California and New York, Two AIGs

This article in the NY Times is interesting in that it shows that for all the chatter about how big business cannot be trusted, neither can government. For those of you who haven’t been paying attention to California, New York or other states suffering serious budget issues, there are indeed some amazing parallels between what many of financial institutions did and what the states are doing right now.

This first one I haven’t heard of too many businesses doing, taking money that really doesn’t belong to the state,

New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million.

Some states are altering accounting rules. Must be real handy to be able to change the rules when the rules become a problem,

Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated.

Unstated, or “off the books” debt. This is one of the things that brought down Enron; hiding debt and losses in companies not affiliated with Enron to make the balance sheet look better,

California’s stated debt — the value of all its bonds outstanding — looks manageable, at just 8 percent of its total economy. But California has big unstated debts, too. If the fair value of the shortfall in California’s big pension fund is counted, for instance, the state’s debt burden more than quadruples, to 37 percent of its economic output, according to one calculation.

Is Jeffrey Skilling out of prison? I think he has a job to do in California. See when a corporation does it, it is bad, but when a government does it, is is wise leadership.

And of course, we can’t forget about credit default swaps,

In fact, New Jersey and other states have used a whole bagful of tricks and gimmicks to make their budgets look balanced and to push debts into the future.

One ploy reminiscent of Greece has been the use of derivatives. While Greece used a type of foreign-exchange trade to hide debt, the derivatives popular with states and cities have been interest-rate swaps, contracts to hedge against changing rates.

The states issued variable-rate bonds and used the swaps in an attempt to lock in the low rates associated with variable-rate debt. The swaps would indeed have saved money had interest rates gone up. But to get this protection, the states had to agree to pay extra if interest rates went down. And in the years since these swaps came into vogue, interest rates have mostly fallen.

Whoops.

What is causing the biggest issues? State pension plans which tend to be quite generous defined benefit plans.

Pensions are debts, too, after all, paid over time just like bonds. But states do not disclose how much they owe retirees when they disclose their bonded debt, and state officials steadfastly oppose valuing their pensions at market rates.

Joshua Rauh, an economist at Northwestern University, and Robert Novy-Marx of the University of Chicago, recently recalculated the value of the 50 states’ pension obligations the way the bond markets value debt. They put the number at $5.17 trillion.

After the $1.94 trillion set aside in state pension funds was subtracted, there was a gap of $3.23 trillion — more than three times the amount the states owe their bondholders.

“When you see that, you recognize that states are in trouble even more than we recognize,” Mr. Rauh said.

And as the article notes, problems with default and financial crises can develop even over surprisingly small amounts of debt,

One finding was that countries “can default on stunningly small amounts of debt,” he said, perhaps just one-fourth of what stopped Greece in its tracks. “The fact that the states’ debts aren’t as big as Greece’s doesn’t mean it can’t happen.”

I find it quite amusing that so many are outraged at what happened on Wall Street and often state that better regulations…indeed better government is the answer, and when we look we see that governments at the state level are doing the exact same things Wall Street did.

So, we are coming out of the storm from the financial meltdown of 2008/2009 just in time for the next meltdown to hit in the form of state budgets. But don’t worry, the states have the power to tax so its not really a problem at all…just like the Federal government had the power to tax and could give vast sums of money to companies like AIG, Citigroup, and others.

FILED UNDER: Economics and Business, Government, US Politics,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Franklin says:

    Great. Who will watch the watchdogs?

  2. Joe says:

    What a mess. Is there any way to fix it, do you think?

  3. Steve Plunk says:

    The only solution to this problem is a reduction of government services. If we raise taxes we will damage the economy. Unfortunately the present path of our federal government is more services and many states (like mine, Oregon) are doing the same. All the while the elected leadership is ignoring this problem.

    Oregon’s public employee retirement system (PERS) was deemed unsustainable decades ago. A defined benefit plan that by statute guarantees 8% minimum returns to the fund (if investments fail to deliver contributing employers must make up the difference) PERS has been a time bomb waiting to go off. What irritates me are the public employees who shrug and say don’t blame us. They say it as they retire at 50 and laugh all the way to the bank.

    Times are a changin’ to say the least. Some sort of bankruptcy and fair restructuring is needed yet not provided for in the law. And before those public employees say “hey, I was promised that” I would remind them I was promised a solvent Social Security fund and schools for my children and grand children as well. Runaway public spending and their pension gluttony threaten both.

  4. steve says:

    First, California is just in the middle of the pack. Alaska has the worst state debt problem, caused largely by pension debt.

    http://www.nytimes.com/imagepages/2010/03/30/business/economy/30statesGraphicA.html?ref=economy

    Next, the pensions are a huge problems as long as they remain defined benefit plans. They should be defined contribution plans like the rest of us. The banks took huge risks, their executives made lots of money, then they got bailed out. The states dont have quite that level of backstop. They should plan accordingly. The states got hit by the market crash just like everyone else, so it killed their pensions. If they switch, they will not be vulnerable to market swings. The states, if they wish to maintain defined benefit plans, should assume their stock portfolio is worth only half of its current value. Of course when the market is good, it will look over funded and people will claim they are being taxed too much and cut it. All the more reason to go to defined contribution.

    As to your larger point, I think, I cannot quite equate AIG with a state government. AIG either knowingly committed fraud, probably not but hard to rule out, or made extraordinarily bad judgments. If you read any of the substantive books on the crisis, you get a picture of extreme risk and management that often did not know what its traders and individual divisions were doing. it was AIG, among many, many other factors that lead to states and the rest of the country getting in this mess.

    For full disclosure, it is more than the markets that caused these problems. State and local officials have set up pension systems that are remarkably stupid. Following is a link to how stupidity affected New Hampshire and what they are doing about it.

    http://www.unionleader.com/pda-article.aspx?articleId=5c6a6d8e-6f89-4446-bcef-be0376b0749a

    Steve

  5. john personna says:

    As I understand the auto company answer to “benefits too high”, they just kept them for older workers, and make a very unfair seeming split. New hires will never get the benefits of the previous generation.

    If states want to “honor” agreements, they might take that path … perhaps amending agreements for those still working, when they can.

  6. Franklin says:

    Pensions are causing misery for all sorts of public and private budgets. Life expectancy has been increasing significantly for the last century at least. Maybe I’m too young to understand, but how exactly did everybody fail to see the long-term problems with generous pensions, or did they just not care?

  7. anjin-san says:

    Pay & pensions for California public employees is completely out of control. The city manager of the next town over from me got a 25% raise last year…

  8. AaronG says:

    @ steve

    I think the situation with AIG is quite analogous to the states.

    For example, one of AIG’s disasters was selling credit insurance (CDS) on mortgage securities. The CDS agreements allowed them to put up no collateral as long as they remained AAA rated. According to the accounting, selling this insurance gave them excellent return on equity, right up to the point the collateral requirements sunk the company.

    State and local politicians are faced with another “free money” situation. They can promise rich retirement benefits and, thanks to ridiculous valuation standards for public pensions, fund those promises with only a fraction of the amount that would actually cover the promises with a high degree of confidence. Until the accounting catches up with reality, these pension promises look much cheaper than other forms of compensation that the public employees would accept in the absence of the promises. Already, many states (eg New Jersey is making large “unexpected” catch-up contributions currently) are starting to pay the price.

    AIG made the judgment that as long as housing prices always rise, the insurance they were selling posed no risk. The states make the judgment that as long as equities always return 12% per year, their pension promises are cheap. How is it worse for AIG to make unfunded promises than for the states to do the same?

  9. Eric Florack says:

    I find it quite amusing that so many are outraged at what happened on Wall Street and often state that better regulations…indeed better government is the answer, and when we look we see that governments at the state level are doing the exact same things Wall Street did.

    Amusing isn’t the word I would have chosen, but there most certainly is a double standard being applied here.

    That said, perhaps a little clarity is an order on the AIG matter. That situation would never have occurred absent a governmentally driven push to arrange for mortgages for people who couldn’t afford them , who also happened to be in the target group for the party in power.