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Banking

Introduction | State of the District | National Banking Trends | State & Local Government Finances Spotlight


State & Local Government Finances Spotlight

State and local government finances :: Potential risks for Sixth District banks :: Current supervisory posture

The continuing impact of the recession on state and local government (SLG) finances (a $2.9 trillion market in the United States) has been in the headlines increasingly in recent months. The deep problems SLGs are having balancing their budgets have led some observers to predict widespread defaults on SLG debt obligations and bankruptcies. These predictions also reference longer-term fiscal issues such as unfunded pension plans at SLGs.

Toward the end of 2010 and into early 2011, the municipal securities markets saw significant outflows and unstable pricing, problems that many observers believe were made worse by, if not caused by, these widely publicized predictions. In this article, we describe our current view of the financial situation of state and local governments, the potential risks these problems could pose to banks in the Sixth District, and our current supervisory posture.

State and local government finances

Record decline in revenues. The current SLG budget problems were precipitated by large, sharp declines in SLG revenues, which are partly reliant on income and sales taxes and reflect the size and scope of the recession. However, the costs of providing services such as education, health care, and public safety continue to increase.

The following chart from the Rockefeller Institute of Government illustrates the point that in percentage terms, revenue declines in the recent recession are by far the deepest in almost fifty years.


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On a quarterly year-over-year basis, revenues showed negligible growth as the economy began its slow recovery in the fourth quarter of 2009 and reflected more typical growth in the second and third quarter of 2010. That said, the total dollar amount of revenue remains at prerecession levels.


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Record budget gaps. According to the Center for Budget Policy and Priorities (CBPP), the steep revenue declines have resulted in the largest budget gaps on record. Moreover, almost every state is dealing with budget gaps. Of the 48 states that CBPP surveys, 45 have projected budget gaps for fiscal 2012, which for most states will begin on July 1, 2011. Projections are not complete, but so far 22 states are estimating shortfalls for 2013.

Assistance provided by the American Recovery and Reinvestment Act (ARRA) helped soften the blow to states by covering 35 to 45 percent of the shortfalls that occurred from 2009 to 2011. The ARRA funds, however, will expire in early 2012, suggesting large gaps again in 2012 and perhaps beyond.


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Likelihood of defaults. Several observers have forecast defaults to occur next year or over a five-year period for many states and large metropolitan areas. In addition to the current budget balancing problems, these observers also allude to other, longer-term issues such as unfunded pensions and post-employment health care benefits to reinforce their forecasts.

Based on current data, it appears that the budget difficulties should not prevent SLGs from servicing their outstanding debt. A number of independent observers such as CBPP, bond rating agencies, the National Association of State Budget Officers (NASBO), and many market participants have pointed out that interest payments as a percent of total SLG revenues have been stable over the last 30 years at 4 percent to 6.5 percent. The U.S. Census Bureau indicates that for 2008, the most recent data available, interest costs were 3.7 percent of SLG revenues with individual states ranging from 1.4 percent (Wyoming) to 6.8 percent (Massachusetts) of revenue. The NASBO indicates that "most state and municipal governments operate under a standard practice of paying their debt service first before covering all other expenses; in some cases this is required by law or ordinance." Although a period of rising interest rates could increase interest costs on current obligations, the overall impact would be muted since as reported by the Municipal Securities Rulemaking Board, the variable rate sector of the municipal securities market comprises only about 15 percent of the total market.

Moreover, SLGs as a whole do not appear overleveraged. As shown below, current SLG debt to GDP ratios are in line with the experience of the last 35 years. Similarly, in February 2011 congressional testimony, CBPP data showed that the average state debt of 18 percent is in line with gross state product, with individual states ranging from 7.1 percent (Wyoming) to 26.2 percent (Massachusetts).


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Bottom line. It is true that in certain revenue-bond sectors, a higher-than-average level of SLG defaults could be expected in a recession as deep and long as this one. An example is community development bonds issued to facilitate housing development in areas hard hit by the real estate downturn. In addition to the near term budget balancing issues discussed earlier, there are other, longer term issues that SLGs will have to deal with in coming years, especially the amount of unfunded pension liabilities at SLGs, rising education and health care costs (i.e. Medicaid), and management of future revenue sources and service needs under changing demographics (such as population aging and areas' growth or decline). However, notwithstanding these valid points, the rating agencies have indicated that, while there may be more downgrades, defaults on the scale predicted by the most negative forecasters are unlikely.

Standard & Poor's as well as other observers have pointed out that most SLGs do not have so much a debt service or leverage problem as they do a political problem. That is, SLGs have a number of ways to improve revenues (such as raising taxes or assessing fees) or reduce costs (laying off employees or cutting service levels). However, these solutions all require negotiated settlements with executive and legislative branches, local citizens, and interest groups as well as fiscal discipline.

Potential risks for Sixth District banks

Sixth District SLG budget gaps. Sixth District states have had to close budget gaps in each fiscal year since 2009 and are again projecting significant budget gaps in 2012. The projected 2012 gaps are smaller than the national average, which has been the general pattern since 2009. The current exception is Louisiana, which continues to be affected by revenue declines and increased costs related to the 2010 Gulf oil spill. (Tennessee has not yet reported its 2012 budget expectations.) To date, the smaller budget gaps have meant that Sixth District states have avoided the more draconian actions taken by some other states. Some District states such as Florida and Georgia (mostly Atlanta), however, have seen significant declines in property values, which could affect future property tax revenues since revaluations, changes in millage rates and the like result in lagging property tax changes.


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Exposures to the risk of loss in banks are often visible and measurable with existing tools and practices. As the fallout from the subprime crisis demonstrated, however, other exposures to loss are far less visible and difficult to measure accurately even when identified. One can think about Sixth District banks' risk of loss from SLG exposures along two lines:

  • Direct exposures: Those exposures that result from exposures to or transactions with SLGs
  • Indirect exposures: Those exposures that are transmitted to the bank through customers or through the general economic impact of actions taken by SLGs to close their budget gaps

Direct exposure to SLGs at Sixth District banks. The most common direct exposure to loss from SLGs is SLG debt securities held in bank investment portfolios. Historically, most bank securities portfolios have included some level of SLG securities.

SLG security holdings at Sixth District banks increased from $6.8 billion at the end of 2003 to $11.4 billion at the end of 2010, but as a percent of assets, these securities declined slightly from 1.7 percent to 1.6 percent of assets respectively. From an aggregate exposure view, these figures suggest that SLG securities held by Sixth District banks do not pose an excessively large risk. The following table illustrates several points about the distribution of those securities among Sixth District banks at the end of 2010.


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Notes:

  • Most District banks, almost 75 percent, held less than 5 percent of their assets in SLG securities.
  • Almost half of District banks, 45 percent, held less than 1 percent of their assets in SLG securities.
  • The large average asset size of banks holding less than 5 percent of their assets in SLG securities indicates that some very large banks have very little on balance sheet exposure to SLGs from their direct securities holdings.
  • A relatively small number of banks with a relatively small average asset size indicate that a few community banks hold a large portion of their assets in SLG securities.

SLG securities at Sixth District banks grew by 5.6 percent in 2010. When viewed by asset size, however, the distribution of the growth and differences in growth strategies become apparent. In particular, exposures declined at the largest banks, while midsize banks and community bank exposures increased.


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Looking at the median SLG securities level adds still more perspective. The declining trend in median SLG securities since 1990 abruptly reversed course in 2009, although as a percent of assets median SLG securities are still relatively small at 1.4 percent. Given the many different types of securities that banks can invest in, an increased appetite for SLG securities in 2009 and 2010 is evident by the increase in SLG securities from 6.8 percent to 11.6 percent of total securities. SLG securities have not comprised as much of banks' total securities portfolio since 1998.

On the surface, the trend reversal is interesting for several reasons: the adverse publicity about SLG financial conditions during that period, the collapse of the auction rate security market; and the fact that a good portion of the banking industry was experiencing losses and could not use the tax advantage that is an important factor for most investors in SLG securities.

The trend reversal is likely because of a number of other factors including the lack of lending opportunities in 2009 and 2010, the issuance of Build America Bonds in 2009 and 2010 pursuant to ARRA, which offered relatively attractive taxable yields. In addition, there was an increase in the amount of bank-qualified bonds that jurisdictions could issue, which allow bank buyers to deduct interest and related carrying costs. For many professional investors who have been skeptical of the case for defaults, the depressed prices during this period were considered a major buying opportunity.


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Based on these considerations, direct exposure to SLGs from securities holdings are currently not significant overall at Sixth District banks. There are some banks, however—primarily smaller, community banks—that do have significant exposures.

Moreover, there may be a trend developing of higher levels of investment in SLG securities. Assuming that SLG budgets will remain challenged for the next one to two years or more, the higher yields required to issue debt may become increasingly attractive to banks. A few banks have made loans to SLGs in the past, and there are indications that with current debt issuance costs so high banks may see direct lending as a business opportunity. We will continue to watch these trends.

Other direct exposures to SLGs include relationships and activities in certain business lines more often found in large banks. In some of these business lines and activities, exposures are easily identifiable. For example, risks involved in underwriting the issuance of municipal securities and providing letters of credit to support Variable Rate Demand Notes or Obligations are identifiable and largely measurable. In other business lines and activities exposures are identifiable, but the amount of financial risk involved is less apparent and more difficult to measure. A representative example could include acting as corporate trustee and providing financial advisory and other wealth management services through trust departments or broker/dealer operations. In this example, the immediate risk might be reputational or legal, but there could be financial risks as well that are not immediately apparent.

Indirect risk exposures to SLGs. These risks usually arise not from the bank itself but may result from events outside the bank's control. Examples could include changes in the credit quality of commercial loan customers that depend on contracts and business relationships with SLGs. For example, the bank may have financed a commercial real estate investor that has leased buildings to SLGs for programs that are being eliminated. Depending on the community, layoffs could hurt borrowers with small business loans, consumer loans, home mortgage loans, or student loans.

The general drag on local economies from large layoffs and spending cuts that ripple through the local economy reducing demand for goods and services and limiting growth opportunities is an effect that is hard to specifically identify and measure but could significantly slow the recovery of some District banks from the severe real estate downturn and general recession. Similarly, some currently less well understood results could slow local economies, such as the potential impact on property values and population migrations from reduced availability or reduced quality of basic services like education and public safety.

Finally, as in the subprime crisis, a very potent risk would be the sudden appearance of unanticipated interconnections between SLG financial problems or defaults and other market participants that create market uncertainties and disruptions resulting in broadly dispersed losses.

Current supervisory posture

Although forecasts for widespread defaults currently appear overstated at present, and Sixth District direct exposures to defaults are not excessive, there are significant uncertainties about how long the current SLG difficulties will remain and how they will be resolved. Given the speed at which financial markets and conditions can change, these issues will remain near the top of our list of concerns and our supervisory plans reflect that concern.

As to addressing direct risk exposure, we continue to emphasize securities portfolio risk management policies and practices as they relate to credit analysis, periodic review and monitoring, and portfolio diversification and concentration limits. At the larger banks, we review business line policies and practices as they relate to SLGs, and we regularly discuss with bank management their efforts to identify and measure specific risks as they relate to SLGs.

While not to diminish the direct risks, overall we believe the major exposure for Sixth District banks involves how actions taken by SLGs to balance budgets are affecting local economies and bank customers. Any adverse impacts would be negative factors for recoveries just beginning to take hold in major District economies, while most banks are still working through the fallout of the real estate downturn. We are discussing these issues on a regular basis with economists. Our examiners are discussing with management of banks their efforts to identify specific customers or customer segments at risk as well as significant local economic fallout from SLGs' actions to balance budgets.