Are States The Next Greece?

Recent Events
The recent downturn in our economy has created severe budgetary stress for states, as their revenues have fallen precipitously and the demand for services has increased. The State of California with it’s politically charged budgetary process, high foreclosure rate, and high unemployment rate has received much negative attention in the media. Some are saying “California is the next Greece”. While there is little doubt California is under financial stress we believe these concerns are overblown.

A Sovereign: Greece
Greece is an independent political and financial entity and enjoys “self rule”. It is responsible for it’s budget and has the ability to issue debt and print money. Much of their debt is sold to foreigners and foreign banks. Greece is part of the European Union (EU), and their currency is the euro. The EU requires certain fiscal disciplines for member nations, such as balanced budgets, in order to use the euro as their unit of currency. Recently, it was discovered that Greece created fictitious budgets in order to become part of the EU and their financial circumstances are much weaker than previously thought. The revelation of Greece’s weakened financial state has led to a lack of confidence in their ability to re-pay their debt which has created a “debt crisis” for the country and the EU. The EU has demonstrated a willingness to bail out Greece if certain austerity programs are implemented. Resistance to these austerity measures and violent demonstrations in Greece by it’s citizens have been shown on television. Other EU countries such as Portugal, Spain, and Italy are also experiencing financial problems. Many are questioning the viability of the euro as a currency, and it has been under severe pressure as holders of euro’s look to sell and trade into more secure currencies.

A State: California
The State of California is a political sub-division of the United States. It is responsible for it’s budget, but is required by law to have a balanced budget. It is not able to print money. The U.S. government has helped the States, including California, through various stimulus packages during the last 1.5 years. Most of the debt of the State is held domestically, and is not subject to additional volatility caused by currency risk, which makes them much less volatile than Greek bonds during the last couple of years. Though
the budgetary process is cumbersome and outdated, the financial reports issued by the State comply with legal reporting standards and offer a fair representation of the State’s financial circumstances. The State has the ability to cut expenses and raise revenues to balance the budget. The rapid decline in tax revenues for the last 2 years has caused a great deal of budgetary stress for the State. The ability to make difficult decisions shows the resiliency of the State. These decisions have been made without fiscal discipline being imposed from foreigners, and without rioting in the streets like Greece. The issue of unfunded pension liabilities and healthcare benefits for public employees has not been adequately resolved, and will likely become a major issue during the next 10 years.

Differences
One of the most important differences between Greece and the State of California is the legal framework and rules for reporting. California has had fiscal discipline imposed on it by existing state and federal statutes. These statutes require a balanced budget, and set priorities for paying bills. For example, the highest priority for the State when paying expenses is to first pay those for education, next is debt service on bonds. All other expenses are subordinate to these and are paid after these expenses have been paid. Since Greece is a sovereign, it has been easier for them to avoid fiscal discipline through false reporting and false promises to their citizens. However, this has come to an end as the EU and IMF are dictating austerity measures for Greece.

Another difference is that there is a closer relationship between a State and the U.S. government, than there is between a member nation and the rest of the EU. Imagine being a German citizen and watching reports on television of the rioting in the streets of Greece, while they are expecting you to bail them out. How would you feel when you aren’t even part of the same country?

Sovereigns are also responsible for the banking system and credit conditions within their borders. Many sovereign nations are still reeling from the extensive bailout programs which were required to bail out the banks during the last credit crisis, and to stimulate their economies. In the U.S. the Federal government is responsible for the banking system. This allows the States to focus on other issues, such as education.

Conclusion
There is little doubt that many Sovereigns are riskier credits than States in the U.S. During the last 10 years, the default rate for all Muni bonds has been only 0.1%. There has not been an instance of a State default for over 75 years. The default rate for all Sovereigns during the same time period was 6.0%, which is 60 times greater than the default rate for all Munis.

(Please see chart below for Muni vs. Sovereign comparison.)