Tag Archives: General Fund

Hercules, California’s Herculean debts

What lead the city of Hercules, California to default on its debts? Guest poster Marc Joffe, Principal Consultant at Public Sector Credit, finds a case of mission-creep in the “dynamic city on the Bay’s”  decision to issue debt to finance power plants and affordable housing.

(For more of Marc Joffe’s research on modeling credit risk, read his 2013 Mercatus Working paper comparing Illinois and Indiana)

Hercules, California Public Power Failure Leads to Default

by Marc Joffe

Cities can default on obligations to their creditors without filing for Chapter IX bankruptcy protection.  This is the lesson of Hercules, California – a 25,000-resident San Francisco suburb whose finances are not quite as mighty as its name implies. Hercules experience is also illustrative of the risks that cities take when they expand beyond their core functions of public safety and public works.

The city is threatening to default on $12.8 million of municipal bonds as early as this August.  In a tender offer issued earlier this month, Hercules offered holders of these bonds 90% of their securities’ face value. According to the bondholder notice, “If an insufficient number of bonds are not tendered, the City anticipates it will soon default on the bonds.” Offering bondholders 90 cents on the dollar in order to avoid facing the risk of non-payment is, for all intents and purposes, a default.

In fact, it is the city’s third default in recent years. In 2011, Hercules failed to repay a $3.75 million loan from the California Housing Financing Agency (CHFA). The state loan was intended to support a mixed use development Hercules planned to build. The development, which included a large affordable housing component, was stymied by neighborhood opposition to low income housing and the City’s inability to acquire a portion of the intended construction site from a nearby homeowner’s association. Earlier this year, Hercules sold the site to a developer who plans to build market rate housing. It has also agreed to repay the CHFA loan in installments through 2026 at a reduced interest rate.

Hercules’ second default occurred on February 1, 2012, when it failed to make a $2.4 million interest payments on Redevelopment Agency (RDA) bonds. The default was absorbed by Ambac, the agency’s municipal bond insurer. Ambac filed suit against the city claiming it had failed to remit RDA related property tax collections to the bond trustee as required. In March 2012, Ambac and the City settled the litigation with the City pledging two parcels of land to the insurer. The City further agreed to place these two properties on the market, apparently to offset the $4.05 million property tax remittance the city had failed to make earlier.

The most recent default (or, more euphemistically, the current tender offer) involves bonds issued to finance a failed public power scheme. In 2001, the City established a public power company – the Hercules Municipal Utility (HMU) – on the assumption that it could replace the area’s for-profit utility, Pacific Gas & Electric (PG&E). The expectation was that HMU would generate a similar rate of profit to PG&E, but under public ownership, those profits could fund other city spending priorities. Unfortunately for Hercules creditors and taxpayers, things did not work out as planned.

In a 2011 expose, the Huffington Post reported that HMU was serving only 840 customers, charging rates 17% higher than PG&E and had lost money in every year since its 2003 inception. In 2010, the City issued $13.5 million in new bonds to finance HMU, but the proceeds were never invested. Now the City has agreed to sell its power plant to the local utility – Pacific Gas & Electric. Unfortunately, PG&E’s bid was insufficient to retire the $12.8 million in 2010 bonds still outstanding and (for reasons discussed below) the city lacks reserves that could be used to fully redeem these remaining bonds. Thus the need for a 90% tender offer.

Municipal bond analysts often assess a city’s fiscal well-being by reviewing its audited financial statements. Unfortunately, Hercules routinely files its audited financials on a delayed basis. Currently, the latest available statements for Hercules are for the fiscal year ended June 30, 2011. Many California cities have already filed their 2013 audits. The failure to file audited financials on a timely basis is part of a larger financial management issue in Hercules. In May and November 2012, the State Controller’s Office issued three audits highly critical of the city’s fiscal controls. One report “found the City of Hercules’ administrative and internal accounting control deficiencies to be serious and pervasive.” These insufficient controls may explain why RDA tax revenues could be directed away from debt service, thereby subjecting the city to costly litigation.

As shown in the accompanying table, Hercules has persistently run large General Fund deficits since 2008.  The city’s inability to balance its books has resulted in the depletion of its financial reserves. According to Hercules most recent budget, the city had a negative unassigned General Fund balance at the end of FY 2012 and FY 2013, meaning it had no reserves that had not already been earmarked for one purpose or another. Despite having borrowed over $150 million, the city thus lacked liquid assets to cover contingencies.

Hercules General Fund Performance (FY 2008-FY2013)





























Sources: Hercules Audited Financial Statements (FY 2008-2011), FY 2014 Budget.
FY 2012 and FY 2013 are unaudited estimates.


Hercules fiscal straitjacket appears to be the result of government overreach. Instead of focusing on efficient delivery of basic services and providing effective financial oversight, City leaders ventured into enterprises attractive to many of their Progressive constituents: publicly owned power and publicly-financed affordable housing. Lacking the skills to properly manage these undertakings, city leadership squandered large sums of borrowed money and ran down their financial reserves. The result for Hercules will be years of higher taxes, subpar real estate performance and reduced access to the municipal bond market.


Illinois’ Fiscal Breaking Points

In a forthcoming paper with Eileen Norcross,“Illinois’ Fiscal Breaking Points,” we un-pack the current crisis in Illinois.

Our review of Illinois’ fiscal and economic indicators shows in addition to a $7.7 billion deficit in the state’s General Fund, Illinois faces $173 billion in unfunded pension liabilities as well as $70 billion in outstanding bonded debt.

To make matters worse the policies currently in place to keep state spending in check are loophole-ridden.  For example, the state has a balanced budget requirement but Section 25 of the State Finance Act allows the legislature to defer Medicaid claims and other payments into the next fiscal year in order to balance the budget.  This budgetary loophole has resulted in over $20 billion in deferred payments since FY 2000. The loophole is slowly being phased out as a budget balancing maneuver.

The recently enacted spending cap limits government spending to 2 percent of year-to-year growth in General Expenditures through FY 2017 and thus for the first time in Illinois’ history places limits on state spending.  However, as research by Mitchell (2010) shows, a TEL that limits budget growth to the sum of inflation plus population growth would be a much better option for the state.

Ultimately, Illinoisans have recognized that their state’s fiscal irresponsibility has resulted in a poor institutional environment and they are voting with their feet by leaving the state. Illinois lost a net of 1,227,347 residents from 1991 to 2009, the city of Chicago has fewer residents than it did in 1920, and the state consistently remains below average in its number of entrepreneurs.

In our paper Eileen and I argue that if the state of Illinois wishes to reverse this resident and business out-migration then the legislature and the Governor must stop focusing on revenue enhancements through increased taxation and borrowing and instead make serious institutional spending reforms.

Strengthen the state’s spending limit and balanced budget requirement, moving the state’s pension system to a defined contribution plan while also removing the constitutional protections to the current plan, and getting rid of tax incentive programs that target individual industries and/or activities.

Illinois is by no means a failed state. If the state continues to promote its growth enhancing policies, such as its flat rate income tax, while also taking the necessary steps towards institutional reform then Illinois’ future may not be as bleak as it currently seems.

A Better Balanced Budget Amendment

A few weeks ago, I wrote about the state-level evidence on strict balanced budget requirements:

I believe the evidence supports this claim. David Primo (2003) and Mark Crain (2003) find that states with a strict balanced budget requirement tend to spend less than other states. Shanna Rose (2006) finds that states with strict balanced budget requirements tend not to experience a political business cycle in which government spending rises just prior to an election and falls shortly thereafter. Bohn and Inman (1996) find that states with strict balanced budget requirements tend to have larger General Fund surpluses and larger rainy day funds.

Since then, the recently-inked debt deal has obliged Congress to take up and vote on a balanced budget amendment. I think the most-compelling argument against such an amendment is the concern that it would exacerbate the ups and downs of the business cycle by forcing spending cuts when the economy is contracting and permitting increases when the economy is expanding.

This is a concern, but there are ways around it.

One answer is a rainy day fund. Forty-seven states have such funds; states contribute to them during good years and then draw on them when the budget is strained due to a downturn or some other event like a natural disaster. Gary Wagner and Erick Elder find that states whose rainy day finds have strict rules governing the amounts they must deposit and the reasons for which they may withdraw from them tend to experience less spending volatility.

Alex Taborrok makes the case for essentially the same scheme at the federal level.  He calls it an “unbalanced Budget Amendment.”

Glenn Hubbard and Tim Kane weigh in with a similar proposal, arguing that “the annual constraint on expenditure should be defined by the median federal revenues of the last five years, not the current year.”  They have a number of other proposals worth considering as well:

  • The “balance” should count accrued liabilities in entitlements.
  • It should use “escalating supermajorities for exemptions,” meaning that “a 3/5 vote in both houses is required the first year of exemption, 4/6 the second year, 5/7 next, and so on.”
  • It should provide a glide path to a lower debt-to-GDP ratio.

David Primo highlights a current proposal in Congress that incorporates many of these features.

Balanced Budget Rules and Unintended Consequences

In my view this is one reason of many why a balanced budget amendment is not a workable path toward fiscal conservatism.

That is Tyler Cowen’s take on my paper with Noel Johnson and Steven Yamarik. I can certainly see why he might come to this conclusion.  We find that when Democratically-controlled states face a binding constraint on their ability to carry a deficit over from one year to the next, they may regulate more instead. A friend of mine calls this the “muffin-top” problem: belt-tightening can sometimes lead to unsightly bulging…elsewhere.  In spite of the muffin-top problem, I am actually still an advocate of a balanced budget amendment at the federal level.

Though I often marvel at the fiscal irresponsibility of state governments, I can’t help but feel that if the states and the federal government were in some sort of fiscal beauty contest, the states would easily come in 1st through 50th while the federal government would come in 51st.  Consider:

  • Collectively, state and local governments are in debt to the tune of about 2.6 trillion dollars, while the federal government has racked up nearly 4 times that amount.
  • The states have accumulated $9.9 trillion in unfunded obligations that will come due over the next several decades.  The Feds, meanwhile have accumulated 5 to 10 times this amount (depending on whether you agree with Medicare’s chief actuary that the current political path is highly unlikely).
  • Most states manage to balance their operating expenses (some gimmickry aside) on an annual or biannual basis. In contrast,
    for the last 80 years, the federal government’s norm has been to run an annual operating deficit (with deficits about 85 percent of the time).
  • When states do borrow, it is typically for long-term capital projects (again, some gimmickry aside).  So future generations are on the hook for bridges and buildings that they, too, will use. In contrast, the Feds don’t even pretend to borrow for future projects; much of what my daughter’s generation will pay for is my generation’s consumption.
  • When states encounter budgetary problems, they tend to deal with them by cutting spending rather than raising taxes.

All of this is somewhat surprising given the fact that, constitutionally, the states were given a blank check whereas the feds were not. As Madison put it in Federalist 45:

The powers delegated by the proposed Constitution to the federal government, are few and defined. Those which are to remain in the State governments are numerous and indefinite.

So why, given so much more (constitutional) power than the feds, do the states seem to manage their affairs more-responsibly? Tiebout competition and the lack of a central bank likely play a role. But I believe the fact that every state but Vermont has to balance its books each year must account for a large share of this relative fiscal probity.  As James Buchanan and Richard Wagner argued over 30 years ago, the ability to buy items for today’s generation while putting the tab on tomorrow’s generation creates a systematic bias in favor of irresponsible spending. In contrast, they argue:

The restoration of the balanced-budget rule will serve only to allow for a somewhat more conscious and careful weighting of benefits and costs. The rule will have the effect of bringing the real costs of public outlays to the awareness of decision makers; it will tend to dispel the illusory “something for nothing” aspects of fiscal choice.

I believe the evidence supports this claim.  David Primo (2003) and Mark Crain (2003) find that states with a strict balanced budget requirement tend to spend less than other states.  Shanna Rose (2006) finds that states with strict balanced budget requirements tend not to experience a political business cycle in which government spending rises just prior to an election and falls shortly thereafter. Bohn and Inman (1996) find that states with strict balanced budget requirements tend to have larger General Fund surpluses and larger rainy day funds.

In our paper we find that stricter balanced budget rules tend to constrain partisan fiscal outcomes.  The fact that they may lead to bulges in the regulatory state is, indeed, unfortunate.  But in my view, that suggests that we should also examine biases in the political economy of regulation and consider institutional reform to address those as well.  Perhaps there is need for a more-conscious weighing of the benefits and costs of regulation?  If belt-tightening leads to muffin-tops, maybe we need more than a balanced budget amendment?  Perhaps spanxs?

Which Governors Are Proposing Spending Increases and Which are Proposing Cuts?

This week, the National Governors Association (NGA) and the National Association of State Budget Officers (NASBO) have released their biannual Fiscal Survey of States. It is full of lots of interesting information, much of which I plan to highlight over the next week or so.

Today, I’ll start with a simple look at the proposed changes in FY2012 spending, alongside enacted changes in FY2011 spending. I’ve organized the data by FY2012 changes, so you can see that Florida’s Gov. Rick Scott is proposing the single-largest percentage increase in General Fund Spending, while Nevada’s Gov. Sandoval is proposing the largest cuts. I should note that, unlike NASBO’s other regular report (the State Expenditure Report) this one only includes General Fund spending, which is less than half of total state spending. Nevertheless, it is the portion of state spending over which state politicians have the most control, so it does provide some important information. I also included indicators for the party-id of the current governor. It is not surprising that there are greater differences between the parties when it comes to proposed 2012 changes than when it comes to enacted 2011 changes; partisan differences in proposed spending tend to be moderated by the legislative process.

In FY2012, the average Democratic governor proposed a spending increase of 5.8 percent, while the average Republican governor proposed a spending increase of 3.4 percent. I ran a regression and these differences were not statistically significant, even after controlling for regional effects. It was a very simple analysis, with limited data, few control variables, and no attempt to overcome concerns about reverse causality (maybe states whose institutions encourage spending growth are more-likely to elect Republicans in hopes of reining in spending?). Nevertheless, this does comport with more-sophisticated analyses. For example, a study by Besley and Case (2003) finds “little evidence of Democratic governors spending more overall” (though they do increase workers’ comp spending).

The literature does, however, find that the political id of the governor–in conjunction with the political makeup of the legislature–does make a difference: Rogers and Rogers (2000) find that when Democrats control both the house and the governor’s mansion, government tends to be larger than when Republicans control both.

It also turns out that divided government, in and of itself, can make a difference. Besley and Case (2003), for example, found that “greater party competition in the legislature is associated with significantly lower taxes, and significantly lower spending on workers’ compensation.”

More analysis of the NASBO/NGA data to come…

The price tag of fiscal evasion in Maryland

To replenish the Transportation Trust Fund (TTF) Maryland residents may expect higher gas taxes, tolls and parking rates. The Blue Ribbon Commission On Maryland Transportation Funding told lawmakers these measures could raise $600 million in new revenues, on top of $200 million in bonds. The reason for the measure is to plug the hole left by lawmakers who have become accustomed to dumping the TTF into the General Fund in order to balance Maryland’s budget. The committee further proposes the state pass a constitutional rule barring such raids.

As I document in my recent paper, “Maryland’s Fiscal Slide,” what seem like small one-time maneuvers to close budget gaps ultimately weaken fiscal discpline and come with a price. Maryland has been dipping into the TTF since 1984 as the fund also became more reliant on bonds. The result is Marylanders now looking at higher taxes and fees, as well as interest payments on transportation bonds.

Desperately Seeking Revenues in Michigan

The New York Times writes that Michigan’s municipal governments are on the hunt for revenues. Mount Clemens collects no revenue from 42 percent of the property within its borders. Mayor Demsey sent out a letter asking tax-exempt organizations to make a voluntary contribution to the general fund. In spite of disbanding its police department and contracting for safety services with Macomb County, the city projects a $1.2 million gap. If the tax-exempted organization pitch in they could cover the city’s shortfall. Interestingly, a local church is running a surplus. They gave the city $1000 a few years ago and are considering another gift this year.

Mount Clemens’ audit reveals several interesting items. First is the effect of state and local mandates. Medicaid Part D negatively affected their budget. And, the municipality must also now pay for a bond issued to satisfy a mandate from the Michigan Department of Environmental Quality.

Second are two large budgetary items that sound like projects best undertaken by the private sector. The city’s business activities include an ice arena and parking facilities.The ice arena costs the city $1.53 million to operate is paid for in user charges that amounted to $1.48 milllion in 2009. (See page 13 of the city’s audit) Last year the city transferred $102,000 from the General Fund to subsidize it and a further $200,000 to be put towards the $2.3 million  “Ice Arena Building Refunding Bonds” issued in 2001.

What Caused the State Budget Gaps?

I know the conventional answer: the recession. And surely there is validity to the conventional answer. The recession was the proximate cause: it sent revenues in a free fall at the same time that it put extra demands on the states’ welfare systems.

But the budget gaps were pretty different from state to state. For example, California faced a 2010 budget gap that was 65 percent of its General Fund while North Dakota faced no budget gap at all. Might differences in state policy and differences in state institutions explain the vast difference in gap size? This was the motivation for my recent working paper, State Budget Gaps and State Budget Growth.

In it, I conclude that large gaps were the result of rapid growth in per capita spending, a lack of economic freedom, and weak balanced budget rules.

To arrive at this conclusion, I performed a series of statistical tests, focusing on the size of state budget gaps, measured as a share of state general funds. In these tests, I controlled for various factors that might influence the size of a state’s gap (its population, income level, demographic makeup, etc.). After controlling for these factors, I was able to estimate the impact of certain policy choices and institutions on the size of states’ budget gaps. In particular, I focused on:

  • Budget size relative to state income,
  • Growth in per capita spending in the two decades preceding the recession,
  • Levels of economic freedom, and
  • Stringency of state balanced budget requirements.

I found that states that spent a large share of state income—and have done so for many decades—had smaller (percentage) deficits. This may be because states grow accustomed to making their budgets balance or it may be because the same factors that permit steady revenue streams also permit large budgets. But this doesn’t mean policymakers should go on spending sprees and expect smaller budget gaps. In fact, a spending spree is likely to make a state’s budget gap worse. Other factors being equal, states whose per capita spending increased the most in the two decades preceding the recession had budget gaps that were nearly 20 percentage points larger than states whose per capita spending increased the least. Since the median state’s budget gap was 23 percent of its general fund, going from the slowest to the fastest-growing state can make a huge difference.

Economic freedom (characterized by low taxes and minimal regulation) makes an even greater difference. Using Jason Sorens and William Ruger’s measure of economic freedom, I found that other factors being equal, the most-economically free states tended to have budget gaps that were 25 percentage points smaller than the least-free states.

Lastly, states with weak balanced budget requirements had larger budget gaps. While every state but Vermont is required to balance its budget, some requirements are weaker than others. It turns out that those states with weak balanced budget requirements encountered larger deficits to begin with: theirs were 8 to 10 percentage points larger than those with strong balanced budget requirements.

So what caused the budget gaps? Policy makers may be all-too-happy to pin the blame on the recession. But my research suggests that policy choices in the decades preceding the recession made a big difference. Rapid growth in per capita spending, a lack of economic freedom, and weak balanced budget rules caused the gaps. The recession just exposed these underlying problems.

Desperate Times: Arizona Leases State House

cap_museumCalifornia’s budget crisis is remarkable for the sheer magnitude of its deficit. New Jersey’s and New York’s revenue streams are entwined with the decimated financial markets. Florida experienced the worst of the housing market collapse.

And Arizona faces its own catastrophe. Its budget shortfall, while at $3.4 billion not as large as California’s, represents 30 percent of its $10.7 billion budget.

After months of wrangling over how to meet the shortfall — program cuts versus tax cuts — a possible solution was reached this week, four weeks into the state’s new fiscal year: the lease of 32 government-owned properties including the State House, a prison, and a state hospital.

The plan involves selling the properties for a quick infusion of cash, and their leaseback over a period of years.

This is the plan’s second go-round. Governor Brewer vetoed it last month. But the state has few options left. Arizona has a constitutional debt limit of $350,000. Under the deal, the state would also have the option of walking away from the lease payments — effectively turning over some of the buildings to the private sector.

Lamentations over the leasebacks are misplaced. Unlike other states — California is “borrowing” money from its cities, New Jersey secured a line of credit from J.P. Morgan to pay its debts — Arizona is taking a step in the right direction.

In fact, looking at the proposed list, it’s not clear why several of the properties aren’t just sold outright.

Does the state need to own a Coliseum and Exposition Center? Simply because it hosts the state fair doesn’t make it a state business.

With a price tag of $84.3 million, privatization is a win-win situation.  Take a non-essential, non-public good off the state’s books, and it has a chance of becoming a profitable (i.e., job-creating) business for a willing investor.

The Arizona Exposition and State Fair’s executive director sees it differently. He writes that the fair is 100 percent self-supporting, and receives no money from the General Fund but, that proposed budget cuts of $2.7 million will mean the Fair will “cease to exist.”

Sounds familiar. Last month, the New England Zoo made even more serious threats when faced with budget cuts: keep our funding, or we’ll have to euthanize these animals.

Maybe under a private owner, the fair will find there’s a lot more it can do before shutting down “one of the most popular all-Indian Rodeos in the Southwest.”