Fate of the States: The New Geography of American Prosperity (7 page)

In fiscal year 2010 the federal government transferred just over $500 billion to the states, with states receiving over $700 billion in tax receipts, over $450 billion from insurance trust revenue (employee retirement systems, unemployment, and workers’ compensation programs), and over $300 billion from other revenues to account for their $1.9 trillion in expenditures.
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In order to balance their budgets, states have increased their borrowing over the past decade. How was this possible when so many states must balance their budgets under the law? The undeniable answer: debt. In fiscal year 2010, states issued $147 billion in new general-obligation bonds (municipal bonds backed by the credit and taxing power of the state rather than by a specific source of revenue, such as highway tolls) and increased their unfunded pension liabilities (the difference between what a state is required to pay into a pension plan and what it has actually paid) by $225 billion. Record-low interest rates have made debt accumulation appear at least manageable, even harmless. As a result, states have amassed close to $1.5 trillion in additional municipal debt since 2000, almost doubling their total municipal-debt load.
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While some states have limitations on how much debt they can have outstanding, the rules typically apply only to general-obligation bonds and specifically to the debt service on those bonds—not to the actual amount of debt amassed. Clearly in a low-rate environment like the one we have been in for the past fifteen-plus years, these “debt limits” encourage the same type of easy-money-mortgage mentality that too many American consumers adopted during the housing bubble. Yes, teaser-rate mortgages may be affordable in the short term, just as issuing $100 billion in five-year general-obligation bonds may be relatively inexpensive. But what happens if you have to refinance your mortgage or roll over your municipal-bond debt at a time when rates are much higher?

Finances should never be that complicated. “Don’t spend what you don’t have” is a simple adage most individuals take to heart but one never fully embraced by politicians. Governments see themselves as providers of last resort for basic social services. For years, states and municipalities could afford to be generous and spend more than they took in. Federal funding helped out the states, state funding supported the cities, and a growing economy supported tax revenues at all three levels. Then came the Great Recession. There was so much demand for unemployment benefits, states had to take loans out from the federal government just to keep the programs going. Now the states are struggling to find ways to pay those loans back. States that borrowed too much or funded their pensions too little are caught in a budgetary vise. It’s even worse for the cities and counties. The feds are sending less to the states, the states are cutting back on aid to cities, and cities are being forced to accept spending cuts and austerity budgets that just a few years ago would have been unimaginable.

Forty-nine states are bound by their own constitutions to maintain balanced budgets, yet for five of the past ten years, the states have run $590 billion in shortfalls. As states issue more debt in order to balance budgets and avoid spending cuts, the size of state debt grows and so does the annual cost of all that debt. Growing debt-service costs have been camouflaged over the past decade by low interest rates, but that game is coming to an end. Even low rates cannot cover up the sheer weight of the debt loads being amassed. Over the past few years, tax receipts have not been growing fast enough to keep pace with rising debt service, forcing states to cut back elsewhere.

As any consumer knows, spending what you don’t have is unsustainable. For states, excessive spending is coming to an abrupt end with bruising consequences—much like what happens to the consumer who runs up way too much credit-card debt. Sooner or later, even the minimum payment on the credit-card bill becomes too large and there isn’t enough money left over to pay for everyday expenses. That’s the predicament far too many states now find themselves in. In six of the past ten years, states have had to cut back or eliminate programs, and in some cases raise taxes, to balance their budgets, but there is less and less wiggle room as the costs of minimum service payments on debt keep growing into a larger portion of the overall pie. Over thirty states have cut public health assistance. Twenty-nine states have cut elderly and disabled assistance. Over thirty states have cut K-12 education programs. Over forty states have cut payroll or imposed furloughs on state workers.
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For some it’s only going to get worse—in part because many of their taxpayers are in deep trouble too.

The Wrong Bet and the Worse Outcome

One fall day in 2001, I visited with the management team at MBNA, the largest independent credit-card company at the time, now owned by Bank of America. The country was in a recession, and the conversation revolved around credit. Were people paying their bills on time? Were delinquencies becoming more or less frequent? For a lender a loan is only as good as the borrower’s willingness to honor it, so judging the risk qualities of a customer is critical. The folks at MBNA told me something important: As far as credit goes, 80 percent of losses came from 20 percent of customers. And what was the commonality of that 20 percent? They were the customers least likely to own a home.

Turns out that it wasn’t just MBNA that believed this. It was the entire lending industry. But back in the fall of 2001, roughly 65 percent of Americans owned homes. That was the way it had been for several decades, so there was a long precedent to support that underwriting mentality and discipline. However, from 2002 on, it became an entirely new playing field. By 2006 homeownership had shot up to almost 70 percent in the United States.
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Did the 80/20 logic still apply? Turns out, lenders didn’t adjust to the new reality of homeownership and consumer credit as homeownership skyrocketed. If people owned homes, they were deemed more creditworthy. Therefore, as more and more people qualified for homeownership, they were plied with more and more debt. From 2000 to 2008 mortgage debt grew by over 150 percent, revolving home-equity lines grew by over 500 percent, and standard credit-card debt grew by almost 60 percent.
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Because rates were near record lows, the monthly payments, or carrying costs, were low too. The clear problem was, there was no guarantee those carrying costs would stay low. Because so much of this new debt was priced on an adjustable-rate basis, it made once-unthinkable debt levels seem manageable to many new or first-time borrowers.

By 2009 the U.S. consumer owed over $14 trillion, mostly in mortgage loans to banks and other consumer finance companies. The situation was especially bleak in the housing-bust states. In California, for instance, consumer debt per capita reached $74,950 in 2010, and the ratio of debt-to-income per capita soared to 174 percent in 2010. Nevada followed closely behind at $57,660 and 156 percent respectively.
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Homeowners had been on a borrowing bonanza. At the peak of the cycle, homeowners took over $300 billion out of their homes and borrowed another $700 billion in home-equity lines of credit. More often than not, that was in addition to their first mortgages. “Skin in the game,” or equity in homes, dropped to under 45 percent by 2008 from well over 65 percent in the 1980s. Heading into 2008, banks were prepared to let homeowners take on even more debt. On top of the over $700 billion in drawn home-equity lines of credit in 2008, there was an additional $700 billion in unused lines extended and ready to be drawn upon. The numbers on credit cards are even more astounding. In 2008 there was over $800 billion in credit-card debt outstanding, but there was also an additional $4.7 trillion in untapped credit-card lines available and ready to be tapped.
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When the housing bust and credit crisis hit, home prices nationally were hit hard, but in some areas they were truly devastated. If a consumer got to the housing party late, as so many did between 2003 and 2006, they found themselves underwater in debt by late 2008, owing more on their mortgage than their underlying home was worth. The ripple effect on local communities where home values were hit the hardest was profound. There consumers had suffered the greatest wealth destruction, and suddenly unemployment was rising too. That’s not all. Consumers in areas that had once been overbanked—where getting a loan had once been easy—were suddenly cut off from new credit. According to the
Wall Street Journal,
loan volume was plunging in the coastal states: “The largest drops were in cities scattered across California and Florida, the states hit hardest by the U.S. housing bust. New lending in Merced, California, which experienced one of the worst housing collapses in the United States, ended last year 81 percent below the peak of 2006. The three largest U.S. cities—New York, Chicago and Los Angeles—experienced decreases of 38 percent, 44 percent and 55 percent, respectively.”
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Conversely, states in the middle of the country have done a better job of keeping consumer debt in check. Residents there have better employment opportunities and more disposable income, and thus lenders are willing to extend them credit. In Cedar Rapids, Iowa, for instance, consumer loan volume in the fourth quarter of 2011 was 52 percent higher than in the same period of 2006, according to the
Wall Street Journal.

There’s a popular expression in the banking industry: “A rolling loan gathers no loss.” What it means is that as long as there is liquidity in the market, losses are not meaningful. Once it becomes difficult to refinance a loan, roll debt over, or even get a new loan, all bets are off. Some borrowers need more time to pay off the principal, whereas others cannot afford the higher interest payments that kick in after the teaser rates expire. That’s when the losses come. By late 2008 the banks were painfully aware of how dangerously aggressive they had been in handing out loans during the boom. In order to protect themselves, they quickly cut back any excess credit lines they had remaining in the system. What that translated into was $4.7 trillion of unused credit-card lines being cut back to $3.2 trillion by early 2010, a more than 30 percent cut of $1.5 trillion from the entire U.S. credit-card system. Given that credit-card lines had truly become a cash-management vehicle for some consumers and small-business owners, these cuts were especially disruptive. At that point, at least 50 percent of credit-card customers were revolving their credit-card debt every month, meaning they did not or could not pay their monthly payment in full each month. Home-equity lines of credit were going in the same direction. From mid-2008 to mid-2010, home-equity lines of credit were cut back from over $700 billion to $514 billion, almost $200 billion less.
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The lending party was officially over. Unused credit lines that had once given consumers a sense of security (albeit elusive and unjustified) for unforeseen events like a sudden car repair, a child needing braces, a spouse suddenly losing a job, etc. were gone. There was no emergency credit available, no new credit offers; it was just the bills that remained.

As people began to emerge from the haze of the housing bust, they were served with not one but two rude awakenings. Not only did they owe $14 trillion in consumer loans, but they owed another $6 trillion that had been run up on their tab in the form of state and local government obligations.
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Because much of this state debt was guaranteed by future tax dollars, state governments had effectively doubled down on an already debt-burdened consumer. It is bad enough losing money you have in the bank or stock market; it is a whole different matter to lose borrowed money, which is effectively what has happened to residents of states that piled on the most debt over the past decade.

Most people understand that when a state issues municipal-bond debt—specifically debt that carries the guarantee of the taxing authority—residents of the state are collectively bound to pay it back. Such a notion is so well understood that almost every state has a cap on this kind of debt so that the total debt load never gets out of control—never jeopardizes the financial health of the states and their residents. But if the cap only applies to the debt service, not to the total amount of debt, state and local governments can too easily talk themselves into taking on debt that could be much more expensive to service down the road. The low-interest-rate environment in the United States enabled, if not encouraged, states to pile record amounts of debt onto their balance sheets while safely remaining below their “caps.” The same “monthly payment” mentality that lured many consumers to take on mortgages that they couldn’t afford enticed states to load up on debt obligations they couldn’t afford either. The cost ends up being borne by all taxpayers, frugal and spendthrift alike. Let’s say, for example, the Fitzgibbon family resisted the temptation of taking on excessive debt or too big a mortgage, but their neighbors, the Gradys, took a huge chunk of equity out of their already highly leveraged home and racked up mounds of credit-card debt to boot. For a while the Gradys enjoyed a far more lavish lifestyle than the more frugal Fitzgibbons—spending on cars, fifty-inch flat-screen TVs, expensive vacations, and the like. When the housing bust hit, the Gradys were faced with bills they just couldn’t afford. The Fitzgibbons might have been sympathetic, but nobody expected them to be on the hook for their neighbors’ debts. But things worked differently for the neighbors when it came to the debts their state and local governments racked up on their behalf. Both neighbors had to pay equally for the excessive government spending of the past decade.

Making matters worse was the 30-plus percent decline in home prices that left nearly a quarter of all people with mortgages owing more on their mortgage than their homes were worth. So imagine your home value declines by 30 percent, but your property taxes actually rise—a familiar story all across the country. The first option used by many local politicians to offset lower tax revenues was simply to hike tax rates. This had the unintended result of actually further depressing home values—and thus property taxes—because the higher taxes did not come with better services. Imagine you’re a prospective home buyer looking at two similar and similarly priced homes in neighboring towns. The school systems are equivalent, as are town recreation programs and the fire and police departments. But one house carries a $5,000 property-tax bill, while the other’s is $10,000. Which house are you going to buy?