Domestic Pigs

A lot of the news flow in recent weeks has focused on the P.I.I.G.S. (Portugal, Iceland, Ireland, Greece, and Spain) and their balance sheet woes - and rightfully so. As usual, we like to focus our Hedgeyes on other issues once our calls become consensus and have been spending time state pension liabilities.

A recent release by the PEW Center on the States shows a $1 trillion gap between the $3.35 trillion in pension, health care, and other retirement benefit-related liabilities currently on States balance sheets and the $2.35 trillion in assets they have to cover them.  Moreover, that funding gap is likely to increase when 2008's losses are factored in, as many states smooth gains/losses over a average of five years.

Currently, 41 States' pension programs are less than 10% funded.  In addition, only 5% of the $587 billion liability for current and future retiree health care and other non-pension benefits is currently funded. Interestingly enough, Illinois - where current president Barack Obama was a Senator prior to taking the Oval Office - was in the worst shape of any state, with a funding level of 54 percent and an unfunded liability of more than $54 billion.

Below are some of the State level exposures that the PEW Center coagulated:

 Domestic Pigs - State Pension Funding Levels

To deal with massive deficits  - totaling approximately $290 billion - many States have tapped into their rainy day funds in fiscal 2009 and 2010 at levels not seen since the 2001 recession. 

Several States have dried up their funds to balance their current budgets, including Alabama, Arizona, California, Connecticut, Maine, New Jersey, Ohio, Oklahoma and Pennsylvania. Sixteen other states relied on their reserves to help eliminate 2010 budget deficits according to a recent NASBO survey.

Factoring in last year, a total of 41 states have accessed reserves to cover their deficits. An interesting takeaway here is that many politicians and state legislators are reluctant to draw upon their rainy day funds out of fear that it would hurt their State's bond ratings, which would ultimately drive up their cost of capital at the worst possible time.

 Domestic Pigs - Two Decades of Saving and Spending

So what's left for poor states to do? They have essentially the same three options they always have:

  1. Raise taxes
  2. Cut programs and reign in spending
  3. Issue debt to fund their deficits

Fiscal 2009 estimated tax collections of sales, personal income, and corporate taxes were 7.4% lower than actual fiscal 2008 collections. Furthermore, States are projecting a further decline of 1.4% in tax collections relative to fiscal 2009 current year estimates. Despite the low projection, raising taxes seems unlikely, considering the current state of unemployment. Although jobless claims have been, for the most part, improving steadily since last March, a 9.7% unemployment level is hardly an environment to raise taxes in. But never say never. If some of these States were named Greece, they’d be told to raise taxes.

Some States have been cutting and plan to continue cutting funding, which has been hanging many municipalities, school districts, and health programs out to dry. For example, in fiscal 2009, 29 States cut K-12 resources (21.1% of State spending) and 30 are planning to do so in fiscal 2010. Likewise, 27 States cut Medicaid funding (21% of State spending)  in fiscal 2009 and 28 are planning to do so in fiscal 2010. In New York, Governor David Paterson temporarily held back $750 million in local aid last December. In Arizona, Governor Brewer wants to defer about $350 million that is owed to school districts this fiscal year until next fiscal year.

Unfortunately for State governments, purging the balance sheet is only a temporary fix. Across the country, State governments are facing lawsuits from municipalities school districts outraged by budget cuts. Expect these lawsuits to continue until States can find a sustainable way to fund their budgets.

So with their backs against the funding wall, States must find a cumulative $18.8 billion to balance their budgets in remaining months of the current fiscal year and an additional $53.6 in fiscal 2011. Moreover, expectations for state pension fund returns on the heels of a 65% rally in the S&P seem aggressive at best.

Lucky for them, they can join Portugal, Iceland, Ireland, Greece, Spain, and our very own United States government in kicking the can down the road by issuing more debt. Piling debt, upon debt, upon debt - now that's a novel concept! Furthermore,  an interest rate hike would effectively raise the cost of capital for each of the 50 states, which would leave states like Kansas that have no access to rainy day funds feeling the pressure to issue as much paper as they can before the cost of doing so increases.

 Domestic Pigs - State Govt Debt Issuance

With funding levels at only 50-60% of liabilities, States like Illinois and Oklahoma will start to see their CDS levels rise meaningfully if fiscal 2011 budget shortcomings are not addressed. A wise man told me that governments  make bad companies, as far as balance sheet analysis is concerned. U.S. Federal and State governments are no different. While the Fed balance sheet has been getting better on the margin in recent weeks, a +$364 billion y/y number is hardly something to ignore. Furthermore, unfunded liabilities have been on the rise and will continue to be an issue.

 Domestic Pigs - US Unfunded Liabilities

By now, it's hardly news that the U.S. has found itself in a serious fiscal hole. It is important to note, however, that the $1 trillion hole left by the developing State pension funding crisis adds one more straw to the camel's back. As we say here at Hedgeye, everything that matters in global macro happens on the margin. With that in mind, the PEW Center's findings are incrementally more negative, and, on the margin, this report should make the U.S. government debt situation appear a little worse. While were not calling for the United States of America to default on its sovereign debt for the first time in history, we are raising concerns that its expanding balance sheet and accelerating sovereign debt issuance could potentially lead a downgrade in its credit rating.

While the decisions of Moody's sovereign debt rating team hardly move us at face value here at Hedgeye, we do recognize their decisions have great influence over debt markets. And we're all familiar with the inverse correlation between credit ratings and cost of capital.

Expect this to get priced into the market over the coming months, as the biggest long term TAIL risks that the global economy faces when it comes to government debt isn’t that of Greece, but of that of both Japan and our very own.

Darius Dale

Analyst