Tax and Sell: An Alleged solution to the State and Municipal Financial Crisis

The article below attempts to defuse the coming (and in some case existing) financial crisis affecting the states and their political subdivisions. The author believes that states and municipalities can overcome this crisis by raising taxes and liquidating assets. What the author does not seem to understand is that while residents demand the continuation of existing (if not greater) government services, the average taxpayer will not accept higher tax rates and buyers will not show up for state asset sales and pay a fair price, let alone be able to qualify for or find financing. Instead of the rosy picture painted by this author, I foresee municipal defaults and significant austerity measures as the coming trend, meaning numerous layoff for state and city workers and even lower tax collections for the political subdivisions. Until the private economy begins returning jobs to the local economies, more pain is sure to follow. To that end, I would not follow this author's investment advice. Selling munis now might not get you a good return, but it'll be better than waiting five or ten years for the full return of your money on a bond refi-d out of a chapter 9 bankruptcy or self-imposed forebearance.

States Aren’t About to Default on Debt
March 29, 2010, 12:57 PM ET (wsj.com)


Everybody thinks municipal debt is “the next shoe to drop.” That’s the phrase I keep hearing. We’re all holding these mysterious “shoes” (why we aren’t wearing them is not clear) and we’ve dropped one shoe already: subprime debt. And now our other shoe will drop.

It’s not commercial real estate or credit-card debt or Greece. It’s the wave of municipal defaults that are expected to hit as tax revenues slow down and cities will be forced to declare bankruptcy. And now that we are a country of debt experts (people are coming out of the woodwork to say they could have easily predicted the subprime fiasco), everyone has an opinion.

There are big differences, however, between municipal debt and subprime debt. Subprime debt in the later vintages (2004-2007) was often lent out fraudulently and with few assets to back up the debt. Municipalities have assets and the ability to collect taxes to create revenue. Homeowners don’t.

Also, states legally cannot declare bankruptcy. There are bankruptcy laws for cities but not states. When a state can’t pay its bondholders it has only two choices: sell assets or increase taxes. It has no other choice.

Let’s take my friend’s example of California as a case study.

The California constitution mandates that education costs be paid first out of any revenue coming in. California has about $90 billion in revenue. About 40% of that goes to education. After that, as per the California constitution, all debt payments have to be made. After that, California can spend on whatever it wants: police, landscaping, random buildings, etc. Debt service payments come to about $5.5 billion per year. In other words, each year California makes its debt payments, with an extra $50 billion to spare. This is why it has no problems refinancing and why municipal bond yields are at record lows. Most states have similar clauses in their state constitutions: that debt service payments come before anything else.

Well, what about cities? Cities can go bankrupt, can’t they? Yes, cities can file for Chapter 9 bankruptcy. But even then, cities are different from corporations. Cities don’t get liquidated. They still have to figure out how to pay off their debts (so they can borrow again in the future) and raise revenue.

Let’s look at the worst municipal bankruptcy in U.S. history: the 1994 bankruptcy of Orange County. The county made a disastrous bet on derivatives (sound familiar) and lost $1.6 billion. It filed Chapter 9 bankruptcy. In 1995 and 1996 it drastically cut back on spending. It then issued long-term recovery bonds and paid back the municipal-bond holders 100 cents on the dollar.

Before a municipality will default on its debts it will cut salaries (as happened in the Vallejo, Calif., bankruptcy in 2008 where it paid out less than contacted salaries to police officers and union workers), cut other spending, raise taxes, and do whatever it can to pay down debt. Its also not easy, legally, for a city to declare bankruptcy. It has to obtain permission from the state, for instance, and only 24 states have laws describing how the Chapter 9 process can occur. Georgia specifically prohibits Chapter 9. This is why more than 15,000 corporations have been able to declare bankruptcy but only 614 municipalities have filed for Chapter 9 since 1937. Even Harrisburg, Penn., which has become perilously close to not paying its debts, has tapped into a reserve fund it had for this purpose and has called talk of bankruptcy “premature.”

Unlike for corporations, a trip to bankruptcy court is no panacea to eliminate or reduce debt. A municipal issuer that files for bankruptcy hinders its access to capital. Since issuing new debt is often part of the resolution, defaulting is generally ill-advised and contraindicated. One may certainly question the wisdom of papering over every shortfall with ever more debt, but it will be some time before debt service itself is the problem, especially in this low interest rate environment. Municipal defaults right now are at about 0.1%. At worst they go to 0.2%, but even this is unlikely due to all the mechanisms in place that municipalities have to cover their debt service.

How to take advantage of this? There are two major players in the space. The smaller player is a little company called Berkshire Hathaway (BRKA, BRKB), run by a curmudgeonly speculator named Warren Buffett. He entered the space when the two biggest players, MBIA and Ambac, ran into trouble by dabbling too much in subprime debt. The other player is Assured Guaranty (disclosure: I own the stock) which counts as its largest investor, the very successful investor Wilbur Ross. These super investors, plus the fact that municipal bond yields are trading at a meager 3.89%, suggest that the smart money is completely aware of the potential for municipal defaults and they are eagerly letting panicked investors insure municipal bonds.

Will more municipalities default? Maybe. Maybe it goes up from a 0.1% rate to a 0.2% rate. But if the bears are looking for something to point at as the “next shoe” to drop then they will have to look elsewhere. States have the assets, the tax-raising ability, and the incentive to meet their debt obligations so they can survive and thrive in the future. And the companies that are right now taking advantage of this will prosper.

James Altucher, a contributor to Dow Jones Adviser, is a managing partner of Formula Capital, an alternative asset management firm, and an author on investment strategies. Unlike Dow Jones reporters, he may have positions in the stocks he writes about.

The Issue of Guaranteed Issue in the New Health Care Law

This is a great piece printed just days after P. Obama signed the new health care legislation into law. Not only does it touch upon the relatively narrow issue of guaranteed issue for children of policy holders, but strongly foreshadows the mountains of rules, interpretations and, ultimately, systems that will be born from the complex new law. From a personal perspective, I wonder how anyone in Congress could have been educated sufficiently on the costs or multiple, significant consequences that the new law will have on the health care system, especially when regulations to enforce the law have yet to be written by bureaucrats. The devil is indeed in the details-- both those in the legislation, and those that are created from it. Be warned, the new law is a budget buster, and functionally cannot be the panacea for a modern health care system. While certain aspects of the law are both noble and needed (i.e. the reforms on policy cancellation and p-x condition-- but see below on that), the trade-offs to industry (i.e. individual mandate) and labor (tax on Cadillac plans suspended until 2018) were simply too generous, and have cratered any present chance for reform.

Sunday, March 28, 2010 nytimes.com
Coverage Now for Sick Children? Check Fine Print
By ROBERT PEAR

WASHINGTON — Just days after President Obama signed the new health care law, insurance companies are already arguing that, at least for now, they do not have to provide one of the benefits that the president calls a centerpiece of the law: coverage for certain children with pre-existing conditions.

Mr. Obama, speaking at a health care rally in northern Virginia on March 19, said, “Starting this year, insurance companies will be banned forever from denying coverage to children with pre-existing conditions.”

The authors of the law say they meant to ban all forms of discrimination against children with pre-existing conditions like asthma, diabetes, birth defects, orthopedic problems, leukemia, cystic fibrosis and sickle cell disease. The goal, they say, was to provide those youngsters with access to insurance and to a full range of benefits once they are in a health plan.

To insurance companies, the language of the law is not so clear.

Insurers agree that if they provide insurance for a child, they must cover pre-existing conditions. But, they say, the law does not require them to write insurance for the child and it does not guarantee the “availability of coverage” for all until 2014.

William G. Schiffbauer, a lawyer whose clients include employers and insurance companies, said: “The fine print differs from the larger political message. If a company sells insurance, it will have to cover pre-existing conditions for children covered by the policy. But it does not have to sell to somebody with a pre-existing condition. And the insurer could increase premiums to cover the additional cost.”

Congressional Democrats were furious when they learned that some insurers disagreed with their interpretation of the law.

“The concept that insurance companies would even seek to deny children coverage exemplifies why we fought for this reform,” said Representative Henry A. Waxman, Democrat of California and chairman of the Energy and Commerce Committee.

Senator John D. Rockefeller IV, Democrat of West Virginia and chairman of the Senate commerce committee, said: “The ink has not yet dried on the health care reform bill, and already some deplorable health insurance companies are trying to duck away from covering children with pre-existing conditions. This is outrageous.”

The issue is one of many that federal officials are tackling as they prepare to carry out the law, with a huge stream of new rules, official guidance and brochures to educate the public. Their decisions will have major practical implications.

Insurers say they often limit coverage of pre-existing conditions under policies sold in the individual insurance market. Thus, for example, an insurer might cover a family of four, including a child with a heart defect, but exclude treatment of that condition from the policy.

The new law says that health plans and insurers offering individual or group coverage “may not impose any pre-existing condition exclusion with respect to such plan or coverage” for children under 19, starting in “plan years” that begin on or after Sept. 23, 2010.

But, insurers say, until 2014, the law does not require them to write insurance at all for the child or the family. In the language of insurance, the law does not include a “guaranteed issue” requirement before then.

Consumer advocates worry that instead of refusing to cover treatment for a specific pre-existing condition, an insurer might simply deny coverage for the child or the family.

“If you have a sick kid, the individual insurance market will continue to be a scary place,” said Karen L. Pollitz, a research professor at the Health Policy Institute at Georgetown University.

Experts at the National Association of Insurance Commissioners share that concern.

“I would like to see the kids covered,” said Sandy Praeger, the insurance commissioner of Kansas. “But without guaranteed issue of insurance, I am not sure companies will be required to take children under 19.”

A White House spokesman said the administration planned to issue regulations setting forth its view that “the term ‘pre-existing’ applies to both a child’s access to a plan and his or her benefits once he or she is in a plan.” But lawyers said the rules could be challenged in court if they went beyond the law or were inconsistent with it.

Starting in January 2014, health plans will be required to accept everyone who applies for coverage.

Until then, people with pre-existing conditions could seek coverage in high-risk insurance pools run by states or by the secretary of health and human services. The new law provides $5 billion to help pay claims filed by people in those pools.

Federal officials will need to write rules or guidance to address a number of concerns. The issues to be resolved include defining the “essential health benefits” that must be offered by all insurers; deciding which dependents are entitled to stay on their parents’ insurance; determining who qualifies for a “hardship exemption” from the requirement to have insurance; and deciding who is eligible for a new long-term care insurance program.

As originally conceived, most of the new federal requirements would have taken effect at the same time, in three or four years. The requirements for people to carry insurance, for employers to offer it and for insurers to accept all applicants were tied together.

But as criticism of their proposal grew, Democrats wanted to show that the legislation would produce immediate, tangible benefits. So they accelerated the ban on “pre-existing condition exclusions” for children.

Consumers will soon gain several other protections. By July 1, the health secretary must establish a Web site where people can identify “affordable health insurance coverage options.” The site is supposed to provide information about premiums, co-payments and the share of premium revenue that goes to administrative costs and profits, rather than medical care.

In addition, within six months, health plans must have “an effective appeals process,” so consumers can challenge decisions on coverage and claims.

Rejoice America! Health Care Passes the House, Only to Later Bankrupt the Nation.

[Note: The Senate version of the health care reform bill was approved by the House tonight by a 219-212 vote.  The Senate bill will now be sent to the President.  The "reconciliation" portion of the health care bill was also approved by the House with 222 votes, sending that portion of the legislation back to the Senate for final consideration by the Senate.  The calculations for the bill's spending and revenue provisions, detailed and discussed in the article below, were not altered by the House vote.]  

The Real Arithmetic of Health Care Reform

By Douglas Holtz-Eakin
nytimes.com, March 21, 2010
Arlington, Va.

ON Thursday, the Congressional Budget Office reported that, if enacted, the latest health care reform legislation would, over the next 10 years, cost about $950 billion, but because it would raise some revenues and lower some costs, it would also lower federal deficits by $138 billion. In other words, a bill that would set up two new entitlement spending programs — health insurance subsidies and long-term health care benefits — would actually improve the nation’s bottom line.

Could this really be true? How can the budget office give a green light to a bill that commits the federal government to spending nearly $1 trillion more over the next 10 years?

The answer, unfortunately, is that the budget office is required to take written legislation at face value and not second-guess the plausibility of what it is handed. So fantasy in, fantasy out.

In reality, if you strip out all the gimmicks and budgetary games and rework the calculus, a wholly different picture emerges: The health care reform legislation would raise, not lower, federal deficits, by $562 billion.

Gimmick No. 1 is the way the bill front-loads revenues and backloads spending. That is, the taxes and fees it calls for are set to begin immediately, but its new subsidies would be deferred so that the first 10 years of revenue would be used to pay for only 6 years of spending.

Even worse, some costs are left out entirely. To operate the new programs over the first 10 years, future Congresses would need to vote for $114 billion in additional annual spending. But this so-called discretionary spending is excluded from the Congressional Budget Office’s tabulation.

Consider, too, the fate of the $70 billion in premiums expected to be raised in the first 10 years for the legislation’s new long-term health care insurance program. This money is counted as deficit reduction, but the benefits it is intended to finance are assumed not to materialize in the first 10 years, so they appear nowhere in the cost of the legislation.

Another vivid example of how the legislation manipulates revenues is the provision to have corporations deposit $8 billion in higher estimated tax payments in 2014, thereby meeting fiscal targets for the first five years. But since the corporations’ actual taxes would be unchanged, the money would need to be refunded the next year. The net effect is simply to shift dollars from 2015 to 2014.

In addition to this accounting sleight of hand, the legislation would blithely rob Peter to pay Paul. For example, it would use $53 billion in anticipated higher Social Security taxes to offset health care spending. Social Security revenues are expected to rise as employers shift from paying for health insurance to paying higher wages. But if workers have higher wages, they will also qualify for increased Social Security benefits when they retire. So the extra money raised from payroll taxes is already spoken for. (Indeed, it is unlikely to be enough to keep Social Security solvent.) It cannot be used for lowering the deficit.

A government takeover of all federally financed student loans — which obviously has nothing to do with health care — is rolled into the bill because it is expected to generate $19 billion in deficit reduction.

Finally, in perhaps the most amazing bit of unrealistic accounting, the legislation proposes to trim $463 billion from Medicare spending and use it to finance insurance subsidies. But Medicare is already bleeding red ink, and the health care bill has no reforms that would enable the program to operate more cheaply in the future. Instead, Congress is likely to continue to regularly override scheduled cuts in payments to Medicare doctors and other providers.

Removing the unrealistic annual Medicare savings ($463 billion) and the stolen annual revenues from Social Security and long-term care insurance ($123 billion), and adding in the annual spending that so far is not accounted for ($114 billion) quickly generates additional deficits of $562 billion in the first 10 years. And the nation would be on the hook for two more entitlement programs rapidly expanding as far as the eye can see.

The bottom line is that Congress would spend a lot more; steal funds from education, Social Security and long-term care to cover the gap; and promise that future Congresses will make up for it by taxing more and spending less.

The stakes could not be higher. As documented in another recent budget office analysis, the federal deficit is already expected to exceed at least $700 billion every year over the next decade, doubling the national debt to more than $20 trillion. By 2020, the federal deficit — the amount the government must borrow to meet its expenses — is projected to be $1.2 trillion, $900 billion of which represents interest on previous debt.

The health care legislation would only increase this crushing debt. It is a clear indication that Congress does not realize the urgency of putting America’s fiscal house in order.

Douglas Holtz-Eakin, who was the director of the Congressional Budget Office from 2003 to 2005, is the president of the American Action Forum, a policy institute.

The Emperor Will Be Purchasing His Clothes From A Thrift Shop

The Perils of Pay Less, Get More
By David Leonhardt, nytimes.com, March 16, 2010

As a society gets richer, its tax rates tend to rise.

This idea is known as Wagner’s Law, named for the 19th-century economist who came up with it. Citizens of richer societies generally prefer more government services, Adolf Wagner explained. With their basic needs met, they want a military to protect them, good schools for their children, comfortable retirement for the elderly, medical care even when it isn’t profitable and a strong social safety net.

Sure enough, the United States followed this path for most of the last century. In 1900, federal taxes amounted to just 2 percent of gross domestic product. By 2000, the share had risen to 21 percent.

Over the last couple of decades, though, we have repealed Wagner’s Law — or, more to the point, only partly repealed it. Taxes are no longer rising. They fell to 18 percent of G.D.P. in 2008 and, because of the recession, to a 60-year low of 15.1 percent last year.

Yet our desire for government services just keeps growing. We added a prescription drug benefit to Medicare. Farm subsidies are sacrosanct. Social Security is the third rail of politics.

This disconnect is, far and away, the main reason for our huge budget problems. Yes, the wars in Iraq and Afghanistan, the recession and the stimulus have all added to the deficit. But they are minor issues in the long run. By 2020, government spending is projected to equal 26 percent (and rising) of G.D.P., mostly because of Medicare and Social Security. Taxes are on pace to equal just 19 percent.

On Friday, Congressional Republicans named six members of a deficit commission that President Obama created last month. In all, the commission will have 10 Democratic members and eight Republicans. It is scheduled to issue its recommendations late this year.

“By any reasonable projection, we’re on an utterly unsustainable path,” Peter Orszag, the White House budget director, told me last week. “And the fiscal commission, while not guaranteed to succeed, offers the best hope of getting ahead of this problem before it becomes a true crisis.”

The commission can succeed, of course, only if it comes up with solutions that Congress and the White House accept. For now, political leaders in both parties are still in denial about what the solution will entail. To be fair, so is much of the public.

What needs to happen? Spending will need to be cut, and taxes will need to rise. They won’t need to rise just on households making more than $250,000, as Mr. Obama has suggested. They will probably need to rise on your household, however much you make.

A solution that relied only on spending cuts would dismantle some bedrock parts of modern American society. Paul Ryan, the ranking Republican on the House Budget Committee, recently released such a plan, and it got rid of Medicare for everyone now under 55.

A solution that relied only on taxes would muzzle economic growth. To cover the costs of future spending — the retirement of the baby boomers and everything else — federal taxes would have to rise by almost 50 percent, immediately and permanently, according to a recent analysis by the economists Alan Auerbach and William Gale.

A solution that combined spending cuts and tax increases would not need to be ruinous — or start in the next couple of years, when unemployment is likely to remain high. But the federal government does have a decent amount of fat in it. And, just as Wagner pointed out, tax increases are not inherently bad. Done right, they do not even have to reduce economic growth by much.

In recent years, economic research has suggested that moderate changes in the tax law don’t actually have a huge impact on growth. You don’t need econometrics to grasp this, either. Just look at the last 20 years. Economic growth after Bill Clinton’s tax increases was far more rapid than economic growth after George W. Bush’s tax cuts. Despite the Bush tax cuts, average annual growth over the last decade — even before the Great Recession began — was slower than in any decade since World War II.

The biggest hurdle to solving the deficit problem will be politics, not economics. Even if the tax increases and spending cuts don’t need to be ruinous, they will not be popular. None of us like the idea of losing benefits or paying more taxes. That’s why Mr. Obama and Congress have outsourced the first stage of the process to a commission.

On the spending side, health care is easily the biggest item. Not only will many people in their 50s and 60s live into their 80s, but technological advances will make medical care for any individual person much more expensive in the future.

A crucial aspect of the final health reform bills is that they take early steps toward trying to distinguish between care that makes people healthier and care that does not. These steps, along with some Medicare cuts, are the reason that many economists think the bills will reduce the deficit. The bills will also make it easier for Medicare to make further changes in the future.

Beyond heath care, Social Security benefits could be reduced for high-income households, and the annual inflation adjustment could be trimmed (making it more accurate, some economists believe). Many corporate subsidies — for agribusinesses and banks, among others — serve no useful economic function. Some military contractors could also stand to be squeezed.

Don’t expect that any one program can close the deficit, though. Military spending, for example, already takes up a much smaller share of the budget than a few decades ago, as Douglas Elmendorf, the head of the Congressional Budget Office, said last week. Without the end of the cold war, the deficit might have already soared.

On taxes, the affluent can certainly stand to pay higher rates than they have. Over the last three decades, they have received both the biggest pretax pay increases and the biggest tax cuts. But there is not enough money at the top to eliminate the long-term fiscal gap. Households making more than $250,000 pay federal taxes equal to only about 5 percent of G.D.P.

The ideal way to raise taxes for everyone else is not through the income tax code — which can affect people’s incentive to work — but through another means. As Victoria Perry of the International Monetary Fund points out, every industrialized country in the world except Saudi Arabia and the United States has some kind of consumption tax. A modest consumption tax would give households more incentive to save and could raise significant revenue. Another option is to reduce some big deductions, like the one for mortgage interest.

I’ll confess that I have a hard time seeing how any of this will happen in the next few years, no matter what the deficit commission recommends. Congressional Republicans have shown little willingness to consider any tax increases, and Mr. Obama has shown no indication of breaking his $250,000-and-under pledge. We voters, meanwhile, tend to oppose government spending in general while supporting the government programs that the spending pays for.

But a lot can happen in a few years. For one thing, interest rates on government bonds are likely to rise, making the need to reduce the deficit more pressing. “It doesn’t seem like policy makers are currently afraid of the bond market,” Mr. Orszag says, “and I wish that weren’t the case.” Someday soon, they may have to be.