The problems of "too big to fail" (TBTF) have long been understood to apply to large financial depository institutions. Recently, global regulatory responses to the financial crisis have extended the category to include nonbank financial institutions such as insurance companies. A key tool in eliminating TBTF and its attendant subsidies and moral hazard is the existence of a credible resolution plan for such entities. Both Dodd-Frank and the Financial Stability Board now require the establishment of resolution plans for systemically important financial institutions (SIFIs and global SIFIs). But there is another type of entity for which a resolution or bankruptcy regime does not exist but that may well be valuable for some very similar reasons: sovereign states. In general, this discussion could apply to sovereign nations—indeed, there is a large literature on this question—but in this post I focus on the sovereign states within the United States.
Financial distress in state governments
If a U.S. state were to find itself in a state of financial distress with, say, inadequate revenues to cover desired expenditures for the provision of state services it could, simplistically speaking, do one of two things: raise taxes or cut its level of spending. Unlike the federal government, most states have balanced budget requirements of various forms that preclude them from using debt to finance operating deficits.
In fact, many of these requirements were initially put in place during the second half of the 19th century following debt defaults by eight states and the territory of Florida in the early 1840s.1 Such requirements helped states regain or keep access to international credit markets by creating constraints on debt issuance and thus lowering the probability of a state default due to severe financial distress.
This type of commitment on the part of U.S. states is particularly important to creditors because the states are, as sovereigns, not subject to U.S. federal bankruptcy laws. Without such recourse, defaults and negotiated restructurings are a distinct, if remote, possibility. Moreover, there is no explicit support or precedent for support from the U.S. federal government for states in distress.
I provide some thoughts on whether this situation is a problem for the U.S. financial system by analyzing whether U.S. states are analogous to SIFIs and the extent to which contagion within the municipal debt market is a possibility.
Are U.S. states SIFIs?
Legally, of course, the answer is no, since the provisions of Dodd-Frank Section 113 authorizing the Financial Stability Oversight Council (FSOC) designation of SIFIs applies only to financial companies. However, we can ask how close the U.S. states come to the spirit of the definition: would financial distress in a U.S. state ever cause a threat to financial stability by inflicting significant damage on financial market functioning and the broader economy?
Liberally interpreting a few of the FSOC's criteria for determining potential damage, many states are large in terms of economic activity, have no substitutes in terms of their provision of services, and make financial decisions under political rather than regulatory oversight. Additionally, in aggregate there is approximately $3.7 trillion of outstanding municipal debt (state plus local) and an estimated $3 trillion in implicit debt due to underfunded pensions (see "The Funding of State and Local Pensions: 2013–2017.")
There are two channels through which severe state financial distress could have significant and broad effects. In contrast to financial companies, distress in a U.S. state significant enough to threaten a bond default could transmit directly to the real economy rather than through a credit intermediation channel (as would be the case with a SIFI). Pressure to meet a bond payment could, in severe cases, divert state funds intended for vendor payments and state employee salaries and reduce the provision of state services. One only need look at cases of sovereign nation distress (like Greece) to see the potential for macroeconomic costs in such a situation. Alternatively, a default would inflict losses on creditors that could potentially transmit the distress into the broader financial system and significantly raise borrowing costs for other municipal issuers.
A look at the bondholder profile of municipal debt reveals that the states are not very interconnected with the financial market, at least relative to SIFIs. Approximately 75 percent of municipal debt is held by households and mutual funds (whose shareholders are households or other asset managers) while only 12 percent is held within the banking system and 9 percent by insurance companies (Federal Reserve Flow of Funds, fourth-quarter 2013). Moreover, the holdings of municipal debt in the banking and insurance sectors is not large; for example, among large banking organizations holdings of municipal debt account for an average of 18 percent of their risk-based capital (Federal Reserve Call Reports, fourth-quarter 2013). Thus, any losses would be largely borne by nonleveraged direct holders and is not likely to set off a sequence of cascading defaults the way the failure of a financial SIFI might.
Another risk factor
However, there is another risk factor when considering the potential financial distress of a U.S. state. There exists no resolution mechanism or plan for such an event. Bank and nonbank SIFIs, as corporations, are subject to federal bankruptcy law (Chapters 7 and 11) and are now subject to the new resolution planning processes and authority established in Dodd-Frank. While some may argue that these options do not establish a clear, credible regime under which such institutions would be "allowed" to fail and successfully undergo orderly resolution, there is at least a system within which to work toward that goal.
For U.S. states, without any resolution mechanism the options available to a state in distress are restructuring negotiations with creditors or the petitioning of support from the federal government. Either of these is subject to a great degree of uncertainty. As mentioned earlier, this federal support was not forthcoming in earlier state defaults. Restructuring, while quite common in the corporate sector, is used there within a legal bankruptcy structure. This structure helps to create incentives and scope for restructuring negotiations and establishes priority among creditors.
The lack of such a structure creates more uncertainty regarding default probabilities and recovery rates, and all else being equal would likely cause municipal bondholders to require higher risk premia to hold bonds of states with a significant risk of distress. If the likelihood of default rose high enough, yields could spike and the potential exists for contagion into the broader municipal bond market. Once an actual restructuring occurred, it would have the potential to set a precedent for creditors and could again cause a broader repricing of municipal bonds issued by states in similar, if less severe, circumstances. Again, it may be the macroeconomic spillovers that are the most concerning rather than the effect on financial institutions.
A case study?
This discussion should not be interpreted to suggest that severe distress or default is likely or imminent in any of the U.S. states. Currently, all state issuers of municipal bonds are investment grade and many are working to meet the fiscal challenges of underfunded pensions. However, the last nine months have provided a view into what a severely distress scenario might look like, through the experience of Puerto Rico, which like U.S. states, cannot file for federal bankruptcy.
Late last summer, Puerto Rico's municipal bond yields rose precipitously following a Barron's cover story on the commonwealth's fiscal situation and the risk to its bonds. Yields on Puerto Rico's bonds jumped to over 8 percent (tax-free), its credit default swap spread was around 800 basis points, and Moody's reported higher expected default probabilities than any sovereign except Argentina. In early February of this year, much of Puerto Rico's debt was downgraded to junk status. Nonetheless, Puerto Rico was able to place a $3.5 billion bond offering in early March 2014. In order to maintain market access and lower the cost of issuance, Puerto Rico issued the bonds under New York legal jurisdiction. Some commentators have suggested that this may allow Puerto Rico to strategically default on its earlier bond issues while continuing to pay on this issue. Interestingly, it is reported that hedge funds were large buyers of the Puerto Rico issue—certainly consistent with their larger appetite for risk versus the high-net-worth household investors and perhaps also their greater ability to negotiate in a restructuring.
To date, it does not appear that Puerto Rico's distress has spilled over into the broader municipal market. Moreover, the direct macroeconomic impact of Puerto Rico's distress on the U.S. economy is quite limited. To the extent that risk-tolerant investors moved in and were willing to supply capital and market access, this is good news from a systemic risk standpoint. However, systemic risk analysis is all about imagining the perfect storm, situations that by definition are not expected to occur.
With this perspective, the lack of an established restructuring or resolution mechanism for U.S. states is a potential vulnerability with respect to financial stability.2 As with SIFIs, plans and processes to handle a severe distress scenario would both stabilize markets in the event it is realized and prompt market participants better to assess and price risk at all times.
Paula Tkac is a vice president and senior economist at the Atlanta Fed. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail firstname.lastname@example.org.
1 English, William B. "Understanding the Costs of Sovereign Default: American State Debts in the 1840's," American Economic Review 86, no. 1, March 1996.
2 In late June, the Puerto Rico legislature passed the Puerto Rico Public Corporations Debt Enforcement and Recovery Act, a first step in addressing this vulnerability, at least with regard to one segment of Puerto Rico's municipal debt.