Debt casts shadow over Main Street as budget crisis looms

Municipal finances have suffered from US economic hardship and are becoming the next cause of concern as funds and jobs dry up

No one would pretend that this is a period of smooth sailing for the US, but optimists would tell you that the world's largest economy successfully navigated through the storms of the sub-prime debt crisis, while a federal government debt crisis, despite ongoing deficits, remains largely over the horizon. Except, could this be an iceberg right in front of us?

The prospective debt crisis that has everyone scurrying for their lifejackets now is not in the banking system, nor at the level of the federal government, but in state and local government in the US.

Of the 50 states, only a number in single figures are likely to have budget surpluses in the coming financial year, causing concern about their ability to meet interest payments on their debt. And below the state level lie thousands of counties, cities and other local authorities whose finances have been tossed around by the economic tempests of the past few years. Tax revenues are depressed and the money that they get allocated from the state government looks sure to be squeezed as states themselves try to face up to their budget problems.

Across these thousands of municipalities, some $2.8trillion of debt is outstanding. Privately, the most senior Obama administration officials accept that not all of it is going to be paid back. And in public, one of the most famous and most feared analysts on Wall Street is going round predicting between 50 and 100 defaults and a big surge in the interest rates that local governments will have to pay in the future.

That analyst is Meredith Whitney, who was out in front predicting crisis in the US banking sector back in 2007. Now, she says, there is a whole new crisis coming in municipal finances and it threatens to knock the economic recovery right off track. Her comments have provoked fury. She has been accused of ignorance and, worse, of willfully exaggerating the problem to win business for her new firm. And her critics warn she is causing the very problem she predicted, because she is scaring away the conservative private investors who traditionally buy municipal bonds.

"It has tentacles as wide as anything I've seen," Ms Whitney told the prime-time news show 60 Minutes in December. "I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the US economy."

And – in words that were chilling to hear for the risk-averse investors who have piled into municipal bonds since the credit crisis, seeing them as a safe and tax efficient way to beat record-low interest rates elsewhere – Ms Whitney went on to say financial advisers were being complacent to ignore the mounting concern. "When individual investors look to people that are supposed to know better, they're patted on the head and told, 'It's not something you need to worry about.' Well, it'll be something to worry about within the next 12 months," she said.

Not everyone agrees. Peter De Groot, at Barclays Capital, says: "Municipal defaults are expected to remain low despite the difficult budget environment, as states have demonstrated the willingness and ability to cut spending to offset structural imbalances. Public entities plan to spend and borrow less and have implemented policies to begin to address longer-term pension and healthcare liabilities."

But it is Ms Whitney who is getting all the play. Late last year, her firm produced a 600-page piece of research on state and local government finances which concluded that investors have long been mis-pricing municipal bonds, dramatically underestimating the risks of default. States are facing huge underfunded pension liabilities and soaring healthcare obligations, in a mirror of the problems at the federal government level, and below that there are burgeoning problems at the county and city level. In September, the state of Pennsylvania handed down more than $3m in early or extra payments to its capital Harrisburg, which had racked up $280m in debt and was about to miss a bond payment. States neither have the capacity nor the popular support to continue such bailouts, Ms Whitney argues.

The economic effects could be large. Across the US, austerity measures by municipalities have more than offset the $787bn economic stimulus package passed by Congress in 2009. And reduced appetite for municipal bonds means less money for road building, new schools and other big projects. States and municipalities are slated to sell about $2.86bn in debt this week, less than half the amount of a year ago, Bloomberg data show.

Partly the decline is because the US government's economic stimulus efforts are winding down. Last year's issuance was boosted by extra tax breaks for so-called "Build America Bonds", designed to fund infrastructure projects that the Obama administration hoped would buoy construction sector employment.

But the decline also reflects the growing jitters over the state of municipal finances, and Ms Whitney has plenty to do with that. According to Lipper US Fund Flows, which tracks the data, investors last week withdrew $1.1bn from US municipal-bond mutual funds, the 12th straight weekly outflow. Since mid-November, about $23.6bn has been redeemed, including a record $4bn in a single week last month.

The decline in demand for these bonds means municipalities are typically having to pay a whole percentage point more now than they did last October, making many government projects unattractive or even unviable. The whole issue is going to be debated today by a House of Representatives sub-committee, at a hearing entitled State And Municipal Debt: The Coming Crisis? Meanwhile, Republicans are proposing legislation that will allow states to declare bankruptcy. That law would be designed with two aims in mind: a bankruptcy would allow states much more easily to slash worker pension obligations and rip up union contracts; it would also signal that there will be no federal government bailouts for the states.

The association of state governors, alarmed, sent a letter last week to House and Senate leaders saying "the mere discussion of legislation, let alone the existence of a law allowing states to declare bankruptcy, would only serve to increase interest rates and create more volatility in bond markets".

So while the issue of municipal debt is no longer below the radar for investors and is also soaring up the political agenda, that doesn't mean a crisis is less likely. It might make it more likely.