Rubik's Municipalities A Billion Different Combinations Only One Solution…

Many of you reading this article probably remember the toy the “Rubik's Cube” invented by the Hungarian mathematician Erno Rubik. Rubik was the first entrepreneur to make a go of it in the late 1970's, which was quite a feat considering he resided behind the “Iron Curtain”. If you have ever played with one of the cubes you know that once the cube is “mixed up” it can be quite frustrating to reassemble the colored sides back to solid colors; there is a method to reassembling the cube from a messed up state but you must know the algorithm, hence the one solution.  

The mixed up state of my son's Rubick cube reminded me of our states and municipalities and their current situation. Looking at the numbers there are at least 31 of the 50 states, as well as Puerto Rico, that are forecasting deficits for the next year of over $80 Billion as a direct result of the decline in temporary aid from the Federal government that was part of a 2009 stimulus. The situations are going to become even more acute in FY 2012 as the stimulus completely dissipates. Many states have taken strong measures to try and combat the situation and an improvement in the overall economy has boosted tax receipts in many states, but not to a high enough level to offset the reduction in aid from the FEDs. Add to the mix that the unemployment ranks remain stubbornly high which is a dual burden both in terms of paying unemployment benefits as well as putting downward pressure on tax receipts; just today there is a report on Bloomberg about Texas going in to the Muni market to raise money to fund unemployment in a attempt to reduce the cost of funding going forward.

Of course the unemployment situation is only one factor driving costs for states and municipalities; union contracts, pension obligations and rising healthcare costs are consuming greater percentages of state and municipal budgets. While the economy is improving it is my contention that it is much too slow a pace to  either produce the necessary jobs to substantially lower the unemployment rate or strengthen the states' or municipalities' tax receipts enough to offset the loss of stimulus funds.

The solution for the states and municipalities in my opinion is to make the extremely difficult and unpopular choices of cost reduction and containment or some of them will have to face bankruptcy. California, Nevada or Illinois currently the poster children for imbalanced budgets but they are far from the only ones. The aforementioned states may be in the news most but CBPP (Center on Budget and Policy Priorities) has put together a chart in one of their reports on the states showing that 31 of the states have budget shortfalls in FY 2011 in the double digits as a percentage of their budget. Many argue that the FEDs or Bernanke would ride in on a white horse and rescue the states from their dilemma, but this appears to me not to be the case as it would create the “hot potato” dynamic that no one at the Federal Reserve or any politician for that matter wants. If the FED was to step in then that would set precedent for every other state to follow and the FED would be stuck monetizing state debt in addition to the treasury debt; of course the state debt shortfalls are small potatoes compare to the needs of the US Treasury but it is still a sizable amount of money none the less. As for congress playing the white knight I don't see that as a logical outcome since everyone in congress is looking to bring home the bacon for their respective states and the amount of dealing and back scratching needed to placate every state would be untenable. Furthermore, if every congressman and senator did not return to their district with some funding in hand election mayhem would ensue and for this reason it would be an all or nothing affair, which means nothing will be done.

As I stated earlier the solutions to this mess are potentially very painful to implement and require politicians with backbones of steel to address the issues head on. Each state has its own albatross but many of the problems relate to bloated state and municipal work forces whose pay and benefits consume large amounts of the budget. The unionization of state and municipal workers contributed greatly to this as the contracts negotiated on behalf of the employees are much richer in pay and benefits than the private sector. As a capitalist I do not begrudge anyone from making more money but in the case of state and municipal employees and their salaries\benefit packages  there is a disconnect unlike in private industry. If a union operates in a private corporation and their expense gets to high in relation to the company's revenues then it can quickly become unviable and the company either has to restructure, raise prices or face bankruptcy; which is what happened to General Motors (NYSE: GM) after years of union demands, poor quality and lack of sales. In a nutshell the problem is that the states and municipalities are in the business of government or at best servicing the public and are reliant on various forms of income whether it is tax receipts or fees and they can only collect so much before breaking the bank, in fact many states have laws limiting how much taxes can be raised. The unions to this point have not been held accountable as the government has been able to raise revenue or receive paper from Uncle Sam, but that dynamic has grown long in the tooth and is now in the process of ending.

As we move in to FY2011 and 2012 the dollars coming from the Federal Government are due to dry up, which leaves the states and municipalities with the hard choice of negotiating with the unions, negotiating with its constituents, reducing the size of state/local government or all of the above.  In many respects the states and municipalities are entering in to a vicious cycle as it is more than likely they will have to reduce the size of their workforce. Reducing the workforce has the double whammy of increasing their unemployment rolls as well as decreasing the amount of taxable receipts. In fact municipalities are already vulnerable to a decline in tax receipts due to falling real estate prices as detailed in an article on Bloomberg titled," Tax Appeals Swamp U.S. Cities, Towns as Property Prices Plunge"(12/8/2010) and this is before they have started cutting their workforces.

A short while back I had written a piece on my blog site called “Municipal Jenga”, named after the kids game with the wooden blocks in which you make a tower and then try to pull out the pieces without it falling. In the blog post I discussed what I perceived to be problems in the municipal bond market and looking at the data on a state level indicates to me that there is potential for serious problems in certain markets. I do not believe that all the municipal bond markets are the same just like all real estate is local so are the municipal markets.

Today it is not as simple to buy municipals or state issues as it once was, instead you have to do your own research. It was not that long ago when individuals wanted to buy a municipal bond the amount of research needed was minimal; one just had to ascertain its rating and as long as it was investment grade you were good to go. In light of the state and municipal budget situations, the condition of the various guarantee companies and the questionable accuracy of the rating agencies the environment has changed and investors need to be much more inquisitive as to the soundness of the security and the entity paying it back than ever before. There are many municipal obligations out on the market that are great investments, but in the current environment one has to be discerning and recognize the risks of the issue was well as the potential for rising interest rates to force the investor to either hold to term or take a potential capital loss. I am well aware that many investors like bonds and municipals in particular, however, in my opinion I believe that we are close to entering a rising rate environment and bonds of all flavors will underperform. If you plan to invest in state or municipal bonds the question is do you believe that the individuals running the government have the intestinal fortitude to do what is needed to solve the State/Municipal Rubik's Cube?

This is my first post here at Benzinga although I do have my own blog (monetaadvisors.com) where I discuss much more than municipal bonds. I cover stocks, commodities,precious metals, currencies, markets, government and interesting general observations that may not get play on Wall Street and subjects that interest me and hopefully you too. I also have recently started my own investment advisory called Moneta Advisors, LLC  based in the Boston area. I have been through a series of careers from which I have learned many useful things along the way. In my past I have been a stockbroker, computer programmer, Sr. computer consultant, and ran a manufacturing company; all the while I remained a private investor until recently.