Fed’s Dudley Warns about Wave of Municipal Bankruptcies

The Fed is doing workshops on municipal bankruptcies now.

It has been a persistent ugly list of municipal bankruptcies: Detroit, MI; Vallejo, San Bernardino, Stockton, and Mammoth Lakes, CA; Jefferson County, AL. Harrisburg, PA; Central Falls, RI; Boise County, ID.

There are many more aspirants for that list, including cities bigger than Detroit. Detroit was the test case for shedding debt. If bankruptcy worked in Detroit, it might work in Chicago. Illinois Gov. Bruce Rauner wants to make Chapter 9 bankruptcies legal for cities in his state, which is facing its own mega-problems.

“Bankruptcy law exists for a reason; it’s allowed in business so that businesses can get back on their feet and prosper again by restructuring their debts,” Rauner said. “It’s very important for governments to be able to do that, too.”

His plan for sparing Illinois that fate is to cut state assistance to municipalities, which doesn’t sit well with officials at these municipalities. Chicago Mayor Rahm Emanuel’s office countered that balancing the state budget on the backs of the local governments is itself a “bankrupt” idea.

Puerto Rico doesn’t even have access to a legal framework like bankruptcy to reduce its debts, but it won’t be able to service them. It owes $73 billion to bondholders, about $20,000 per-capita – more than any of the 50 states. If you own a muni bond fund, you’re probably a creditor. Bond-fund managers use its higher-yielding debt to goose their performance. But now some sort of default and debt relieve is in the works. The US Treasury Department is involved too.

“People before debt,” the people in Puerto Rico demand. It’s going to be expensive for bondholders.

That’s the ugly drumbeat in the background of New York Fed President William Dudley’s speech today at the New York Fed’s evocatively  named workshop, “Chapter 9 and Alternatives for Distressed Municipalities and States.”

So they’re doing workshops on municipal bankruptcies now….

“We at the New York Fed are committed to playing a role in ensuring the stability of this important sector,” he said, referring to the sordid finances of state and local governments. But he wasn’t talking about future bailouts by the Fed. He was issuing a warning to municipalities and their creditors about “the emerging fiscal stresses in the sector.”

It’s a big sector. State and local governments employ about 20 million people – “nearly one in seven American workers.” The sector accounts for about $2 trillion, or 11%, of US GDP. And its services like public safety, education, health, water, sewer, and transportation, are “absolutely fundamental to support private sector economic activity.”

The problem is how all this and other budget items have gotten funded. There are about $3.5 trillion in municipal bonds outstanding. So Dudley makes a crucial distinction:

When governments invest in long-lived capital goods like water and sewer systems, as well as roads and bridges, it makes sense to finance these assets with debt. Debt financing ensures that future residents, who benefit from the services these investments produce, are also required to help pay for them. This principle supports the efficient provision of these long-lived assets.

“Unfortunately,” he said, governments borrow to “cover operating deficits. This kind of debt has a very different character than debt issued to finance infrastructure.” It’s “equivalent to asking future taxpayers to help finance today’s public services.”

In theory, 49 states require a balanced budget every year, but it’s easy enough to “find ways to ‘get around’ balanced budget requirements” and cover operating expenses with borrowed money, he said, including the widespread practice of “pushing the cost of current employment services into the future” by underfunding pensions and retiree healthcare benefits for current public employees.

The total mountain of unfunded liabilities remains murky, but estimates for unfunded pension liabilities alone “range up to several trillion dollars.” With these unfunded liabilities, employees are the creditors. That would be on top of the $3.5 trillion in official debt, where bondholders are the creditors.

And eventually, high debt levels and the provision of services clash as in Detroit and Stockton, he said, and render public sector finances “unsustainable.”

But cutting services to the bone to be able to service the ballooning debt entails a problem: citizens can vote with their feet and move elsewhere, thus reducing the tax base and economic activity further. To forestall that, municipalities may alter their priorities and favor the provision of services over debt payments. “This may occur well before the point that debt service capacity appears to be fully exhausted,” he said.

In other words, the prioritization of cash flows to debt service may not be sustainable beyond a certain point. While these particular bankruptcy filings [by Detroit and Stockton] have captured a considerable amount of attention, and rightly so, they may foreshadow more widespread problems than what might be implied by current bond ratings.

That was easy to miss: foreshadow more widespread problems than what might be implied by current bond ratings. Dudley in essence said that current bond ratings – and therefore current bond prices and yields – don’t reflect the ugly reality of state and municipal financial conditions.

It was a warning for states and municipalities to get their financial house in order “before any problems grow to the point where bankruptcy becomes the only viable option.”

It was a warning for public employees and retirees – in their role as creditors – to not rely on promises made by their governments concerning pensions and retiree healthcare benefits.

And it was a warning for municipal bondholders that their portfolios were packed with risky, but low-yielding securities that might end up being renegotiated in bankruptcy court, along with claims by public employees and what’s left of their pension funds. And it was a blunt warning not to trust the ratings that our infamous ratings agencies stamp on these municipal bonds.

Some states are worse than others. Even with capital gains taxes from the booming stock market and startup scene raining down on my beloved and crazy state of California, it ranks as America’s 7th worst “Sinkhole State,” where taxpayers shoulder the largest burden of state debt. Read…  The 10 Worst “Sinkhole States” in America

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  17 comments for “Fed’s Dudley Warns about Wave of Municipal Bankruptcies

  1. LeftCoastIndependent says:

    This is what happens when wages don’t keep up with the cost of living. The ponzi falls apart.

    • Gee says:

      In theory, there are the multiple warnings you mention. But in reality, the one that is the most sickening and most indicative of the new economic reality is the one for:

      “…public employees and retirees – in their role as creditors – to not rely on promises made by their governments concerning pensions and retiree healthcare benefits.”

      People signed up for these otherwise low paying jobs precisely because of the PROMISE of a pension, which is supposed to make up for that shortfall.

      Labor market economists like to wax eloquent about the rational economic actor that made such a choice, but that was based upon an implied contract. Some might say explicit contract, but you see how that is working out once it gets into the courts.

      The fact that these promises are nothing of the sort, is a truly remarkable shift of the economic paradigm. Now, many retirees won’t have a pair of dimes to rub together in retirement, which will be forced upon them, and will go back to work if they can in some degrading and low paying service role which wears them down standing on their feet all day.

      All this so that the bondholders can have a nice fat risk adjusted return, much better than they actually anticipated, in that the risk that has been fobbed off on the municipal employees. You can pretty much count on it nowadays that the employees will be sacrificed before the bondholders. You can see it all around the globe, and not just at the municipal level.

      • CrazyCooter says:

        At multiple times, I worked with/for local/state governments in various roles. It was clear then, and more clear now, that what was being promised might not be paid in the future.

        Have you bothered to go pull the list of pensions by state and look at their (under)”fundedness”? Do you even have a basic premise as to how defined benefit pension accounting works? It has been a LIE for a long time and pretending one didn’t see it coming isn’t going to protect one.

        This game is going to work (and has worked) for a lot of people, but there will be more and more losers going forward.

        I don’t wish you (or anyone) ill will, but let’s focus on the facts and deal with the problems. It is going to be a rough ride for all.



        • Gee says:

          Thanks Uncle Cooter,

          It may have been somewhat clear to you then (whenever that was) and may be more clear to you now, that the promises might be broken, but I can assure you that many people were not remotely informed about how the level of funding of their pensions, and they had a long history of promises that were fulfilled to count on, as proof that the promise to them would be fulfilled as well. That’s the thing about these types of contracts…a long established reputation can go a long way, and hold a lot of water even without a written contract, but once broken, there is little to no chance that anyone for generations will have any kind of trust in anything offered without explicit written contracts stating the expected outcome. And even THEN, they will be quite suspicious.

          I do agree there will be more losers in the future, but if you already spent much of your life accumulating a set of skills that you figured would serve you in a job that would allow you to stay on and get the promised pension, and it turns out that promise is anything but, well, that sure might have been good to know before you made that investment of time in that career, since it may not be too transferable to another that perhaps pays more, that would fund your retirment via your own savings. And now, you cant get that job because you have the wrong skills and/or are too old.

          So where does that leave anyone thinking that they might want to go and invest in such a career in the future? Well, the sensible and good intentioned but untrusting types will avoid such employers who cant keep promises, but others who might not trust the promise may still sign up, and bring the same level of ethics to the job, taking advantage of the situation, and bringing as little to the table as possible, seeing as they wont get rewarded anyway. In the end, it degrades the quality of people that would even enter into a work contract with such a disingenuous employer.

      • rjohnson says:

        “People signed up for these otherwise low paying jobs precisely because of the PROMISE of a pension, which is supposed to make up for that shortfall.”

        You must live in some 1950s alternate reality. Most public employees I know are grossly overpaid compared to their peers in the private sector. They work 9-5 and get plenty of vacation.
        I can only dream of such an existence.

        Now, I’m not the slash and burn type and actually feel good that at least someone outside the 1% is making some money. But the constant wage increases have to stop at some point. These public salaries are strongly coupled in many states ( see CA prop 13 exception) to bogus property appraisals based on inflated FED goosed free money.

        • Gee says:

          I’m not living in the alternate reality, I’m talking about the past, when promises were made. Not quite the 50s past, but in some cases the 70s or 80s past. I will agree with you that today, there is a different problem in govt and education and other types of jobs where productivity is very poor and high level administrative types are rolling in dough for doing glod knows what. But that isn’t what I’m talking about. I’m talking about promises, and what breaking them implies about the future.

  2. Marty Smith says:

    Interesting that Meredith Whitney got crucified for saying Munis were a problem back a couple of years ago. Now a FED guy says it and its gospel. Granted Whitney’s timing may have been premature, but she was spot on. No one will remember that when the guano hits the fan.

    • Wolf Richter says:

      These things take YEARS to play out. Look at Detroit – maybe a decade or longer before it finally happened. I have no clue why she put a date (and such a near one) on her prediction, especially in our zero-interest-rate era where almost any entity can keep borrowing to fill any holes. That sell-by-date on her prediction was a beginner’s mistake.

    • Michael Gorback says:

      My thoughts too Marty, except that being right is worthless if the timing is wrong. Lots of people saw the dotcom bust too early and got killed going short. Japan has been a widow maker trade for a long time even though we know it vwill end badly.

      It’s been a real education for me watching the lengths to which desperate oligarchs will go to preserve their status. Judging by hedge fund performance I’m not alone. The longer it goes too far one way the farther it has to go in reverse.

      As Wolf said, if you make a prediction don’t give a date. IMHO it wasn’t so much a rookie error as it was hubris. She believed the hype about her in the press.

      • Gee says:

        Yup. She also got caught up in the moment. I mean, on the verge of the next depression, how it could it not happen now? Right? Well, for some reason, she failed to reason how TPTB can change the rules of the game (ie FASB, etc) and prolong the inevitable dying off of their corrupt system. But for now, it continues. As I said on another thread, what is the cure for a credit bubble induced financial crisis? Well of course, another credit bubble! These people are hopeless and will never learn nor change until their heads are on pikes. Of course, they also know now that the best way to avoid that fate is to militarize the police forces. (You didnt think all this stuff was coincidental, did you?) :-|

  3. Paulo says:


    re: “You can pretty much count on it nowadays that the employees will be sacrificed before the bondholders.”

    You nailed it. I have often seen the promises made by employers, but unless there is a method that ensures protection ‘nailed down ahead of hard times’, the shareholders and bondholders will always prevail.

    With private companies we often see this. My father-in-law was a printer for the Vancouver Sun. The company was taken over by Conrad Black (along with many others) who then lived large and rich in a very corrupt way. After his jail time in Chicago he then tried to stiff the pensioners to recoup his ongoing personal losses. Luckily, the printers Guild/Union had enough power to stop it. It probably only worked because this was a bad guy. If he was a connected friend, the pensioners would have lost out.

  4. ERG says:

    Tax Free Municipal Bonds, anyone?

    I’m sure it would be easy to find them with an (falsified) BBB rating!

    Anyone? Bueller? Bueller?

  5. michael says:

    The issue is fraud.

    If the local, state, and federal government used the same accounting practices they require of the individual this would end and right now. They will reap what they sow. I say leave them with nothing.

  6. Vespa P200E says:


    How about the Orange County Cali BK from 1994 largely due to the CFO gambling with the derivatives?

    From Wiki:

    Orange County was at one time the largest county to have declared bankruptcy. In 1994, longtime treasurer Robert Citron’s investment strategies left the county with inadequate capital to allow for any rise in interest rates for its trading positions. When the residents of Orange County voted down a proposal to raise taxes in order to balance the budget, bankruptcy followed soon after. Citron later pleaded guilty to six felonies regarding the matter.

  7. NY Geezer says:

    In 1948 when there were only about 6 million public sector jobs the pay scale was low and those employees received generous retirement benefits to compensate. Then it was not necessary for governments to issue bonds for payroll and related expenses. The cost of running government was cheap and private sector jobs were booming.

    Today there are about 21 million public service jobs. For most the pay scale and benefits greatly exceed comparable private sector pay and benefits. This is where a large amount of today’s middle class jobs are found. The cost of running government is large and private sector jobs pay mostly much lower wages than public sector jobs. Many are minimum wage part time jobs.

    Many who worked in the public sector since 1948 have retired and are receiving generous pensions and benefits paid for out of underfunded pension funds. These funds take time to collapse because they each still contain many billions of dollars and some funds have even issued bonds.

    Government access to increasing amounts of public debt is essential if this system is to continue to work. Governments can not solve this problem simply by stiffing existing bondholders when they constantly need new money that can not be raised through taxes or fees because taxing the .01% is off the table. But borrowing from them is an entirely different matter. They are willing to lend because they are confident they will be paid first when the system fails. Even a small haircut for bond holders will result in the disappearance of many potential lenders and much higher costs of borrowing.

    This is a class struggle that the .01% are too entrenched to lose under the current system of governance. Taxes and fees that target only the 99% are not able to provide sufficient additional income to make much of a contribution to government’s need for more and more money. Lenders and future lenders must be treated with the utmost consideration otherwise the debt system would fail today rather than in the future and government wants to postpone failure as long as possible.

  8. Petunia says:

    In FL the financial industry has penetrated local govt on every level, commissions both municipal and county, water authorities, school boards, and the list goes on and on. These people hold both a govt job and a private sector job, usually in brokerage, banking, or insurance. Their main focus is to direct the govt body to legislate in favor of bond deals. No bond deal left behind is the order of the day. The other thing they push for is large reserves to be accumulated “in order to improve the local credit rating”, but instead it is to steer money to their firms. Once they accumulate millions in an account they find some project that must be done to insure the survival of the locality. It is just plain robbery.

  9. d says:

    Corrupt Union’s, underfunded pension’s, and injury benefits not paid unless over 40% of the total benefit is given to a Lawyer to fight the union fund, to get the remainder of your benefit due, paid to you.

    Gross underfunding of Pension’s by states that then welch on benefits due, by turning beneficiary’s into creditors.

    How did what is supposedly a democracy with rule of law, get where it is regarding pension’s, and pre paid injury insurance benefit’s?

    Pension funds are supposed to be sacrosanct.

    They call Russia and China Mafia states. Laughed at Argentina, when the government stripped all value from its pension fund’s, something which will bite horrifically soon for the population of that grossly mismanaged state.

    Allowing: Union’s, States, and munis, to create this underfunding situation, then avoid pension payments in this way, makes America the Mafia state, of all Mafia state’s.

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