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Tuesday, May 29, 2012

The Safety of State Bonds: A Historical Perspective

By Marc Joffe

The last state general obligation bond default occurred in 1933. Yet many state GOs yield significantly more than US Treasury bonds, reflecting investor fears of future defaults. While past results are no guarantee of future performance, history does offer investors valuable insights into our present situation.

As Table 1 shows, state and territorial bond defaults were relatively frequent during the 19th century.

Table 1. List of State Bond Defaults.
State
Default
Cure
Source
Notes
Alabama
c. 1870

New York Times (1930)

Arkansas
1/1841
7/1869
English (1996)
Some bonds repudiated in 1884
Arkansas
3/1/1933
1941
KBRA (2011)

Florida
1/1841
2/1842
English (1996)
Territory; Debt repudiated
Florida
c. 1870

Ratchford (1941)

Georgia
c. 1870

New York Times (1930)

Illiniois
1/1842
7/1846
English (1996)

Indiana
7/1841
7/1847
English (1996)

Louisana
2/1843
1844
English (1996)
Some bonds repudiated
Louisiana
3/1/1933
5/20/1933
KBRA (2011)
Due to failure of Hibernia Bank
Maryland
1/1842
1/1848
English (1996)

Michigan
7/1841
7/1849
English (1996)
Some bonds redeemed at 30%
Minnesota
1860

Ratchford (1941)

Mississippi
3/1841
11/1852
English (1996)
Mostly repudiated
Missouri
c. 1870

Smythe (1904)

North Carolina
c. 1870

New York Times (1930)

Pennsylvania
8/1842
2/1845
English (1996)

South Carolina
c. 1870

New York Times (1930)

South Carolina
7/15/1932

KBRA (2011)
No loss of principal or interest; maturing bonds were redeemed with new bonds rather than cash.
Tennessee
c. 1870

Ratchford (1941)

Texas
c. 1930

KBRA (2011)
Interest and principal not remitted to certain state-controlled funds; individual investors do not appear to have been impacted.
Virginia
c. 1870

Ratchford (1941)

West Virginia
c. 1870

New York Times (1930)



Sources:
English, W. B. (1996). Understanding the Costs of Sovereign Default: American State Debts in the 1840's. The American Economic Review, 86, 259-275.
Kroll Bond Rating Agency (2011). An Analysis of Historical Municipal Bond Defaults Lessons Learned – The Past as Prologue.
New York Times. Old Repudiated Debts that Stir the British. August 10, 1930. Page X12.
Ratchford, B. U. (1941). American State Debts. Durham, NC: Duke University Press.
Smythe, R. M. (1904). Obsolete American Securities and Corporations. New York: R. M. Smythe.

Most of the 19th century defaults occurred in two waves: one that followed the Panic of 1837 and the other following the Civil War. The first wave of defaults happened after a number of states made heavy investments in canals and state-chartered banks. In the deflationary years that followed the 1837 financial collapse, eight states and the territory of Florida failed to service their obligations. A recent article by Jeff Hummel provides an excellent summary of this situation, along with references for further reading.

The post-Civil War defaults were concentrated in ravaged Southern states, many of which took on substantial loads of debt under “carpetbagger” controlled governments. The carpetbaggers – northerners who came down south with their possessions wrapped in old carpets – seized control of some state governments, issued bonds and then kept much of the proceeds. When local politicians regained control of state governments, they deemed the carpetbagger-incurred debt as illegitimate and repudiated it.

Since the 19th century, all states with the exception of Vermont have implemented balanced budget requirements and other restrictions on debt issuance. As a result, state bonded indebtedness as a percentage of GDP has remained relatively low, while the national debt has skyrocketed.

During the 20th century, there was only one case in which a state bond default resulted in losses for individual investors: the Arkansas default of 1933. Arkansas got into trouble after assuming a large volume of road bonds issued by local governments during the 1920s. This heavy debt load combined with sharply decreased property tax collections (the result of falling property values during the Depression) rendered the state insolvent.

Many readers will undoubtedly be skeptical of state balanced budget requirements given the many news reports of politicians circumventing these restrictions. While elected officials do employ many gimmicks, they also impose real spending cuts and revenue enhancements when closing budget gaps. The result is some growth in debt burdens, but not nearly enough to trigger a solvency crisis. Professors Daniel Bergstresser and Randolph Cohen provide a detailed discussion of constitutional balanced budget rules, methods used to circumvent them and their overall restraining influence in a recent Harvard Business School paper.

Evaluating a Government’s Debt Burden

A government’s debt burden is often stated in terms of a Debt-to-GDP ratio. This ratio scales debt to the size of the economy, thus providing a more consistent measure across political subdivisions with varying populations and wealth. The Bureau of Economic Analysis reports US GDP by State. This BEA measure is called Gross State Product (or GSP). The Census bureau collects state and local government financial data (including indebtedness) each year, with the most recent data being available for Fiscal 2009. By combining the BEA and Census data set, we can measure Debt/GSP by State, as we do in Table 2.

Table 2. Debt/GSP Ratio By State, 2009
State
Total Debt
Gross State Product
Debt/GSP Ratio
Alabama
8,155,943
166,819,000
4.89%
Alaska
6,589,698
45,861,000
14.37%
Arizona
12,324,879
249,711,000
4.94%
Arkansas
4,135,051
98,795,000
4.19%
California
134,571,934
1,847,048,000
7.29%
Colorado
17,202,374
250,664,000
6.86%
Connecticut
28,394,151
227,550,000
12.48%
Delaware
5,984,645
60,660,000
9.87%
Florida
38,885,422
732,782,000
5.31%
Georgia
13,455,164
394,117,000
3.41%
Hawaii
6,880,242
65,428,000
10.52%
Idaho
3,501,676
53,661,000
6.53%
Illinois
56,962,364
631,970,000
9.01%
Indiana
23,711,889
259,894,000
9.12%
Iowa
6,353,306
136,062,000
4.67%
Kansas
5,857,295
122,544,000
4.78%
Kentucky
13,364,138
155,789,000
8.58%
Louisiana
17,504,772
205,117,000
8.53%
Maine
5,297,276
50,039,000
10.59%
Maryland
23,472,579
285,116,000
8.23%
Massachusetts
74,597,901
360,538,000
20.69%
Michigan
29,591,278
369,671,000
8.00%
Minnesota
10,524,424
258,499,000
4.07%
Mississippi
6,208,639
94,406,000
6.58%
Missouri
19,217,206
237,955,000
8.08%
Montana
4,723,765
34,999,000
13.50%
Nebraska
2,516,775
86,411,000
2.91%
Nevada
4,444,804
125,037,000
3.55%
New Hampshire
8,411,660
59,086,000
14.24%
New Jersey
56,897,866
471,946,000
12.06%
New Mexico
8,001,721
76,871,000
10.41%
New York
122,651,630
1,094,104,000
11.21%
North Carolina
19,910,714
407,032,000
4.89%
North Dakota
1,888,148
31,626,000
5.97%
Ohio
27,949,184
462,015,000
6.05%
Oklahoma
9,855,393
142,388,000
6.92%
Oregon
12,678,820
167,481,000
7.57%
Pennsylvania
41,924,042
546,538,000
7.67%
Rhode Island
9,180,938
47,470,000
19.34%
South Carolina
15,313,021
158,786,000
9.64%
South Dakota
3,626,024
38,255,000
9.48%
Tennessee
4,847,786
243,849,000
1.99%
Texas
30,438,160
1,146,647,000
2.65%
Utah
6,267,888
111,301,000
5.63%
Vermont
3,426,670
24,625,000
13.92%
Virginia
24,301,179
409,732,000
5.93%
Washington
24,603,219
331,639,000
7.42%
West Virginia
6,501,995
61,043,000
10.65%
Wisconsin
20,913,355
239,613,000
8.73%
Wyoming
1,320,852
36,760,000
3.59%
50 State Total
1,045,339,855
13,915,950,000
7.51%

By international standards, these ratios are quite low – well below those of the US federal government and other major Western countries. They also compare favorably to large Canadian provinces such as Quebec and Ontario – which had bonded debt to gross product ratios of 44% and 30% respectively in 2009 (according to public accounts documents filed by each province).

Also, it is worth noting that the Census debt totals include much more than a state’s general obligation bonds. These totals also incorporate revenue bonds, industrial revenue bonds, pollution control bonds, special assessment bonds, certificates of participation (COPs), judgments, mortgages and construction loan notes (CLNs) – which are generally junior to general obligations.

When assessing states and national governments, rating agencies often consider the ratio of interest expense to revenue. This ratio is more useful that Debt/GDP because it also reflects the impact of interest rates and the government’s ability to derive revenue from the economy. Japan, for example, can sustain very high Debt/GDP ratios (above 200% by some measures) because it faces very low interest rates. Governments that have relatively limited ability to extract revenue like Greece (due to tax evasion) and the US federal government (due to difficulty of passing tax increases) may face crises at lower levels of Debt/GDP. American states also face lower ceilings on their Debt/GSP ratios because their ability to raise tax rates is limited by the relative ease of relocating to another state (as opposed to another country).

Table 3 shows Interest Expense to Revenue ratios based on Census data.

Table 3. Interest Expense to Total Revenue, 2009
State
Interest Expense
Revenue
Interest/Revenue Ratio
Alabama
340,732
20,504,479
1.66%
Alaska
310,326
9,001,893
3.45%
Arizona
508,006
23,232,724
2.19%
Arkansas
161,048
12,879,574
1.25%
California
6,220,851
113,389,307
5.49%
Colorado
805,668
10,336,795
7.79%
Connecticut
1,432,900
20,931,946
6.85%
Delaware
284,055
5,787,487
4.91%
Florida
1,480,969
45,602,974
3.25%
Georgia
660,288
33,614,408
1.96%
Hawaii
432,964
6,751,116
6.41%
Idaho
180,803
5,537,466
3.27%
Illinois
2,963,785
40,530,099
7.31%
Indiana
899,488
27,948,706
3.22%
Iowa
252,713
13,207,715
1.91%
Kansas
346,754
11,654,910
2.98%
Kentucky
525,344
18,993,131
2.77%
Louisiana
954,107
23,100,188
4.13%
Maine
268,987
6,468,113
4.16%
Maryland
1,044,928
24,071,623
4.34%
Massachusetts
3,736,377
37,260,774
10.03%
Michigan
1,147,573
47,714,878
2.41%
Minnesota
526,994
22,781,153
2.31%
Mississippi
218,614
14,375,357
1.52%
Missouri
847,712
17,937,884
4.73%
Montana
167,993
4,828,033
3.48%
Nebraska
108,050
7,380,731
1.46%
Nevada
212,010
7,531,884
2.81%
New Hampshire
391,573
5,639,852
6.94%
New Jersey
2,139,595
42,946,396
4.98%
New Mexico
324,507
9,643,066
3.37%
New York
5,505,131
92,112,356
5.98%
North Carolina
637,401
30,150,407
2.11%
North Dakota
146,457
4,372,683
3.35%
Ohio
1,445,927
24,961,252
5.79%
Oklahoma
490,185
17,428,959
2.81%
Oregon
456,106
7,507,145
6.08%
Pennsylvania
1,823,759
38,795,484
4.70%
Rhode Island
437,293
4,710,553
9.28%
South Carolina
780,304
19,897,729
3.92%
South Dakota
135,135
2,436,934
5.55%
Tennessee
236,118
18,750,827
1.26%
Texas
1,242,925
82,053,694
1.51%
Utah
243,708
8,783,428
2.77%
Vermont
164,354
4,559,365
3.60%
Virginia
919,732
26,224,905
3.51%
Washington
1,110,674
24,476,808
4.54%
West Virginia
246,458
11,112,547
2.22%
Wisconsin
1,262,365
8,518,436
14.82%
Wyoming
64,221
4,787,884
1.34%
50 State Total
47,243,967
1,123,226,058
4.21%

These ratios reflect each state’s total revenue – not just its general fund revenue – and its interest expense on all bonds – not just general obligations.

When Arkansas defaulted in 1933, its interest to revenue ratio was about 30% - well above the level in any other state at the time and well above present levels. The only two other defaults during the last century by governments similar to US states in comparable nations (New South Wales, Australia in 1931 and Alberta, Canada in 1936) also occurred after the interest to revenue ratio exceeded 30%.

Applicability to Today

Could a state default with an interest to revenue ratio significantly below 30%?  While any financial result is possible, it is highly unlikely. Default is a political decision in which elected officials balance two considerations: (1) inability to spend money on programs due to debt service expenses versus (2) embarrassment and loss of bond market access by defaulting.

When interest expenses are a relatively low proportion of revenue, defaulting does not make any political sense. Indeed, defaulting makes much less political sense now than it did in the 19th century or during the Great Depression.

Most state debt in the 19th century was held in Europe. In 1933, most Arkansas debt was held by investors in other states - in New York and elsewhere. With the inception of state income taxes and their exclusion of most in-state municipal bond interest, a very large proportion of state bonds are now owned by high income residents. Since the bonds are in the hands of voters and campaign contributors, the choice to default is even more politically suicidal than in was in the 1930s.

Pensions and Retiree Benefits

Fears about current state credit quality center around public employee pensions and other employee benefits.  The size of this problem – from a credit standpoint – is often exaggerated because the unfunded liability is juxtaposed with the state’s annual budget. Since the unfunded liability is payable over many years, this comparison is faulty. Further, unfunded liabilities quoted in the media often apply to an entire pension system, whose costs are only partially borne by the state. For example, the State of California is responsible for only about 36% of the beneficiaries in the CalPERS system (according to page 151 of the CalPERS 2011 Comprehensive Annual Financial Report.

Underfunded state employee pensions are nothing new. The problem was also common in the 1970s and early 1980s – the last period of extended poor stock market performance – and did not produce any general obligation defaults. Statistics published by Alicia Munnell and her colleagues at the Boston College Center for Retirement Research show that pension contributions as a proportion of state budgets have yet to return to the peaks reached thirty years ago.

Unfunded retiree health benefits have also been a constant. While it is true that health care costs have risen substantially in recent decades, much of this extra cost is borne by Medicare.

Conclusion

When considering the risk of a state G.O. bond default, investors should be careful to separate their political views from actionable investment information. Inadequately funded retirement plans and political evasions of balanced budget requirements are bad public policies – worthy of criticism in the court of political opinion. Whether these issues are serious enough to trigger an outright default on principal and interest payments, is a very different question, and one that is best answered through historical research and quantitative analysis.

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Marc Joffe is a consultant with PF2 Securities Evaluations, which recently published an open source Public Sector Credit Framework. In 2011, he researched and co-authored Kroll Bond Rating Agency’s municipal bond study. Prior to that, Marc was a Senior Director at Moody’s Analytics. Marc owns State of California bonds.