Local Governments on the Brink?

1. Local Governments on the Brink? Rick Mattoon Senior Economist and Economic Advisor Federal Reserve Bank of Chicago Economic Development in Rural Wisconsin October 26-27 Wausau, WI

2. Presentation outline • Issues and trends facing local governments • Issues in credit markets

3. This time was different • Context—the 2001 recession put state governments under significant stress, however the nature of the recession (the tech bubble) had money being reallocated from tech to real estate. • The ensuing increase in property values and boom in new development helped property tax oriented municipalities. Many municipalities also create impact fees and other development related taxes to further capture the gains from the real estate boom.

4. This time was different • This recession has seen deep adjustments in property values. The question is does this translate into declining property tax collections? • Why does this matter? Property tax is still the largest source of local revenues and historically has been a predictable and growing base. However since the 1970s tax revolts, other revenue sources, particularly fees have grown in importance. Also in some states locals can have sales taxes and income taxes. Lots of heterogeneity in local tax bases • For farm areas…the opposite problem…rising farm land values although might not translate into revenues if special exemptions and treatment are common

5. Home Building And Prices Single Family Housing Market (millions of units, annual rate) Home Price Indexes (Q1-2000=100) Case-Shiller Composite 20 Price Index FHFA Purchase Only Price Index Loan Performance Home Price Index Permits Starts Jun-2011 Aug-2011

6. The adjustment process • It isn’t fast. Lots of communities use moving averages or irregular assessment cycles for calibrating taxable values. Leads to confusion…the market value of my house is X but the assessed value is Y. • Some communities can simply adjust the tax rate to adjust for the declining value • If this isn’t possible, eventually revenues will decline. For example, the National League of Cities 2010 survey reported an expected decline of 1.8% in property tax collections after years of gains

7. National League of Cities 2011

8. How are they coping? • Personnel cuts • Delaying/canceling infrastructure • Cutting basic services • Drawing down reserves, not much on the revenue side other than some fee increases • Biggest wildcard…state aid—in Wisconsin, 2011-13 budget cuts direct state aid by 7% ($48 million) and categorical aid by $136 million • Spending pressures include public safety and infrastructure costs, employee related healthcare costs, pensions

9. How are they coping…reserves are significant and could act as a buffer(ending balances as a percentage of expenditures, NLC)

10. What else might they do? • Never waste a crisis • Michael Pagano, Dean UIC School of Public Administration • Reform tax structure—link tax base to the underlying engines of economic growth—particularly taxes on income and wages • Broaden sales tax base to reflect consumers tastes for consuming services • Restructure property tax particularly to reflect growing number of tax-exempt properties. Non-profits consume city services • Consider regional tax authority—minimizes border wars and some services might be better provided at a regional level • Using pricing more effectively—fees should reflect cost of services

11. What about muni-bond market and debt issuance • 2 schools of thought—Armageddon vs a tempest in a teapot • Meredith Whitney—defaults will be in the hundreds of billions. Even NourielRoubini expects elevated (but not systemic) problems with defaults of $100 billion over the next five years • As a benchmark, S & P muni bond index ($1.27 trillion in debt) reported $2.65 billion in defaults in 2010 and $2.9 billion in 2009.

12. The Tempest in the Teapot School • Historic performance suggests defaults are rare (600 bankruptcy filings since the Great Depression) and even when they occur bond holder recovery has been above 80%, much better than private sector • Most of the defaults are in no-rated issues and tend to be single-purpose governments—sewer systems, housing projects, etc. • Lots of legal protections and state interventions to prevent either a default or a Chapter 9 filing • Stigma of filing is high and this alone helps prevent filings • Debt levels as a percentage of expenditures aren’t that exaggerated and the term of debt issuance seems matched to the life of the bonds.

13. Further evidence • Much of the poor performance of the muni market at the end of 2010 and into 2011 is because of reasons other than a change in the underlying credit-worthiness of issuers. • Examples • BABs (Build America Bonds) flooded the market at the end of the year…might have overloaded the market for muni bonds even if these are taxable • Extension of Bush tax cuts—less need for wealthy to shelter income • Rally in equity markets—repositioning portfolios • Still able to issue…just at higher costs…Illinois Pension bonds ($3.7 billion in March) high rate (ranging from 4.96% for five year maturities to 5.877% for bonds maturing in 2019). This was estimated at almost 2 full points above market for A1 issuers. This was also above the interest rate offered on last years’ pension bond offering of $3.47 billion at 4.42% (five year maturities). • End of mono-line insurers • Finally, the muni market rallied even after the S & P downgrade of the U.S.

14. What might change this picture? • The dreaded off-balance sheet liabilities • Pensions and OPEB • Rating agencies might start treating this as a binding obligation of the government so governments with large unfunded liabilities might get taken to task • Reported liabilities are probably understated (Novy-Marx and Rauh). GASB rules allow for unrealistic discount rate • Path to full funding is very difficult, according to N-M and R, Wisconsin’s real liability is $56.2 billion which represents 3.7 years of state revenue. Milwaukee’s unfunded liability ($3.4 billion) works out to $14,853 per city household. (Good news Chicago’s is $41,966) • OPEB is even worse…pay as you go for the most part

15. Conclusion • Municipal finances are under significant stress, particularly for property tax reliant towns. • Other forms of aid from state or feds seem unlikely • Slow climb out for housing market will keep the pressure on for a while • Special risks will be pension and OPEB funding, federal tax reform such as capping the deduction for home mortgages