(Reuters) - The recession that began in 2007 created budget emergencies in almost all U.S. states and in many cities and counties, spotlighting deeper, long-standing fiscal problems.
Members of Congress worry the only solution will be a sweeping federal rescue -- one that Washington can barely afford under the burdens of its own massive deficit.
Analysts, taxpayers and investors in the $2.9 trillion municipal bond market have begun to fear possible consequences of the budget crises.
Below are the top threats to economies of state and local governments and to those who buy and trade their debt.
Of the longer-term problems, none looms as large as underfunded pensions and other post-employment benefits for public employees.
The issue has boiled over in Wisconsin and other states where Republicans were recently elected as governors and state legislators. Public workers and Democrats are opposing moves to curb union rights and cut employee benefits.
All three rating agencies are giving greater scrutiny to how pension obligations affect states’ credit-worthiness, and the U.S. Securities and Exchange Commission has rapped New Jersey for not properly disclosing its low pension funding levels.
No one can say for certain how much states with economic woes have underfunded pensions and other benefits, such as healthcare, promised to retired employees. Estimates for states’ pension under-funding range from $700 billion to $3 trillion because of disparities in calculating future returns on investments made by pension systems.
The Pew Center on the States put the total shortfall on promises made to retirees at $1.26 trillion.
In recent years, the Governmental Accounting Standards Board has required states to put promises made to retirees outside of pensions on their books. But these “OPEBs” are easier to change than pensions and could provide places for states to cut.
Some Republican members of Congress are considering allowing states to declare bankruptcy, which they cannot do now because the U.S. Constitution recognizes them as sovereign governments. Bankruptcy would allow states to sort out their finances in federal courts and renege on pension promises. States led by both Republicans and Democrats roundly oppose such a bold move, saying it would raise borrowing costs and do little to help their situations. The chances that any bill will make it through Congress and become law are small.
The housing crisis, financial meltdown and recession reduced nearly all revenue sources for states, cities and counties. The National Governors Association and National Association of State Budget Officers have dubbed the revenue decline a “collapse.”
Of late, states began to see improvements in their revenue collections. But so far, the increases have been modest and revenue has yet to return to levels reached before the recession. Moreover, some of the recent revenue rise came from states hiking taxes, and taxpayers are showing little appetite for further increases.
All states except for Vermont and many cities and counties must end their fiscal years with their budgets balanced. To make up for less revenue, many governments were forced to cut spending. Looking ahead, they have fewer areas to adjust if revenue remains soft.
Prices have begun rising recently, and yields dropping, but the risk remains that borrowing could become too expensive for issuers, especially after three sell-offs over three months. Currently, many are holding off on selling bonds.
The most obscure-sounding threat -- a shortage of bank liquidity facilities -- could have some of the biggest implications for local governments.
The cost of liquidity facilities, which support commercial paper and variable-rate demand bonds, is likely to rise in the near future because the number of providers is shrinking and the international Basel III accord on banking regulations is strengthening capital requirements for banks. That, in turn, could drive up borrowing costs.
When the bond insurance industry broke down in 2008 and a credit freeze seized the municipal bond market, many local governments bought the facilities to give liquidity for their debt. Consequently, most facilities will expire around the same time this year.
In the shorter run, states and local governments are dealing with the approaching end of the $819 billion economic stimulus plan giving states the largest transfer of federal funds in U.S. history.
The last of the money, in the form of additional reimbursements for Medicaid, runs out this summer. But already, states and local governments say they are falling off a stimulus “funding cliff.”
Another stimulus measure that suspended interest charges on loans the federal government makes to states for unemployment benefits has ended, and states are now looking at mounting bills for those loans.
Republicans, who hold a majority in the House, have made it clear that there will be no additional stimulus and, in a twist, states have said they have no interest in a direct federal bailout. They are more concerned that the federal government’s current debates about shutting down, or slashing domestic spending, would cut short any recovery they are experiencing.
The Federal Reserve has the power to make short-term cash loans, but Fed Chairman Ben Bernanke has said the central bank has no plans to buy states’ short-term notes and the Fed’s authority limits it to providing temporary assistance, not a full bailout.
Meanwhile, states and local governments are concerned about federal programs that could require them to spend money they do not currently have. Many of the reforms in the healthcare law passed last year to give all Americans access to medical help must be carried out at the state level. The all-encompassing No Child Left Behind education bill has expired, as has the long-range statute laying out how interstate transportation will function, commonly known as the “Highway Bill.”
Backlash against bank analyst Meredith Whitney’s recent forecast of an impending wave of credit defaults by struggling local governments is growing stronger. Analysts and traders are concerned that anxiety about governments’ bad fiscal conditions will make those situations worse.
For 27 consecutive weeks, there have been sizable net outflows from municipal bond funds, which are popular with individual investors who have been unnerved by the headlines.
Few cities have defaulted since the recession began in 2007. Some of the cities raising the most concern are struggling with unique problems and not nationwide trends. For example, Harrisburg, Pennsylvania, may come close to defaulting because it financed an expensive trash incinerator that has burned through cash without generating revenue.
Writing by Lisa Lambert; Reporting by Lisa Lambert, Jim Christie in San Francisco, Karen Pierog in Chicago, Michael Connor in Miami, Joan Gralla and Edith Honan in New York; Editing by Kenneth Barry, Jan Paschal and Andrew Hay