to generate the revenue necessary to provide essential services.
Glenn Watson is a Free Vector Advisor specializing in public and municipal finance, representing state and local government entities. Email Glenn at glenn@freevectoradvisors.com.
