Local Government Financial Crisis – the next subprime?

Reading Michael Lewis’ shocking account of Wall Street’s apparent deliberate effort to destroy the housing market in The Big Short got me to thinking “what’s next?”¬†¬† Apparently, I am not alone, as indicated by this NY Times article noting that many states are facing unprecedented debts due to pension obligations and severe revenue shortages.¬† Headlines trumpet the crisis of city after city across the country facing unpopular choices of cutting police and fire positions, closing libraries, terminating services and deferring maintenance in desperate attempts to address the shortfall.¬† For many cities, it may be a case of too little, too late.¬† With the States and Federal government in similar straits, there is no one to bail the cities out.

Like the housing crisis, the tremors of doom ripple through the bond market, and it is very likely there is a “big short” in play by some investors who are betting against the cities, just as they bet against the subprime market and walked away with billions of dollars in profits when the inevitable collapse of the house of cards came down in September, 2008.¬† Meanwhile, the fallout of the housing collapse continues to drag the entire economy despite the infusion of billions of dollars by the government.¬† Now, the lender of last resort is in trouble; the cities are drowning in debt and the lifeguards have been laid off.¬† Unfortunately, the confluence of these two disasters feed on each other in a negative way:¬† foreclosures cause a widespread drop in home prices, destroying neighborhoods while reducing revenue that would fuel job growth;¬† lowered prices chokes new development that would produce fees that would pay for government services; the loss of revenue threatens municipal bond ratings that would otherwise help fund the debt.

Whether municipalities will file for bankruptcy or default on their bonds is a more complicated question than predicting whether millions of homeowners would eventually default on the ridiculous “designed to fail” subprime mortgages that were issued in the early years of the past decade.¬† Only a few defaults have actually occurred, and municipal bankruptcy is much more difficult to accomplish, in many cases requiring State approval.¬† However, just at the ill-fated government programs designed to help homeowners avoid foreclosure failed in spectacular fashion, municipal efforts to halt the slide towards bankruptcy are facing stiff obstacles.¬† At the front are the unions, who understandably vigorously oppose any cuts to pension benefits or wage concessions.¬† Immediately behind them are the taxpayers, who just as understandably reject any proposal to increase taxes, unless it’s levied against someone else, like marijuana dispensaries, alcoholic beverage establishments, or tobacco stores.¬† And then there are the residents themselves, who demand not only that the city maintain police and fire services, but also understandably want potholes filled and streetlights replaced quickly.¬† Last, but not least, are the multitudes of elected officials who, while dedicated enough to hold office in turbulent times, lack the knowledge, training or experience to ask the right questions and make the right decisions.

The inevitable consequence of all this is that cities will make poor choices.¬† A few have just shut down and contracted out their operations, but that only kicks the can down the street.¬† Unfortunately, officials are still in the early stages of denial — “it can’t happen — it’s never happened before” — just as Lewis documented Wall Street’s initial response to evidence that the subprime loans were doomed to failure.¬† “Housing prices always rise,” they said.¬† And they created complex securities that guaranteed they would make money no matter what happened, until it did.¬† With cities, the story is the same — instead of making the really tough choices, they look for creative ways to avoid the inevitable, from raising taxes and even investing in junk bonds — and increase fees.¬† The problem, of course, is that these are band aids at best, not solutions, and in some cases make the problem worse.¬† Just as Wall Street’s appetite for anything that would generate transaction fees led to the promotion of even more subprime loans, many municipal attempts to create revenue are designed to avoid laying off government employees, not reduce the overall deficit.¬† Worse, such measures could have an adverse impact on the private sector, making it more difficult for small businesses to expand, hire new employees, or otherwise do their part to help the economy.