In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.


In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Fiscal Risks and Borrowing Costs in State and Local Governments88

State and local governments (SLGs) face important fiscal challenges, most notably because of the unfunded liabilities they have under public employee pension plans and related to other post-employment benefits. This chapter examines the state of SLG finances with a focus on how challenges posed by such liabilities and political polarization that may hinder implementation of policies to address them are priced in by municipal bond markets. Analysis suggests that state borrowing costs will increase if unfunded liabilities are left unchecked and that certain budget institutions may help contain the negative impact of unfunded liabilities and political polarization on borrowing costs. This highlights the need for public pension and budget process reform.

A. Introduction

107. In the wake of the Great Recession, fiscal imbalances in the U.S. have surfaced at all levels of government. The federal budget deficit as a percentage of GDP widened rapidly from 1¼ percent in 2007 to 11½ percent in 2009 and remained above 3 percent in 2013, while debt held by the public rose from 35 percent of GDP in 2007 to 74 percent in 2013. The aggregate SLG deficit as a percentage of GDP, measured on an annual basis, reached 2½ percent in 2009—the widest since 1980s—with gross debt increasing considerably from 25 percent of GDP in 2007 to 29 percent in 2013.89

108. These imbalances raise concerns about the sustainability of public finances and, for SLGs, put upward pressure on financing costs. Indeed, municipal bond spreads over Treasuries rose sharply during the crisis and remain well above historical averages (Chart).90 Moreover, several states suffered from credit downgrades in 2009-11, including those with large stocks of debt such as California, Illinois, and New Jersey. Admittedly, the reserve currency status of the dollar and safe haven flows into the Treasury market have, so far, helped keep federal borrowing costs at historical lows despite the sharp rise in federal debt held by the public. However, the lack of a consolidation plan to stabilize medium-term debt dynamics and doubts about the effectiveness and predictability of policymaking amidst political polarization led to a sovereign credit rating downgrade in August 2011.91 Consequently, a spike in Treasury yields as a result of sustainability concerns building up poses an important risk, with implications for SLGs.


Treasury and Municipal Bond Yields


Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005

Sources: Bloomberg; IMF staff calculations.Note: Municipal bonds refer to the Bond Buyer 20-Bond Index, consisting of 20 general obligation bonds that mature in 20 years. The average rating of these bonds is equivalent to Moody’s Aa2 and S&P’s AA. Tax-equivalent yields are computed using the marginal tax rate on interest income from NBER’s TAXSIM.

109. Post-employment obligations and the associated uncertainty keep concerns about SLG finances alive even as short-term fiscal balances improve, including the crowding out of much needed education and infrastructure spending. The losses suffered by public pension funds during the crisis and high-profile municipal bankruptcies brought awareness about the long-term challenges. Increasing underfunding in government-sponsored pension plans means additional unsecured debt.92 Moreover, legal uncertainties exist when it comes to the seniority status of existing, general obligation debt to such additional debt. As a result, borrowing costs for SLGs may come under pressure. Furthermore, the higher debt service costs materializing as a result of unchecked post-employment obligations compete for resources that could otherwise be devoted to education and infrastructure spending. Already plagued with narrow, eroding tax bases and volatile revenues, SLGs also face a reduction in the sources provided by the federal government. As resources dwindle, health care expenditures and pension promises may increasingly crowd out spending on essential services, with implications for potential growth.

110. This chapter, relying on econometric analyses and case studies, seeks answers to the following questions:

  • How do state credit ratings and borrowing costs vary with unfunded pension and other post-employment benefit obligations?

  • Do credit ratings and borrowing costs reflect the political and institutional characteristics of state legislatures?

111. The rest of the chapter is structured as follows. We start with a brief discussion of the medium-term outlook and long-run challenges as well as the uncertainties surrounding them. Then we present the regression results and the case studies looking at the relationship between credit ratings and unfunded liabilities and the political and institutional characteristics of the state legislature. We conclude with a discussion of the policy implications emerging from the empirical analyses.

B. Outlook and Risks: A Bird’s Eye View

112. SLGs are in better shape than they were in the immediate aftermath of the Great Recession. Tax receipts were hit hard by the recession and, even with the rainy-day funds providing some breathing room and the federal emergency funds mitigating some of the damage on the revenue side, difficult decisions had to be made to cut spending on education, health, transportation, and welfare. As tax receipts picked up with the ongoing economic recovery, SLG finances have improved and rainy day funds have been replenished (Chart).


State and Local Government Finances

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005

Sources: NASBO, Haver Analytics; IMF staff calculations.

113. With the cyclical rebound, the SLG fiscal drag on growth is expected to turn into an impulse in the near term. Revenues are gradually recovering, but have not yet returned to pre-recession levels, and, hence, could have a further bounce-back barring a permanent loss in tax bases. As housing and labor market recoveries continue, tax receipts will rise while spending pressures related to the recession (e.g., unemployment benefits and welfare payments) will ease. These dynamics should give SLG consumption and gross investment enough room to start reverting back to their long-term averages.

114. Soon enough though, SLGs will have to address the structural challenges, most notably, public sector employee retirement plans and health care expenditures.

  • Public sector employee retirement plans: Many public sector employee pension plans are seriously underfunded and promises made under these plans may have to be reconsidered. But it is not even clear how large the funding needs are. The estimates are sensitive to actuarial assumptions and put unfunded liabilities in defined-benefit public pension plans somewhere between $¾ trillion and $3 trillion (Table). Moreover, legal protections under some state constitutions and political economy considerations make it difficult to take measures that would help reduce the funding gap. Finally, ongoing bankruptcy cases will set precedents as to the extent local governments can force various stakeholders to take haircuts.

How Large are Unfunded Pension Liabilities?

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  • Health care benefits for public sector retirees93: Although total unfunded liabilities for non-pension post-employment benefits are smaller in size at an estimated $600 billion and easier to address than pensions at least from a legal perspective, many states have not been adequately prepared to meet the commitments they have made under these programs. The average funding ratio across states is estimated to be less than 10 percent while only about 40 percent of required contributions are actually made. Moreover only three states (Alaska, Arizona, and Ohio) have other post-employment benefits funded at 50 percent or more because generally these benefits are funded on a pay-as-you-go basis.94

  • Health care cost growth and the Affordable Care Act: Medicaid is a large spending category in state budgets (estimated to account for 20 percent in FY2012, ranking second after K-12 education) and enrollment in the program is expected to increase significantly in 2014 and thereafter as a consequence of the Affordable Care Act, but by how much remains to be seen. The Government Accountability Office (GAO) projects that SLG health care spending will increase by about 2 percentage points of GDP over the next two decades (about $350 billion in current dollars). Additional uncertainty comes from the difficulty in predicting how fast health care costs will rise in the future, including whether efforts to bend the cost curve will be successful or not.95

115. Other sources of risk surrounding the outlook for SLG finances include:

  • Fiscal policy uncertainty at the federal level: Uncertainty about federal fiscal policies translates into uncertainty at the SLG level. Moreover, fiscal consolidation at the federal government level has important consequences for SLGs. This is especially the case in places with closer ties to federal government activities (e.g., District of Columbia) and in places with greater reliance on federal grants (e.g., New Mexico).

  • Reliance on procyclical taxation and shrinking tax bases: Over the last half century, SLGs have increasingly become more reliant on procyclical revenues, in particular personal income taxes (Table). Combined with balanced budget requirements and SLG responsibilities for social safety net expenditures, this trend has been manifested in larger and more volatile deficits. In addition, structural changes in the economy (e.g., shifting of consumption from goods to services and increase in cross border activities) and some legislative actions (e.g., introduction of sales-tax holidays) have led to an erosion of the SLG tax bases. These trends will need to be addressed in order to avoid self-inflicted fiscal distress during recessions and to maintain the level and quality of essential services provided by SLGs.

  • Options available at times of distress: Recent high-profile bankruptcy cases have reopened the question regarding what legal options are actually available to financially-distressed local governments and what different stakeholders should expect in the aftermath of a Chapter 9 filing (see Boxes 1 and 2; Appendix includes a partial list of recent bankruptcy cases). Political economy factors, including frameworks that would ensure timely and sound policy decisions even when the degree of political polarization is high, and relationships between a state government and local governments as well as those with the federal government, are also likely to come into play.

Reliance on Procyclical Taxes

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Sources: Census Bureau; IMF staff calculations.Note: Taxes are ordered based on the correlation between their growth rate and the gross state product growth.

116. Municipal bond market developments since the crisis in part reflect the increasing awareness of the challenges faced by SLGs. Not only has the spread over the Treasuries widened (as mentioned in the Introduction), but also the spread between high-quality and low-quality municipal bonds have increased (Chart). While the Build America Bonds (BABs) have kept issuance levels at pre-crisis levels in 2009-10, issuance to raise new capital since the expiration of the BAB program has dropped to levels seen in the 1990s (in nominal terms).96 Increased number of Chapter 9 filings and headline-grabbing distress stories (often citing unfunded pension liabilities), in addition to the anticipation of tapering by the Federal Reserve, led to a sell-off in 2013. The composition of the holder base has shifted from retail investors to banks and, to a much smaller extent, insurance companies and other investors, although retail investors continue to be the major group with more than two-thirds of the holdings.


Municipal Bond Market Developments

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005

Sources: American Bankruptcy Institute; Bloomberg L.P.; Securities Industry and Financial Markets Association (SIFMA).

C. Empirical Analyses

Are They All in the Same Boat?

117. Aggregate statistics for SLGs mask a great degree of cross-sectional variation. States, as well as local governments, have different economic, fiscal, and political risk characteristics and, these differences are reflected in the states’ credit ratings and borrowing costs (Maps). For instance, North Dakota has enjoyed large budget surpluses even during the Great Recession in part thanks to strong economic activity driven by the shale gas boom. The state’s credit rating was upgraded from AA in 2008 to AAA in 2013. Meanwhile, Arizona was hit hard by the housing boom-bust and struggled with budget deficits. Unsurprisingly, its credit rating was downgraded in 2010 from AA to AA-. The contrast between California and Pennsylvania on the one hand and North Carolina and Virginia on the other with respect to their debt levels also seems to be carried over to their credit ratings and bond spreads. The former two states are among the most heavily indebted and the lowest rated, and pay some of the highest borrowing costs. The latter two, in part thanks to their low debt levels, enjoy the low yields that come with their stellar AAA credit ratings. Similarly, liabilities related to public employee pensions and other post-employment benefits vary considerably across states. For example, with regard to pensions, Wisconsin has negligible unfunded liabilities with a pension plan that is 99.9 percent funded, while Illinois has very high unfunded liabilities (about 12 percent of gross state product) and the worst funding ratio in the nation at about 55 percent in 2010. High unfunded liabilities for pensions do not necessarily translate into high unfunded liabilities for other post-employment benefit plans. For example, Oklahoma has one of the highest unfunded pension liabilities as a percentage of gross state product at 10 percent but it has very small unfunded liabilities under its health care plan for public sector retirees. In terms of political polarization in state legislature, California ranks as one of the most polarized and Louisiana as one of the least.


Real Income Growth, 2010


Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005


Market Value of Outstanding Bonds, 2010

(percent of G SP)

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005


Unfunded Pension Liabilities, 2010

(percent of G SP)

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005


Unfunded Other Post-Employment Benefits, 2010

(percent of G SP)

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005


Political Polarization, 2010

(Shor S. McCarthy, 2013; higher values indicate more polarized legislature)

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005


Credit Ratings, 2010

(S&P, AAA. correspond s to a numerical value of 8)

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005


Municipal Bond Yields. 2010

(spread over Treasury bands)

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005

Econometric Setup and Findings

118. The baseline regression explores how credit ratings and municipal bond spreads relate to state economic and fiscal characteristics.97 We estimate the following equation using OLS:


where CR is the credit rating (or bond spread, when available) for state i in year t. UPL and UHL stand for unfunded pension liabilities and unfunded other post-retirement benefits (mostly health care), respectively. DEBT and BBAL are the outstanding debt and the budget balance. The right-hand-side variables so far are all expressed in percent of the state’s gross product (GSP). IG and UR are the real income growth and the employment rate, respectively. TAX is the tax rate applicable to the marginal investor. Finally, POL is a measure of political polarization in the state legislature. The regression results are summarized in the text table.

119. We focus the discussion of the results mostly on the regressions where the dependent variable is the credit rating. The findings for bond spreads are qualitatively similar to those for credit ratings but the sample size is much smaller and the relationships are often either not statistically significant or less robust to alternative specifications. As one would anticipate, spreads tend to be higher for lower-rated states (Chart). Hence, we use “borrowing costs” interchangeably with credit ratings when discussing the results.

120. Not surprisingly, state credit ratings are negatively correlated with debt levels. Econometric analysis exploiting the variation across states reveals that states with higher levels of debt (in percent of gross state product) have lower credit ratings. As expected, budget surpluses and lower marginal taxes are also associated with better ratings. Links with income growth and unemployment rate are not statistically significant.

Summary of Regression Results

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Sign of the coefficient obtained in the regressions for each variable is shown.

Average Spread by Credit Rating


Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005

121. Increased awareness about unfunded pension liabilities appears to be reflected in the ratings. States with larger unfunded pension liabilities have lower credit ratings and face higher borrowing costs. Interestingly, unfunded liabilities under health care and other benefits, which are not only smaller and but also received much less attention than pensions, are negatively related to credit ratings but this relationship loses significance when unfunded pension liabilities are also included in the regression. Also noteworthy is the fact that unfunded liabilities in the regressions are as reported by the states themselves, that is, likely assuming more generous rates of return. Under more prudent return assumptions, these liabilities would be larger—and upward revisions to unfunded liability estimates are indeed expected to take place once the recent change to the Governmental Accounting Standards Board (GASB) rules is fully implemented.98

122. Political polarization has some bearing on market perceptions of a state’s creditworthiness as well. States with less polarized legislatures tend to have higher ratings. This is likely to reflect uncertainty pertaining to fiscal policies and the propensity for fiscal showdowns.

123. Budget institutions also relate to borrowing costs. This relationship is, however, more difficult to detect in econometric specifications, perhaps due to the fact that these variables have relatively higher degree of persistence within a state. Still, there is some regularity when the sample is split based on certain budget practices, suggesting that good budget institutions can mitigate the adverse effects of low funding ratios, high outstanding debt levels, and high degrees of polarization in local politics. In particular, unfunded post-employment benefit liabilities are priced in the state credit ratings if budget deficits are allowed to be carried over, if there is a supermajority requirement to pass revenue increases, and if there are caps on rainy day funds (Chart).99


Credit Ratings, Challenges, and Budget Institutions

Citation: IMF Staff Country Reports 2014, 222; 10.5089/9781498331104.002.A005

Source: IMF staff estimates.Note: The bars show the magnitude of the coefficient on unfunded pension liabilities (UPL), outstanding debt (DEBT), and political polarization (POL) when the sample is split based on a budget institution indicator. Dependent variable is the credit rating. Only statistically significant coefficients are shown. The differences between coefficients obtained in the subsamples are also statistically significant.

124. Teasing out robust, causal relationships is a difficult task and several caveats should be taken into account when interpreting these findings. Given that many of the variables of interest change minimally from one year to the next in the same state, introducing state fixed effects in the regression equation is problematic and, hence, any correlation may well be driven by some omitted state characteristic. Another issue is related to the measurement of borrowing costs: municipal bond markets are loosely-regulated, decentralized, over-the-counter markets.100 That is why we primarily focus on credit ratings. Reverse causality is also a problem as states may take actions to improve indicators of fiscal health in response to a ratings downgrade and a rise in borrowing costs. Therefore, the results of the econometric analyses should be taken with a grain of salt.

Case Studies

125. The importance of sound fiscal policies and budget institutions can be further illustrated with case studies. Regression analyses shed light into the role played by budget outcomes, unfunded pension liabilities, and political polarization in municipal bond markets and hinted at the interactions with institutional characteristics. Nonetheless, given the lack of variation in some of the variables used, we use case studies to complement this evidence (especially that on the role of budget institutions). We look at the experience of four states where the credit rating is much higher or lower than that implied by the “fundamentals”.101 Good news is that blemished credit can be fixed and market pressures can be alleviated when necessary actions are taken (also see Box 2 on Detroit and Puerto Rico).


126. Alaska demonstrates how flexible yet conservative budget institutions can help offset the impact of moderately high liability levels. Alaska has an inherent vulnerability due to its economy’s dependence on the natural resource industry. To mitigate the volatility induced by energy-related revenues, the state has set aside very large reserves for general fund operating needs (principally in the Constitutional Budget Reserve Fund and the Statutory Budget Reserve Fund). There are no caps on these funds and repayment provisions are flexible in that there is no fixed time limit to replenish the reserves. Moreover, Alaska projects revenues for a ten-year window—at least twice longer than any other state. Although the funding ratios of major statewide pension systems are weak at about 55 percent compared to the national average of 70 percent, Alaska has kept up with its contributions and taken steps to address the issue, including closing of defined benefit plans to new employees in 2005. These actions seem to have helped maintain the state’s AA+ rating in 2010 despite a budget deficit of almost 3 percent of GSP and get an upgrade to AAA in 2012.


127. California exemplifies how markets reward active deficit reduction and improvement in budget institutions. Faced with immediate liquidity pressures as the deficit soared in the aftermath of the dot-com boom, California enacted Proposition 57 and 58 in 2004, authorizing issuance of long-term bonds to pay off accumulated deficits. However, they also prohibited any future deficit bonds and required enactment of a balanced budget and the establishment of a budget stabilization account. As a result, the state got a three-notch boost in its bond rating from BBB to A. The state’s effort to balance its general fund budget through tax hikes enacted in 2012 also led to a ratings upgrade while its revenue-anticipation notes issued in August 2013 had the lowest yields since the 1970s. But California’s current rating of A is still about two notches below what one would expect based on its fundamentals, especially considering its relatively small unfunded pension liabilities. Instead, it seems that remaining weaknesses in budget institutions—including the ability to spend unanticipated funds without legislative approval, the scope to carry over deficits, and the supermajority requirement for revenue increases—have weighed on California’s credit rating.


128. Illinois shows how inaction to correct imbalances and adopt good budget institutions can calcify into a bad reputation and translate to higher borrowing costs. Illinois currently has the lowest credit rating across U.S. states at A-, although the econometric model would predict three notches higher. The state was not always at the bottom: actually, Illinois and Alaska had the same rating as late as 2007. However, several decades of skipping or skimping on payments for the required contributions to pension plans resulted in the state having the worst funding ratio (at about 40 percent) in the nation. While all other states that faced similar challenges have taken some sort of action, Illinois became known for its political gridlocks and repeated failures to deliver on pension reform. Moreover, a budget stabilization fund was introduced in 2000—Illinois was one of only five states that did not have one at the time—but design flaws led to the fund being used for the alleviation of ongoing cash flow problems rather than for fiscal emergencies. These factors have produced what has become known as the “Illinois effect,” whereby similarly structured and rated municipal bonds carry higher interest rates if the issuer is located in Illinois.

New Jersey

129. New Jersey confirms that failing to address structural imbalances and implement sound fiscal management practices can hurt creditworthiness. With a volatile income tax base heavily dependent on a small number of high-income residents, the state had difficulty meeting the challenges posed by the Great Recession, and was forced to make deep cuts in school funding and aid to local governments. The latter, in turn, were forced to raise property taxes. The state has underpaid its pension contributions for years, even before the recession started and made only 14 percent of the required pension contributions in 2012 after failing to make any payments in 2010 and 2011. Overly optimistic revenue forecasts spanning only one year coupled with one-off moves to plug annual deficits rather than implementation of permanent solutions are all factors that have raised concerns about budget processes. In addition, liquidity has become a concern as rainy day funds, drained in 2009, have not been replenished. The state’s credit rating has been downgraded three times from AA+ in 2002 to A+ in 2014.

D. Policy Implications

130. There are important challenges facing SLGs on the horizon. Problems such as rising health care costs and underfunding of promises made under public employee benefit plans mean that tough choices will have to be made if SLGs are to avoid large cutbacks to other essential functions, such as in education and infrastructure investment. Moreover, federal government consolidation efforts will reduce financial resources potentially available to SLGs. The significant fiscal adjustment in the past few years has improved fiscal balances, but this should not give a false sense of safety. SLGs will have to tackle the ticking time bombs of public sector employee retirement and health care plans soon. Many states have enacted reforms in this area recently but these tend to remain on the margin and be limited to new hires only (see Appendix for a partial list of recent pension reform actions).

131. Empirical analyses point to unfunded pension liabilities being associated with lower credit ratings, especially when budget institutions are weak. If left unchecked, these liabilities will continue to grow as the population ages and may increase borrowing costs. Moreover, such implicit liabilities are likely to weigh on credit risks with potential to raise financing costs and weaken SLG finances more broadly.

132. In order to keep future borrowing costs in check, SLGs should:

  • assess the extent of their unfunded liabilities under more realistic actuarial assumptions, move away from defined-benefit plans, pursue reforms as necessary to ensure fiscal health, enhance risk sharing, and establish separately-governed trust funds if they choose to maintain pay-as-you-go financing102;

  • improve their budget frameworks, including adoption of multi-year plans laying out conservative revenue forecasts, better enforcement of balanced budget rules and rules governing the use of unanticipated funds, and introduction of more flexible revenue-increase and rainy-day fund rules.

Legal Options Available to Financially Distressed Local Governments

Aside from undertaking a voluntary, out-of-court debt workout, legal options for a financially distressed local government to reduce, extend, and/or restructure outstanding debts are limited. Moreover, uncertainties surrounding privileged debt render outcomes unpredictable, regardless of the restructuring scenario.

Some—but not all—local governments may be eligible to seek protection under Chapter 9 of the U.S. Bankruptcy Code. As a general matter, the U.S. Constitution allocates powers to the federal government but preserves State sovereignty in accordance with the Tenth Amendment. Thus, while bankruptcies are carried out exclusively in federal courts under the U.S. Bankruptcy Code, its application to the States is carefully circumscribed. Eligible debtors under the Bankruptcy Code include local governments, but not States. For a local government to file a bankruptcy petition, in addition to other preconditions, it must obtain State approval. Many States limit which entities can file and under what circumstances. Even when the Bankruptcy Code does apply, the court’s powers over the operations of the local government are limited. For example, the court could not direct the local government to sell assets nor could it appoint a trustee or receiver to oversee its affairs. Local legislation may empower a State to exercise this type of control, in tandem with, or independently from, federal bankruptcy proceedings. For example, the State of Michigan appointed an emergency manager to Detroit before bankruptcy proceedings commenced, and has continued to exercise this authority throughout the bankruptcy proceedings.

Currently, the U.S. Bankruptcy Code does not apply to the Commonwealth of Puerto Rico (or the District of Columbia). In contrast to States where sovereignty is constitutionally protected, Congress retains full legislative control over U.S. territories, including Puerto Rico. Such powers would allow Congress to intervene prior to default (for example, to impose tighter fiscal controls) or post default (for example, to amend the U.S. Bankruptcy Code to ensure its application or to create a special insolvency procedure). As a matter of policy, however, several factors would likely influence a decisive exercise of this authority, including whether doing so would impose a burden on U.S. taxpayers more broadly or unduly undermine the historical local self-governance enjoyed by Puerto Rico.

Under any restructuring scenario, a key issue will be ascertaining the extent to which debt incurred by the local government is privileged. In particular:

  • State constitutions and local labor laws may place restrictions on the ability of the local government to restructure public employee and retiree benefit plans. While this could serve as an impediment to a debt workout, the Bankruptcy Code generally allows a municipal debtor to adjust or eliminate these obligations. However, there may public policy reasons to limit the scope of such adjustments, which would need to be balanced against the Bankruptcy Code’s requirement to ensure that similarly situated creditors (i.e., other unsecured creditors) are treated in a fair and equitable manner.

  • State constitutions and local law may grant privileges to certain bondholders, and thus the treatment of general obligation bonds across the States and territories may not be uniform. General obligation bonds, which are backed by general tax revenues and the “full faith and credit” of the issuing entity are presumed to be unsecured debt, unless State laws provides otherwise. California legislation, for example, establishes a lien in favor of general obligation bondholders; this is not the case in Michigan. Also, the Puerto Rican Constitution provides that the public debt of the Commonwealth, constitutes a first claim on available resources and empowers bondholders, to bring suit to require application of available resources to the payment of principal of, and interest on, public debt when due.

2013 Municipal Bond Market Distress

Recent high-profile cases of financial distress have brought U.S. municipal bond markets and the state of SLG finances to the spotlight. In the largest U.S. municipal bankruptcy ever, the city of Detroit filed for bankruptcy on July 18, 2013, while yields on Puerto Rican bonds have soared in the fall of 2013 on concerns of the island’s debt sustainability. Considerable uncertainty remains, also reflecting uncharted legal questions raised by these episodes.

Detroit’s bankruptcy filing occurred after decades of decline due to a depressed local economy (severely affected by the scaling down of local auto industry employment), declining tax revenues (driven by falling house prices and population loss, especially in higher-income segments), and deteriorating quality of city services. The bankruptcy was highly anticipated and already priced in. Yields on 10-year benchmark municipal bonds rose by 15 basis points between July 18 and July 25 before receding. They stood at 2.3 percent on June 17 [lower than the July 18, 2013 level of 2.66 percent]. The legal process will take a long time. Currently, the goal is to finish the process by early fall 2014. Along the way, important precedents may be set at least in two main areas.1

  • There is a legal gray area on how public pensions will be treated. Michigan is one of nine states that explicitly protect public employee pensions in the state constitution but, under the federal bankruptcy law, a judge may be able to subvert the state constitution to reduce the Detroit’s obligation to its pensioners. A legal battle is expected, perhaps ultimately reaching the Supreme Court.

  • The haircut the bondholders would take under Detroit’s restructuring proposals is generally higher than what the market currently assumes for loss-given-default in municipal bankruptcies. Re-pricing risk across the municipal market cannot be ruled out if Detroit is successful in negotiating higher haircuts.

Highly dependent on federal aid and tax incentives, Puerto Rico has been in recession since 2006, when the phase-out of an important tax credit was completed. The recession exposed long-standing structural problems. These include high public debt ($70 billion, around 100 percent of GDP); heavy government involvement financed by subsidized debt (Puerto Rican bonds are “triple-tax-free,” meaning that they are exempt from federal, state, and local taxes, and the government sector accounts for 27 percent of total nonfarm employment); and lack of competitiveness, in part because of high labor costs relative to Caribbean neighbors (the U.S. federal minimum wage applies in Puerto Rico) and a low labor force participation rate (emigration to the mainland is common and residents often qualify for direct transfers from the U.S. federal government).

Doubts about Puerto Rico’s debt sustainability surfaced in the summer of 2012 and intensified in the fall of 2013. The island’s increasing reliance on bank credit and other short-term measures to fund budget gaps came into the spotlight against the backdrop of a struggling economy. The government unveiled plans—including pension reform, tax hikes, spending cuts, a balanced budget proposal, and incentives to attract businesses to the island—to address the problems but flows out of Puerto Rican debt continued. In February 2014, all three major credit rating agencies downgraded Puerto Rico to junk status. Paradoxically, Puerto Rican debt rallied after the downgrade, thanks to the removal of uncertainty regarding credit rating agency action and the island was able to raise $3.5 billion in bond sales in March. Yields on 10-year Puerto Rican bonds stood at 8.8 percent on June 17, up from 6.2 percent at the end of August 2013 but down from above 10 percent observed in early late January/early February. Moreover, Puerto Rico was able to tap the markets and raise $3.5 billion in general obligation bonds in March 2014.

Unlike Detroit, Puerto Rico cannot file for bankruptcy under Chapter 9. With the standard bankruptcy procedure off the table, a potential default would fall in the legal twilight zone and set new precedents. Some of the issues highlighted above for Detroit also apply to Puerto Rico, but the fact that the island is not eligible to file for bankruptcy under current law further complicates the legal questions (see Box 1).

While these cases may set precedents on a range of legal matters regarding municipal bond distress and create some ripple effects, there is little risk of immediate contagion and a negative systemic impact. Historically, municipal bankruptcies have been rare and idiosyncratic, and recovery rates have been close to 100 percent even in the case of default—and default rates are much lower than comparable corporate bonds (Table). Indeed, Arezki, Candelon, and Sy (2011) find that an increase in financing costs of a state results in more favorable borrowing conditions for other states, perhaps reflecting the captive municipal bond demand in retail investor portfolios and consistent with the widening of spreads between high- and low-quality municipal bonds documented in Section B. Limited exposure by foreign investors given that they cannot take advantage of the tax-exempt status of these bonds should reduce the potential spillovers to international markets.

Default Rates

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Historical default rates for municipal and corporate bonds rated by Standard & Poor’s. Cumulative default rates up to 2007 expressed in percent.

Detroit and Puerto Rico experiences have, so far, continued to demonstrate that individual municipal bankruptcy and distress cases do not generate waves of defaults. Detroit’s estimated $18.5 billion in liabilities (nearly half of which are for retiree benefits) are small relative to the $3.7 trillion size of the U.S. municipal bond market. Puerto Rico arguably poses a bigger risk. An estimated 75 percent of mutual funds have exposure to Puerto Rico. Disclosures by UBS and Citigroup (the top two under-writers of Puerto Rican debt) suggest that spillovers may occur since Puerto Rican debt is used as collateral. That said, damage may still be contained and there is no obvious trigger event that would lead to a Puerto Rican default. Even with debt at three times that of Detroit, Puerto Rico is less than 2 percent of the municipal bond market and other municipal issuers are in much better shape than they were only a few years back.

1 Early in the bankruptcy process, the emergency financial manager of Detroit proposed to classify all general obligation (GO) bonds as unsecured debt, leading creditors to argue that the city had a statutory requirement to levy taxes as necessary and segregate certain tax proceed to pay for a particular class of GO bonds. This classification proposal, which would have had important ramifications for creditor rights in the municipal bond market, has since been dropped from the debt restructuring proposal.

Appendix 1: Details on the Econometric Analyses and Recent Developments

The econometric specification we use to examine the relationship between municipal bond market’s perception of a state’s creditworthiness and state characteristics builds the list of variables to include based on the analyses in Bayoumi, Goldstein, and Woglom (1995), Poterba and Reuben (1999), Novy-Marx and Rauh (2009b), and Grizzle (2010).

Data come from a variety of sources including Bloomberg, Bureau of Labor Statistics, Census Bureau, National Association of State Budget Officers, Pew Center, and NBER TAXSIM. Sample period covers 2008 through 2014.

We present the results under two main specifications: first with the credit rating as the dependent variable and then with the bond spread as the dependent variable. The latter is available only for 19 states (and Puerto Rico but Puerto Rico is not included in the regressions because of missing information on some of the control variables). The baseline regression results are in Tables 1 and 2.

Table 1.

Determinants of State Credit Ratings

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Notes: The sample consists of 50 states. The credit rating is the Standard & Poor’s rating of a state’s general obligation bonds. UPL stands for unfunded pension liabilities, UHL stands for unfunded retiree health benefits, DEBT is the market value of a state’s outstanding bonds, BBAL is the budget balance. UPL, UHL, DEBT, and BBAL are expressed as percent of gross state product and lagged by one year. IG is real income growth over the previous year. UR is the unemployment rate in the previous year. TAX is the top marginal tax rate on interest income (source: TAXSIM). POL is a measure of political polarization in the state legislature (source: Shor and McCarthy, 2013).
Table 2.

Determinants of Municipal Bond Spreads

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Notes: The sample consists of 19 states. The municipal bond spread is calculated as the difference between the yield on a state’s general obligation bonds, as reported by Bloomberg, and the 10-year Treasury bond yield. UPL stands for unfunded pension liabilities, UHL stands for unfunded retiree health benefits, DEBT is the market value of a state’s outstanding bonds, BBAL is the budget balance. UPL, UHL, DEBT, and BBAL are expressed as percent of gross state product and lagged by one year. IG is real income growth over the previous year. UR is the unemployment rate in the previous year. TAX is the top marginal tax rate on interest income (source: TAXSIM). POL is a measure of political polarization in the state legislature (source: Shor and McCarthy, 2013).

These results are robust to several changes to the specification including addition of other macroeconomic and fiscal controls (such as log level of state per capita income, revenue-to-GSP ratio, and average growth rate of revenues in the last three years) and different lags of the control variables.

An obvious concern is the endogeneity of outstanding debt levels. If a state is perceived to be in better fiscal health (e.g., because of its economic potential or because it has better budget institutions) and faces lower borrowing costs, it may opt for higher levels of debt because it can afford to do so. To address this concern and check the robustness of the coefficients on unfunded pension and other post-employment benefit liabilities and political polarization, we use an instrumental variables approach. Noting that most general obligation debt is long term and issued to finance infrastructure spending, the instrument we use is the population density of the state: more densely populated states tend to have higher demand for infrastructure and, hence, higher debt levels but population density is not related to credit ratings or bond yields. The instrumental variable regression results are in Table 3. First-stage results (available upon request) confirm the suitability of population density as an instrument for outstanding debt level. The main coefficients of interest on unfunded pension liabilities and political polarization remain largely unaltered in the IV regressions while the coefficient on outstanding debt is no longer significant. The latter may be an indication that the municipal bond market does take into account the fact that most debt is issued to finance capital projects with potential to benefit long-term growth.

Table 3.

Instrumental Variable Estimates

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Notes: Population density is used as an instrument for the debt level because most long-term general obligation bonds are issued to meet infrastructure needs. The credit rating is the Standard & Poor’s rating of a state’s general obligation bonds. The municipal bond spread is calculated as the difference between the yield on a state’s general obligation bonds, as reported by Bloomberg, and the 10-year Treasury bond yield. UPL stands for unfunded pension liabilities, UHL stands for unfunded retiree health benefits, DEBT is the market value of a state’s outstanding bonds, and BBAL is the budget balance. UPL, UHL, DEBT, and BBAL are expressed as percent of gross state product and lagged by one year. IG is real income growth over the previous year. UR is the unemployment rate in the previous year. TAX is the top marginal tax rate on interest income (source: TAXSIM). POL is a measure of political polarization in the state legislature (source: Shor and McCarthy, 2013).

Finally, Tables 4 and 5 provide a partial list of recent municipal bankruptcy filings and pension reform actions.

Table 4.

Recent Municipal Bankruptcies

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Table 5.

Recent Pension Reforms

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This chapter was prepared by Madelyn Estrada, Deniz Igan, and Dinah Knight. It has greatly benefited from discussions with Rabah Arezki, Ravi Balakrishnan, Kathleen Byrne, Roberto Cardarelli, Nigel Chalk, Matt Fabian, Tracy Gordon, David Jones, Lusine Lusinyan, Marcelo Pinheiro, and Tigran Poghosyan.


All years refer to calendar years. Federal government deficit figures include IMF staff’s adjustment for financial sector support costs. It should be noted that all states save Vermont have a balanced budget rule in place on a fiscal year basis (over two fiscal years in some states), but how binding the rule is varies across states. Technically, SLGs may not issue debt to close budget gaps (although they sometimes find ways around this constraint or legislate onetime fixes), hence the smaller increase in the SLG debt level compared to the federal debt held by the public.


In fact, municipal bonds tend to have lower yields than Treasuries because of their tax advantage, offsetting their illiquidity. Since the crisis, the “muni/Treasury ratio” has consistently exceeded 100 percent.


Such debt does not have to correspond to actual securities. Indeed, ratings agencies have recently started to combine outstanding market debt and unfunded retirement obligations into a single measure to assess the total financial burden on SLGs.


There may be other post-employment benefits but health care plans constitute the major portion. We use the terms health care benefits and other post-employment benefits interchangeably in the rest of the chapter.


For comparison, 40 out of 50 states report pension funding of at least 60 percent.


Chapter 3 of the IMF Country Report No. 13/237 looks at the factors driving health care spending growth and discusses the policy options to contain future health care spending.


Established through the American Recovery and Reinvestment Act of 2009, the two-year BAB program authorized SLGs to issue special taxable bonds that received either a 35 percent direct federal subsidy to the borrower (“Direct Payment BABs”) or a federal tax credit worth 35 percent of the interest owed to investors (“Tax Credit BABs”). BABs proved wildly popular, financing one-third of all new state and local long-term debt issuances from 2009 through the program’s expiration in 2010. In total, the Joint Committee on Taxation (JCT) identified more than 2,275 separate bonds that were issued to finance $182 billion in new infrastructure investment, with participation from all 50 states, the District of Columbia, and two territories.


See Appendix for details of the econometric analyses.


Unlike private pension systems, which are governed by federal law and regulations, state and local pension plans are not required to follow specific methods in calculating funding adequacy. Most plans adhere to the guidelines issued by the GASB but the board has no enforcement authority. Moreover, until June 2012, GASB rules allowed plans to use discount rates based on the expected rates of return, typically around 8 percent, to calculate pension liabilities and determine the degree of underfunding. The high discount rate underestimates the present value of promised benefits, which should instead be discounted by the riskless rate of return because these payments are certain to be made. With the rule change, the high discount rate can be used only for the funded portion of pension liabilities (i.e., the part backed by underlying pension assets) and the rest has to be discounted using a riskless discount rate, leading to a funding ratio that would be some 20 percentage points below the one estimated under the old rule.


Tests confirm that the coefficients obtained in the subsamples based on a budget institution indicator are statistically different from each other. These results are further confirmed when the difference between the actual and the predicted credit rating is regressed on budget institution indicators.


Municipal bond markets have been given generous exemptions under the Securities Act of 1933 and the Securities Exchange Act of 1934, except for antifraud cases. A limited regulatory scheme requiring dealers to register with the Securities Exchange Commission (SEC) and giving Municipal Securities Rulemaking Board (MSRB) authority to issue rules governing trades was introduced under the Securities Acts Amendments of 1975, but the “Tower Amendment” kept issuers exempt from requirements to file any presale documents. The Dodd-Frank Act expanded the MSRB’s authority and brought municipal advisors into the regulatory circle, but did not change the provisions applicable to issuers. Concerns about timeliness and comparability of financial information, lack of disclosure by conduit borrowers, adequacy and accuracy of disclosure regarding funding obligations under pension and other post-retirement benefits, and the illiquid, opaque, and fragmented market microstructure make it particularly difficult to construct bond yields at the state level and extract information from these series.


Specifically, we use the estimated coefficients to predict the credit rating for each state based on their economic, fiscal, and political characteristics. The four states chosen have the largest differences between the actual and predicted credit ratings consistently (that is, not only in a single year but consecutively over a three-year period).


The new GASB rules take steps in this direction by requiring more realistic appraisal of the unfunded portion of pension obligations as well as higher required contributions and more transparency in the reporting of obligations.

United States: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.