Center for Financial Innovation and Stability

Notes from the Vault

Gerald P. Dwyer
February 2011

• Interest rates on state and local government debt have exceeded rates on federal government debt since the onset of the financial crisis in 2007, presumably at least partly due to credit risk.
• Decreases in tax revenue and increases in debt are informative, relatively simple measures of fiscal pressures faced by governments.
• The available data do not support a forecast of widespread defaults and losses on municipal bonds.

The ongoing sovereign debt crisis in Europe has heightened awareness of government debt and the sustainability of governments' spending and tax policies. At the same time, large deficits in some U.S. states have brought states' and local governments' finances to the headlines. There also have been sustained controversies concerning state government spending (Weitzman 2011). Before these developments, Meredith Whitney, a financial analyst, claimed on 60 Minutes that hundreds of billions in dollars in defaults on local government debt were likely (Kroft 2010). These comments were followed by substantial outflows from funds holding these bonds (Lydon 2011). More recently, Nouriel Roubini's consulting firm—known for its relatively gloomy forecasts—estimated defaults on $100 billion of state and local debt over the next five years, with about 20 billion dollars in actual losses (Corkery 2011).

These estimated defaults and losses can be compared to about $2,411 billion in total state and local debt outstanding in 2008. If the losses are confined to local government debt, as is generally expected, these estimates are more appropriately compared to local debt outstanding of $1,539 billion. Defaults on hundreds of billions of dollars of debt would be defaults on more than 10 percent of total debt, and even defaults on $100 billion are defaults on 6.5 percent of total debt. Both figures indicate quite a bit of local government debt in a distressed state in the next five years.

Defaults are not the same as losses. Default can mean a delayed payment or, in the case of Whitney, even just a violation of covenants in the documents creating the debt. Total losses of $20 billion generate a loss rate of about 1.3 percent over five years, which is not zero but is hardly catastrophic.

These concerns about debt and possibly the loss estimates have affected yields on state and local government bonds. Often called municipal securities for short, most bonds issued by state and local governments are exempt from federal income tax, which lowers the interest rates that state and local governments pay. These bonds are not traded on an organized exchange and, naturally enough, can be priced differently across states and across issuers within a state. As a result, it is not simple to estimate yields. There are various measures, with advantages and disadvantages.

No matter what the measure, recent months have been associated with increases in yields on municipal debt. Chart 1 shows yields on U.S. Treasury 10-year bonds and Bond Buyers' index of 20 state and local government bonds. The bonds in this index have an average rating of roughly AA. The yields track each other, but sometimes the yield on U.S. Treasury bonds is greater than the state and local government bond yields and sometimes it is less.

The 20-Bond Municipal Index consists of 20 general obligation bonds that mature in 20 years. The average rating of the 20 bonds is roughly equivalent to Moody's Investors Service's Aa2 rating and Standard & Poor's Corp.'s AA. The indexes are indicative yields rather than actual price or yield quotations. Municipal bond traders are asked to estimate what a current-coupon bond for each issuer in the indexes would yield if the bond were sold at par value. The indexes are simple averages of the average estimated yields of the bonds.

An estimate of the after-tax yield on these state and local government bonds is quite a bit more than the yield on these U.S. Treasuries. These state and local government securities generally are exempt from federal income tax. For example, if the yields on both bonds are 6 percent and a taxpayer has a marginal income tax rate of one-third, the after-tax yield on the Treasury bonds is only 4 percent after tax, quite a bit less than the 6 percent after taxes on the state and local bonds. When the yields on both bonds are more or less the same, as they have been since 2007, the after-tax yield on the municipal bonds is quite a bit higher than the yield on Treasuries.

The yields on state and local government bonds generally have been lower than yields on U.S. Treasury securities. The average difference between the yields is 0.31 percent per year up to the start of the financial crisis in August 2007. Recessions, shown by the bars in chart 1, do not appear to explain much of the yield differences.

Chart 2 shows yields on 10-year municipal bonds for selected states and for the U.S. Treasury. While available only since 2005, these yields have a constant maturity of 10 years for both the Treasury and municipal bonds, which makes them more nearly comparable than the bonds in chart 1. The bonds included in chart 2 are roughly representative of the market. U.S. Treasury bonds are included for reference. Over this period, Georgia municipal bonds have among the lowest yields. California, Illinois, and Wisconsin are included because they were in the news quite a bit in January and February 2011.

The 10-year Treasury yield is the constant maturity yield. The yield for each state for each month is estimated from a yield curve populated with general obligation bonds issued by the state government and municipalities in the state. All bonds have the same average rating as the state general obligation. The option-free yield curve is built using option adjusted spread model. The yield curve is based on contributed pricing from the municipal securities' rule-making board, new issue calendars, and other proprietary prices contributed to Bloomberg.

As in chart 1, yields on municipal bonds increased relative to U.S. Treasury yields in 2007 and have yet to return to the relationship before the financial crisis. The yields on California and Illinois bonds are elevated relative to U.S. Treasuries and Georgia bonds. Wisconsin bond yields are not so different than Georgia bond yields.

What is an informative way to measure the financial stress faced by states and local governments? Some analysts have been using debt relative to gross domestic product (GDP), presumably by analogy to countries such as the United States and countries in the European Union. A little bit of thought shows why this is not an informative measure of fiscal pressure or distress. The ratio of debt to GDP is a useful indicator for a country because it can be used to construct an estimate of the fraction of GDP that must be devoted to debt service. For example, if a country has a ratio of government debt to GDP equal to one, then an interest rate of 5 percent implies that 5 percent of GDP must be devoted to debt service. If the interest rate is 10 percent, then 10 percent must go to servicing debt, and so on. For a country, much or all of total government debt serviced by citizens is the debt of the country's government. For a state, that is far from true. Residents of California must pay interest on their share of federal government debt as well as all of California's debt, and the federal debt is the larger of the two.

A more pertinent measure of fiscal pressure under current circumstances examines both the growth rates of tax revenue and debt. Falling tax revenue, by itself, provides evidence of fiscal pressure from receipts. Absent changes in spending, less revenue shows up as greater debt growth. By itself, higher debt growth may indicate financing of a long-term investment and not fiscal pressure at all. Combined with falling tax revenue, higher debt growth is more indicative of fiscal problems that have not been addressed.¹

Chart 3 shows the percentage changes of state government revenue and government debt. The states in the upper left panel are the ones with negative growth of government revenue and positive growth of debt. While it might seem at first glance that Alaska, with revenue falling by 27 percent, might be in substantial difficulty, this surmise is incorrect because of state reserves. The decline in revenue related to oil affects Louisiana as well, which is the state with a 10 percent decrease in revenue and a 7 percent increase in state debt. Arizona is the state with a decrease in revenue and the largest increase in debt, 17 percent. California shows up with a 4 percent decrease in revenue and a 10 percent increase in debt. Illinois, from 2008 to 2009, has a 1 percent increase in revenue and a 3 percent decrease in debt.

The chart shows the percentage change of general revenue and debt for each state from the fiscal year ending in 2008 to the fiscal year ending in 2009. The two-letter abbreviation for each state indicates each observation.

Local governments are of substantial interest. Claims of likely defaults are concentrated in some of the numerous local governments. Unfortunately, data on local governments' finances for 2008 to 2009 will not be available from the U.S. Census Bureau until October 2011. Chart 4 shows the data for 2007 to 2008, which cover part of the recession but not the extended aftermath. In the aggregate by state, local governments were in reasonably good shape at of the end of their 2008 fiscal years. Only in Michigan had local governments suffered an actual decrease in revenue. Partly this reflects the noncyclical nature of local governments' revenue compared to states' income taxes and sales taxes. Still, the large number of governments in each state no doubt masks individual problems.

The chart shows the percentage change of general revenue and debt for local governments in each state from the fiscal year ending in 2008 to the fiscal year ending in 2009. The two-letter abbreviation for each state indicates each observation.

Even with all the qualifications, the data do not support a forecast of widespread defaults and losses on municipal bonds.

Gerald Dwyer is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. Thomas Cunningham provided helpful comments on an earlier draft. Ellyn Terry's research assistance is greatly appreciated. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.

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¹ Even with both falling tax revenue and higher growth of debt, there may be little reason to change fiscal policy if the lower tax revenue is not too large and is temporary.

References
Corkery, Michael. 2011. "Muni default estimate: $100 billion," Wall Street Journal, March 2. http://online.wsj.com/article/SB10001424052748703409904576174933066991472.html

Kroft, Steve. 2010. "State budgets: The day of reckoning," 60 Minutes, December 19. http://www.cbsnews.com/stories/2010/12/19/60minutes/main7166220.shtml.

Lydon, Tom. 2011. "Muni ETFs suffer record outflows, ETF Trends," January 23. http://www.etftrends.com/2011/01/muni-etfs-suffer-record-outflows/.

Weitzman, Hal. 2011. "Wisconsin deadlock as Democrats flee budget vote," Financial Times, February 18. http://www.ft.com/cms/s/0/14250d74-3af1-11e0-8d81-00144feabdc0.html#axzz1GbGP50XY.