Fiscal Federalism Part II: Without Deep Federal Support, State and Local Governments/credits are in deep trouble.

Fiscal Federalism Part II: Without Federal help that remains highly uncertain, many state and local governments and credits as are likely to be in serious trouble.

George D. Friedlander, Executive Director, George Friedlander and Associates.

gfriedlander1@gmail.com

Summary and Opinion: The Heroes Act should be viewed as a floor, not a ceiling.

As we discussed in Part I of our report on “Fiscal Federalism” state and local governments, public employees and taxpayers in a large number of states are badly in need of financial support from the Federal Government, as budgets get severely damaged by sharp cuts in tax revenues and substantial increases in costs, both needed to deal with major issues related to the Pandemic and to erosion in the economy, seemingly in all possible ways. Predictions for economic growth over the next several quarters, at the very least, are actually sharply negative. As we further noted in Part I, the policy case for such Federal support is extremely strong: in the Pandemic, we are looking at an emergency that is the equivalent of 50 states worth of hurricanes fires and floods, lasting more than two years, with a very slow economic rebound on the “other side,” that leaves states, local governments public employees and taxpayers all badly damaged.

The good news, for now, is that the House is apparently imminently going to enact “The Heroes Act” with $3 trillion in further expenditures for a variety of targets and activities. The allocated State and Local Government Coronavirus Relief Funds comprise $916 billion of the anticipated proceeds, with $500 billion allocated to the states, and $375 billion allocated to local governments, along with other, smaller expenditures. Funds can be used for COVID-related expenses to replace foregone revenue not projected on 1/1/2020, or to respond to negative economic impacts of COVID. Funds are to be available until expended, providing flexibility over the next several years.

In our view, the “bad news” associated with this proposed bill is straightforward: we anticipate that the Senate is going to be highly resistant to further Federal Expenditures of this magnitude to fight the Pandemic, given that the federal government is already on its way this year to spending nearly $4 trillion more than it collects in revenue, analysts say. This would be a budget deficit roughly twice as large relative to the economy as in any year since 1945. Of course, roughly half of that related to existing promises and cuts in taxes, having nothing to do with the Pandemic. Nevertheless, in our view, state and local governments—and the Federal economy—are facing a major crisis at a time of substantial resistance from the Senate, particularly from "Deficit Hawks" that are rearing their head for the first time in years. They had disappeared during the massive tax cuts that were, in our view not nearly as urgent as expenditures needed to fight the current crisis.

We are not at all convinced that the House-allotted $916 billion will be anywhere near sufficient, given the magnitude of the economic crisis. The state of California alone is envisioning a $54.3 billion budgetary deficit for FY 2021, and that does not include shortfalls at the local level—municipalities, counties, school districts and special purpose activities, from colleges through facilities servicing the elderly. If the Senate cuts back from the proposed House levels, we anticipate a wide number of major concerns, ranging from very sharp cuts in services, to widespread cuts in public payrolls, to reduced capacity to respond to the Pandemic as a form of economic stimulus, to—importantly—severe cuts in credit ratings that the rating agencies will be forced to consider, for states, for local governments, and for revenue bond issuers and special purpose financings. We would expect the implications of such erosion in credit strength to be jarring, but we do not envision that it will even begin to be fully felt by the market—either in ratings, or in market valuations—until the market can better discount the anticipated outcome of Senate-House negotiations over the Federal/State component of the Heroes Act. 

As we discussed in Part I and further discuss in the following, we are not optimistic that such moneys will be agreed upon by the Senate and the Trump Administration, however, the battle has been waged. In a joint statement, Maryland Gov. Larry Hogan (R) and New York Gov. Andrew Cuomo (D) said states need at least $500 billion in aid to make up for revenues lost during the crisis. They note that the lack of Federal moneys is leading to deep cuts in spending and payrolls that will severely limit any rebound out of the Pandemic-induced economic crisis. "Each day that Congress fails to act, states are being forced to make cuts that will devastate the essential services the American people rely on and destroy the economic recovery before it even gets off the ground," Hogan and Cuomo wrote.

They note the wide bipartisan agreement on strong Federal support for state, local and tribal activities. Despite this support, Senator Mitch McConnell appears to remain dismissive, calling such support “exactly the wrong approach. “

To that we respond, what then is the right approach? Gutting state and local payrolls and risking a deep dive in access to capital as credit damage spreads seem to us to be an simply awful approach, contrary to governmental policy or economic requirements. We also note that, in the absence of deep, readily available Federal moneys, other urgent maters such as infrastructure generally responding to climate change, and reconfiguring cities and town for the post-pandemic American economy will be tossed to the wayside.

Where do we go from here?

In our recent Special Focus, part I, we made the case that:

1. Holes in state and local budgets resulting from the Pandemic are going to be huge resulting both from deep cuts in tax collections and sharp increases in Pandemic-related expenditures;
2. The payroll cuts, reductions in provision of essential services and damage to state and local credits are going to be dire if these holes remain unfilled;
3. Only the Federal government has the wherewithal to provide the resources necessary to fill these holes;
4. The case for the Federal government to take on provision of support for state and local governments, is a strong one. A key factor id the ongoing extremely low borrowing costs at the Federal Government level, with 10-year Treasuries at 0.65%, versus
5. If the Federal government doesn’t take on that role, the damage to the entire US economy will be vastly greater than necessary.

The calculation of the damage from the Pandemic specifically for any given state, local government or special purpose facility is relatively straightforward: on the revenue side, losses in income taxes, sales taxes, property taxes, and revenues that previously were providing income or avoiding deficits, including hospitals, mass transit, ports and airports, and a host of other special purpose governmental projects, including higher education, transportation and utilities. On the expenditure side, increased deficits include increases in unemployment insurance and healthcare costs, but also a number of major sources of spending that we do not find fully explained or calculated in most discussions. These include provision of food and healthcare to uninsured users of healthcare facilities, support for housing in order to prevent foreclosures and evictions(where the need is likely to be vast), and quite simply, a need for state and local governments (but especially states) to step in to prevent personal fiscal insolvency among the vast hoards of unemployed and underemployed families and individuals.

Unfortunately, at this point in time, it seems unlikely that the Senate, in particular, will provide anything close to the moneys needed to fill these budgetary holes. Just how big are they likely to be? Well, the day after our first “Special Focus” came out, the state of California estimated that the budgetary gap in that single state, for the single fiscal year of 2021, would be $54.3 billion. Could that extrapolate to $100 billion or so over two years? We think so, as most economists anticipate an extremely gradual rebound, and it seems unlikely that the economic trough has been reached as yet. And, of course, that doesn’t include in-state county and city deficits, such as at school districts, which are likely to be vast. Oklahoma, a much smaller and more sparsely populated state, announced that its budget gap for April alone would be $30 million--state-level only. We note that none of these projections fully take into account the potential impact of a “second peak” in the pandemic in the fall, as a number of epidemiologists note the risks from a too-fast reopening, and in the potential overlap of a COVID-19 outbreak with a seasonal flu outbreak. Nor do they appear to adequately take into account the risk of a very deep global recession. And, none of these projections take into account the risks of weather events over the remainder of the summer and fall, including hurricanes, floods, forest fires and droughts that would typically lead to the need for specific Federal crisis support away from the Pandemic. We will be reaching out to various independent research organizations in an attempt to better identify aggregate budgetary deficiencies, but it seems clear based upon initial rough calculations and the projections coming out of California that we are looking at Pandemic-related aggregate deficits that exceed $1 trillion annually.

We note that massive payroll cuts for state and local employees have already started, but many of these are temporary, and related to teachers who will go back on the payroll when schools open up. According to Route 50, nearly 1 million in payroll spots at the state and local government sector have already occurred. U.S. Labor Department figures released on Friday show that in April the number of local government jobs fell by 801,000 and the number of state positions by 180,000. Most of the state losses—176,000—were tied to education. The same was true for 468,000 of the jobs included in the overall local government figure, reflecting widespread school closures. So, as schools open back up, vast job losses and service cuts at the state and local level will take their place.

 As in our first piece, we stress that Federal payment for a large portion of these costs would NOT be providing a “Blue State Bailout,” as the Senate Majority leader has suggested. The moneys we are discussing are very specifically related to revenue losses and expenditure increases resulting ONLY from the Pandemic; any talk of such a bailout, identified fairly, relates to other budgetary issues that existed prior to the Pandemic and are not a consequence of the Pandemic.

 In our view, neither the rating agencies nor municipal market pricing is doing a sufficient job of signaling just how essential the Federal role in filling state and local budget gaps is likely to be, and how dire the impact for credits is likely to be if the Federal government doesn’t take on that role. Frankly, it is the nature of rating agencies to await a change in identifiable risk before changing ratings, rather than including such a change as a measure of new, future risks. We have a lot more to discuss with respect to the crises that will occur if the Federal Government doesn’t provide a “CARES III” that sharply reduces the need for state and local governments to fill budgetary holes of $2 trillion or more over the next two fiscal years. For now, suffice it to say that in our view, these risks to provision of essential services, to keeping our economy functioning, to maintain services and payrolls, and by extrapolation to a wide range of state and local credits, appear to be undersdiscounted in current ratings and market valuations.

There are a whole host of other issues to be discussed that relate to:

• state and local creditworthiness and capital projects, including infrastructure,
• climate change costs in their various forms, including resiliency, sustainability and shifts in demographics,
• dramatic changes in how businesses and employees behave, including sharply increased work-from-home and reduction in urban concentration,
• Technological change that will overlap with the change in habit patterns induced by the Pandemic,
• Business and job losses that appear permanent in some cases.
• The pace, expanse, timing and success of any reopening, with uncertainties that affect the entire nation, and differing outcomes from state to state, region to region and municipality to municipality.

 We note that, if we look far enough out, some leading technological experts see not just risks but a combination of positives and negatives, including more effective and efficient use of automation, artificial intelligence, and low-cost substitutes for business travel, including sharply greater use of video conferencing. We also see a vast number of policy issues that overlap on both the positive and negative side, including providing for healthcare costs through technology as provision by employers dwindles, utilizing automated solutions that reduce some of these costs. Addition concerns with potential +/- outcomes are vast in number and magnitude, and we will attempt to track them to the extent possible. Even without a more precise examination of data and behaviors, however, one pattern seems clear to us: uncertainties have gapped upward, and these uncertainties reflect dramatic new credit risks.

Is the new set of credit risks fully incorporated into the municipal bond market? We believe that they are not.

When the Senate majority leader told a right-wing radio host last week that he opposes any further federal aid to states and localities, encouraging them to seek bankruptcy protection instead, he added yet another worry to the municipal bond market. The message appeared to be that, as far as Senator McConnell is concerned, states, cities and towns are essentially “on their own” in dealing with a global force that is largely beyond their control, and that the Federal government has no responsibility for the financial concerns of governments, their essential employees, or their key governmental functions. His reference to “blue state bailouts” suggested that a) the impact of the Pandemic is somehow the fault of the states with high incidence of the pandemic, and not the responsibility of the Federal government. Our goal is NOT to get into a pitched battle with the right side of the aisle regarding “who pays.” Rather, it is to identify the risks to state and local governments, to essential public employees, and the challenges going forward that relate to funding of essential projects, both during the pandemic and in its aftermath. In our view, it is essential that we learn to identify risks that are related to bonded debt—credit ratings—in an environment of dramatically different risks for the issuers of such debt, and to investors, than we have ever before seen in the past 60 years. That said, we have to identify the rapidly changing relationship between the Federal government and state and local governments, which actually began substantially PRIOR to the pandemic, with concerns about the implications of climate change and technological change that we have discussed in prior white papers.

Traditional techniques for modeling and analyzing municipal credits are already   obsolete—and the marketplace, portfolio managers and rating agencies are going to need to address that. Issues that relate to these factors include:

1.              An intersection of disruptions—COVID, climate, technology, demographics, demand patterns, post-pandemic behavioral patterns

2.              The need to understand the difference between liquidity problems and a credit crisis, and how they overlap. A lot of work has been put into identifying the proper role for the Fed in providing liquidity, and in identifying enhanced financing techniques. However, we make the case that without the needed budgetary support, liquidity support and new or renewed financing techniques simply will not be sufficient in many cases.

3.             Pressures on state and local governments on the governmental and credit spectrum are going to be severe and long-lasting. State and local pensions are a mess, in many cases. However, that is not what the need for a Federal response to this nationwide emergency needs to be about in our view.

4.             The difference in outcomes between winners and losers on that credit spectrum will be substantial. Energy-producing states are in huge trouble. Other states and local governments with concentration in a specific industrial sector will be under additional pressure. These industrial concentrations have already shown up in some sectors—meat packing, for example, which is likely to generate sharply reduced economic activity in some Midwest communities, such as in Nebraska, Iowa and South Dakota. We are also concerned about localities with a deep concentration of universities. Automobile manufacturing states will remain under pressure as new car production remains low. Airlines remain in serious trouble, and this will affect cites with large international airports. Cities that rely heavily on mass transit will face deep challenges until herd immunity kicks in. In all of these cases, the decline in tax receipts and revenues is likely to be much deeper than the national average.

5.              The national healthcare system will be badly damaged in many ways, and feed back onto state/local pressures. 

6.              Like it or not, politics are going to be a big deal in determining outcomes. Taxes, support for those in crisis, Federal support for state and local governments, climate change responses, environmental repair, the structure of healthcare will   all fall under the rubric of essential policymaking during and after the Pandemic.

7.              As we note, disruptive change is coming, hard, with Covid-19 only one factor. We would add technological change, climate change and responses, and drastic changes in habit patterns and employment patterns created by the Pandemic to the list.

8.              Pressures coming out of the energy sector are likely to be severe, given reduced demand and still-weak energy prices.

9.              State and local governments are going to have to fight like heck to fix their worlds, and to get needed support from Congress. The outcome of “fixes” will dramatically affect the level and spread of changes in creditworthiness, but also in new capital spending, economic growth and provision of services.

10.            Where will the leadership come from? The need for that leadership will be vast, and right now seems extremely limited. The relationship between leadership and ESG is going to be essential.

 Implications for revenue-based credits.

As we envision it, severe credit crises related to the Pandemic are going to come in a number of forms, running from state/local governments facing service insolvencies, to specific tax-backed districts such as school districts that will see massive cuts in property tax receipts, to a variety of revenue-backed credits and project financings that will be severely affected by a) changes in taxpayer/consumer behavior b) aversions to using a wide variety of facilities that are not easily socially distanced, including airlines and mass transportation, to c) revenue-supported facilities, such as utilities, where the taxpayer base is facing decimated incomes and personal budgets. In addition, these shortfalls will be exacerbated in cases where the Federal government does not step in to support budgets damaged by revenue holes and increased expenditure requirements. We are also talking about smaller, lower-rated credits that are under pressure from sharply lower use, including many elderly care facilities, colleges and charter schools. We anticipate that the magnitude of drops in debt service coverage at many of these types of facilities would put them on the path to insolvency as well.

Additionally…

Undoubtedly, the municipal bond market went through a severe period of massive illiquidity and high yields relative to Treasuries that lasted largely from March 19, 2020, to April 3, 2020, in response to the ongoing COVID-19 pandemic. Since then, the muni market has settled in a bit, even though yields on even the highest-rated credits remain at extremely high levels as a percentage of Treasury yields, particularly in the short-to-intermediate maturity range. Our intention for this first “take” on this set of ideas is to explain why are we so concerned about credit strength beyond the current measurables-- why, in our view the risks facing state and local credits remain under-stated in ratings and pricing.

--We link our concerns to vast funding needs of state and local governments that go well beyond the dire issues generated by the Pandemic;

--In our view, the solutions to this ongoing credit and funding crisis require massive Federal components that will be ongoing for a number of years; and

--Set the stage for more detailed discussion of key components of this analysis including in future “white papers.”

Why we are so concerned about credit strength beyond the current measurables.

There is no doubt that state and local government budgets are a “train wreck,” and indeed, one that is already being incorporated into current discussions from the rating agencies and some strong national organizations—Pew, NASBO, Economic Policy Institute, etc. However, in terms of ratings/measurable credit risk, we fear that there are a number of factors that appear to be considerably worse than current measurements provide for.

 At the outset, a number of key questions related to the Pandemic still need to be answered in far more detail that we currently have available. These include:

• The capacity for various state economies to open back up in a meaningful way by May or June, even as polls show a majority of taxpayers being more concerned about mitigation of Pandemic risk than they are about going back to work;
• The magnitude of any such re-opening, including the extent to which American residents are willing to re-start demand-side activities that have contact risks associated with them, including mass transportation, large-scale sports and entertainment, and direct retail buying that requires an anticipation of a revitalized economy.
• The extent to which the pandemic re-surges in the fall of 2020—potentially overlapping with the influenza as was suggested by various epidemiologists.
• The ability to achieve testing capacity that meets the needs of leading health experts,
• Capacity for contact tracing, a key way to keep the growth in the number of COVID-19 cases “flattened;”
• The extent to which having COVID-19 leads to a relatively long-term immune response—as of late April, the strength of the path towards immunity appeared to be largely unknown.
• Of course, timing of the availability of a vaccine, and the capacity to distribute such a vaccine in sufficient quantities to develop a broad-based herd immunity response;
• Second peaks and rebounds related to the re-opening of state economies—which states are re-opening too soon, and how bad will the outcomes be?
• And, of course, the path of sharply growing clusters of patients, in at least four identifiable categories so far: nursing and convalescent homes, prison inmates, the military/Veterans Administration patients, and meat-packing plant employees. In all of these cases, the clustering of cases remains exceedingly strong and does not appear to be moving past any discernable peak.
• We are quite concerned that some of these major weather-related events could interfere with social distancing needs—e.g, a fire, flood, tornado or hurricane that forces citizens to huddle in close public quarters such as gyms or stadiums, even while the Pandemic continues to have additional hot spots, peaks and mini-peaks;
• A so far totally inadequate response by The Administration/Congress in terms of the budgetary and funding needs of state and local governments—we are reach a point where solutions that do not include strong infusions of liquidity and funding from the Federal Government are unlikely to make governments sufficiently whole, sufficiently quickly.
• Indeed, we would make the case that there is a massive political component to the impending “fork in the road” on the Federal support. Whether some of our readers want to go there  or not, it seems, in our view, that in the aftermath of the 11/2020 election, we will need to identify the potential for more dramatic policy responses, that depend at least in part upon the makeup of the party in power, in order to meet the vast needs for revenue support and guarantees from the Federal government that we envision.

 To end this section of our discussion, we also note that any lack of discounting or signaling of weaker credit strength within the muni market should not, in our view, suggest that the credit environment is in good shape. (“Absence of evidence is not evidence of absence.”) We cite continuing strong US stock market as evidence that capital markets can be highly optimistic even as risks are magnified. We cannot claim to know just how weak municipal credits are likely to get. We do, however, believe that, the willingness or lack of willingness of Congress to make needed support payments to state and local government as an essential form of Federal subsidy remains highly uncertain, and it needs to be tracked closely in coming weeks and months.

The risk of massive additional infections is a serious rating problem.

As noted on USA today on Monday, Dr. Michael Osterholm, director of the Center for Infectious Disease Research and Policy at the University of Minnesota, said the initial wave of outbreaks in cities such as New York City, where one in five people have been infected, represent a fraction of the illness and death yet to come. "This damn virus is going to keep going until it infects everybody it possibly can," Osterholm said Monday during a meeting with the USA TODAY Editorial Board. "It surely won’t slow down until it hits 60 to 70%" of the population, the number that would create herd immunity and halt the spread of the virus. Even if new cases begin to fade this summer, it might be an indicator that the new coronavirus is following a seasonal pattern similar to the flu.

https://www.usatoday.com/story/news/health/2020/05/11/coronavirus-expert-michael-osterholm-warns-virus-spread-far-from-over/3108333001/

While to be sure, there are infectious disease experts with less onerous predictions than those of the widely respected Dr. Osterholm, the fact remains that there is at least a RISK OF a major outbreak in the fall that would do severe damage to state and local governments and to the long list of types of credits we describe above. Certainly, on Tuesday May at a Senate hearing, Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases expressed similar if somewhat less specific concerns.  In our view, the only way to at east moderate these risks for state and local bonded debt would be for these governments to receive a very substantial amount of additional financial support from the Federal government. At this point we admit that we are quite frankly shocked that these onerous risks are not more rapidly and automatically being turned into imminent additional payments under an additional round of Federal subsidies, targeted to such state and local governments. At this point, unfortunately we cannot envision that such payments are likely to happen, so we fear that state and local governments and their bonded debt will end up quite severely damaged, in ways that neither current credit ratings nor market valuations adequately reflect.