01/14/11 North Weymouth, Massachusetts – “I’ll never grow up, never grow up, never grow up, Not me!”
– Peter Pan, Lyrics from play
“I knew Peter Pan and you’re no Peter Pan.”
– Vice-Presidential candidate Lloyd Bentsen, (sort of), 1988
“Top Illinois Democrats have agreed to push a plan that would temporarily boost income taxes by 75 percent and double cigarette taxes,” harked CBS Chicago on January 6, 2011. The proposed plan would increase Illinois’ personal income tax rate from 3 percent to 5.75 percent for the next three years. After that, it would drop back to 3.25%. So they say.
Illinois is a state in which the legislators have so betrayed the taxpayers that a lifetime on Devil’s Island would be too good for them. For instance, the liability of the four state pension plans is calculated at $151 billion or $280 billion, depending on the assumptions used. The $280 billion figure is analytically controversial but deductively compelling given the efforts to deny and confuse bondholders and the public alike respecting the coming collapse of the municipal bond market.
Springfield, the capital of Illinois, is a nice town. As state capitals go, it is strikingly uninhabited with a population of 110,000 (and falling, but not as fast as its benefit obligations are rising). Farm country starts about three blocks from the state house. Illinois has more representation in its capital than any other state.
The politicians raised pension benefits faster than poker bids in Macau. Presumably, they have boosted their own benefits faster than the state’s public servants, who, once they retire, no longer pay one cent for health insurance.
Clay ducks would have done better at funding promises than the elected representatives. There are $70 billion of assets to support the $280 billion of pension obligations (See The Liabilities and Risks of State-Sponsored Pension Plans in which Professors Novy-Marx and Rauh lay forth their provocative and engaging argument).
Illinois borrows from the bond market each year to pay benefits, a total of $16 billion since 2007. Bondholders have been paid $550 million (on the first $10 billion) for funding this pyramid scheme. In other words: Illinois taxpayers have paid a $550 million late-fee that, if there were justice in this world, would be paid by the Illinois legislators.
These legislators – and this is true across the country, not just Illinois – cannot conceive of a time when there will be no buyers of bonds to pay benefits that the politicians failed to fund. By borrowing to meet current payments, the “top Illinois Democrats” have fostered the national charade of limitless taxing authority. State General Obligation (G.O.) bonds are backed by the “full faith and credit” phrase, stamped on their offerings. Wall Street research would have it that a G.O. bondholder can take that phrase to the bank. It is from this precipice that bondholders hang by their fingernails.
Goldman Sachs research chips in: “[G]eneral obligation debt is backed by a state or local government’s pledge to raise taxes to service that debt if necessary.” Barclay’s wrote to its California-averse clients that the state is obligated “in good faith to use its taxing power as may be required for the full and prompt payment of debt service.”
There are four problems here.
First, the State of Illinois had accumulated over $5 billion of unpaid bills by the end of 2010. Electricity to the governor’s mansion will be cut off if the politicians don’t grow up.
Second, the authority to raise taxes to meet bond payments often does not work. The most recent instance is the State of Oregon. In early 2010, voters increased tax rates on high earners and businesses to fill a $700 million deficit. Civil servants danced in the streets: “We’re absolutely ecstatic,” said Hanna Vandering, a physical education teacher from Beaverton and vice president of the statewide teachers union. “What Oregonians said today is they believe in public education and vital services.” (The Oregonian, January 26, 2010) On December 16, 2010, the state of Oregon had received one-third less than was expected from windfall tax receipts. Those Oregonians who weren’t talking while Hanna Vandering was spouting decided they would rather leave town than contribute to this scandalous love-in between legislators and public unions.
Third, the authority and inclination of courts to issue a writ of mandamus (ordering state officials to raise taxes) is not a topic discussed in brokerage firm research. It is hereby suggested to municipal bondholders who are recipients of such reports to ask why this is so. There have been many decisions in which the court concluded it did not have the authority (or inclination: because efforts, such as in Oregon, are generally unsuccessful) to demand tax increases. The decisions are too varied to discuss here. (See, as a start, Tax Increases in Municipal Bankruptcies, Kevin A. Kordana, Virginia Law Review, volume 83, No. 6, pp. 1035-1107.) Readers may recall that states cannot file for bankruptcy. This is true, but an insolvent body that reneges on its obligations to bondholders will sit in the dock. Municipal decisions are the obvious precedents for the courts.
Fourth, a Sword of Damocles hovers over all transactions and contracts in the United States today: who still trusts the “full faith” of any government body? And, this is the worst situation of all: politicians who think they can fly.
Regards,
Frederick J. Sheehan
for The Daily Reckoning
Frederick Sheehan
Frederick Sheehan is author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession and co-author of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve. Sheehan was a director at John Hancock Financial Services where he wrote the Market Outlook and Market Review. He contributes to the Gloom, Boom & Doom Report, Whiskey & Gunpowder, and the Prudent Bear, among others. He also advises an investment firm and a non-profit foundation. Sheehan is a CFA and graduate of Columbia Business School.
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This was a very painful article to read. Probably true but very painful to realize that things are in this condition. Mish Shedlock (blogger)is starting a recall move against the governor. I just noticed his website is down this morning. I guess after this article the DR will be down too.
I live in California. I have one thing to be thankful for and that’s the fact that it’s not Illinois.
yep Il has higher property tax too. I think Illinois will fall 1st…sucks thats where I live.
Here is the real scam. Jeb Bush and Newt Gingrich just wrote and op-ed on this. They propose that state’s be allowed to file voluntary bankruptcy. Re-negotiate or default on all contract/obligations with the common workers. However, they want there to be a guarantee for bondholders. I bet you can guess who the largestholder of these junk go bonds are??? Yep Goldman Sachs and all of their clients. By the way, I saw a 60 minutes the other week and the most successful professional gambler alive was in agreement with what I am about to say. Investing with wall street is not risky….it is absurdly ignorant as the odds don’t slimly favor the house, but are fixed so that the only real winners in dollar terms are the wall street players.
Here is what America needs to do save itself from these tyrants. We need a national “sell out” week. Where every person with a retiremnet or investment account withdraws their money from mutual funds in a coordinated effort to bankruot these thieves from within. I am afraid that this is the only way out. A bloodless revolution American style… using only dollars( or is that IOU’s)
Fascinating post, Mr. Sheehan. For further info on the enforceability of “full faith and credit”, you should contact a professor of State Constitutional law. Not many law professors examine this topic, but Mr. Long (now at Wayne State University) taught an excellent seminar on it last year.
The gist of “full faith and credit” is that state courts sometimes have held municipal govts in contempt for failing to fund obligations, and have directed state marshals to auction off municipal property. However, among the half dozen Constitutions I have looked over, I did not find any state in which the state court had apparent constitutional authority to direct that state marshals should auction off state executive property for payment of obligations.
And under the 11th amendment, ratified to protect the State of Georgia from exactly the same circumstances now faced by the States of California, Illinois, New York, etc … Federal courts also lack constitutional authority (subject matter jurisdiction) to enforce a state’s bond obligations.