When it comes to bankrupt or near-bankrupt states, the focus right now is all on Europe.
We’ve got Ireland figuring out what to do about Anglo-Irish Bank, with the final bill put at €29.3bn this morning (although it could hit €34bn in a ‘severe hypothetical stress scenario’). And we’ve got the usual rumblings about Greece and Portugal and all the rest just waiting in the wings.
But maybe everyone’s looking in the wrong place. Because it’s not just little ‘peripheral’ euro-economies that are in trouble.
In fact, some far, far bigger economies – some of them among the world’s largest – are in just as big a mess.
We’re talking about the largest states in the US.
US states are worryingly reminiscent of the banks pre-crisis
You may recognise Meredith Whitney’s name from the banking crisis. She was a relatively unknown analyst until, in October 2007, she warned that US banking giant Citigroup was going to have to cut its dividend. She got the banking crisis right, and since then everyone’s paid attention to what she has to say.
This week she put out a 600-page report on what she reckons will trigger the next financial crisis. The report (‘The Tragedy of the Commons’) takes an in-depth look at the financial condition of the 15 biggest states in the US. And it’s really not a pretty sight.
“The states situation reminded me so much of the banks pre-crisis,” she told CNBC. “The similarities between the states and the banks are extreme, to the extent that states have been spending dramatically, growing leverage dramatically.” So states are heavily indebted. But at the same time, they are still spending more – around 27% collectively – than they take in via taxes.
To be fair, none of this is a huge surprise. People have been fretting vaguely about the financial condition of the states for well over a year now – you can read our most recent primer on the topic here: Could we soon see a US state go bust? By far the worst is big-spending, low-taxing California, says Whitney. The best is small-government, fiscally conservative Texas.
But how could this trigger another financial crisis? Well, the main issue isn’t the states themselves. As Felix Salmon puts it on Reuters, states may be spending beyond their means, but “states can and will get bailed out by the federal government, in extremis.”
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How US cities could set off the next financial crisis
The real problem is the municipal debt – the money owed by cities and towns. As Shawn Tully notes in Fortune magazine, these ‘municipalities’ get about a third of their revenue from the states that they’re in. But if the states need to hold onto that money to patch up their own tattered budgets, then the cities and towns won’t have enough to pay the interest bills on their own debt.
“The states will secure their own shortfalls, and leave the cities to fend for themselves,” says Whitney. Effectively, the cities are the weakest link in the chain. They’re the ones that will end up going bust if anyone does. And investors aren’t prepared for that, she reckons. “I see a lack of transparency and an abundance of complacency on the part of investors and politicians, just as we saw before the banks imploded.”
Scary stuff. And obviously this isn’t great news if you live in one of these states. We’re all fretting about ‘the cuts’ looming on the horizon in Britain. But some of these cities will have no public services left by the time they’ve dealt with their budget problems. Taxes will have to rise, all of which will drag on America’s ‘recovery’. And the threat of another property bust would just make the whole situation worse.
What this means for us
But from the point of view of an investor on this side of the Atlantic, what does it mean?
Well, Whitney tells CNBC that she reckons this will ultimately result in another ‘trillion-dollar’ bailout from the government. And David Fuller on Fullermoney.com describes the problem as “a good reason to be cautious on the rate of US economic recovery over the next few years.”
However, it also means that there’s even more incentive for the Federal Reserve to keep interest rates low, says Fuller. Basically, the Fed will print as much money as it needs to. That’ll undermine the dollar, but that’s the least of the Fed’s worries – for now. And a weak dollar is good news for “US multinational equities”, particularly those with exposure to emerging markets. “With strong balance sheets they can afford to raise dividends, make share buybacks, increase capital expenditure, borrow cheaply and make takeovers.”
Of course, the promise of a weak dollar is also generally good for gold. But we’ve discussed that one enough this week, so I’ll not go on about it again now. Otherwise, we’d agree that high-quality blue chips (of whatever nationality) still look like the best bet in the current economic environment – although if we do end up with a sub-prime style blow-up in the muni-bond market, I suspect there would be a knock-on panic effect on stocks worldwide. You just have to look at the jitters over Europe to see that.
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