When states don’t pay their debts

By Felix Salmon
June 17, 2010
Greg Ip reports on how Illinois is going to have to start making unnecessary unemployment payments just because it's refusing to pay its debts:

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Greg Ip reports on how Illinois is going to have to start making unnecessary unemployment payments just because it’s refusing to pay its debts:

Illinois owes Shore Community Services, a non-profit agency in suburban Chicago, some $1.6m for services to the mentally disabled. The agency has had to lay off a dozen staff. Jerry Gulley, the executive director, says his outfit’s line of credit could be exhausted soon. The bank will not accept the state’s IOUs as collateral. “That’s how sad it is,” shrugs Mr Gulley.

Ip explained to me that these aren’t physical IOUs, like California issued, and they’re certainly not bonds — they’re just unpaid receivables. But even so, this is crazy: there’s no way that Illinois should allow the employees of a noble non-profit to be laid off just because it hasn’t got around to paying its bills. It’s the job of the state to encourage employment, not layoffs.

Other banks are reportedly accepting state receivables as collateral, but it seems to me that Illinois would do well to set up a formal system of paper IOUs, which would presumably be much easier to borrow against. More generally, I think that there’s a very good chance we’re going to see quite a lot of state-issued scrip in the years to come, not only from Illinois but also from other states with similar CDS spreads, like Portugal. As Ip notes, these states “do not issue their own currency, so inflating away their debt is not an option”. But issuing scrip is the next best thing.

The problem with states like Illinois, California, and New York is not the willingness of the executive branch to remain current on its debts; rather, it’s the ability of the legislative branch to make the kind of tough fiscal decisions which are politically dangerous. The more dysfunctional the state legislature — and all three of them are pretty gruesome in that regard — the more likely it is that the state treasury will find itself in a position of simply not being able to meet its contractual obligations as they come due.

Outright default on a state’s bonded debt is still unlikely:

The assumption of many investors is that the federal government would never let a state default. It might allow an isolated case, but if a default looked like the start of a wave, the federal government would surely blink—just as Europe did when confronted by Greece.

This is surely right, and I doubt that any state is going to attempt to pay its bond coupons in scrip. Everything else, however, is fair game — including payments for services to the mentally disabled.


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And of course, where there are receivables, there’s a securitization opportunity. Just sayin…

Posted by gringcorp | Report as abusive

Felix, if you are correct, then you may as well head to Albany/Springfield/Sacramento and look for a job as a consultant with the following plan:
1. Issue as much debt as needed to clean up outstanding payables.
2. Issue an additional amount, as much as appears necessary to guarantee re-election of state Legislature and Governor.
3. Threaten default, get bailout.

Oh, and then swing by lower Manhattan and put the word out to the rating agencies that all states share the sovereign rating.

Posted by johnhhaskell | Report as abusive

you’re new to the state budget situation:

http://marketwatch666.blogspot.com/2010/ 06/time-for-it-to-hit-fan.html

Posted by rjs0 | Report as abusive

here’s gillian tett of the FT on the same: http://www.ft.com/cms/s/0/eb39cc88-7a1b- 11df-9871-00144feabdc0.html

Posted by rjs0 | Report as abusive

We have GOT to stop letting investors off the hook when they assume the feds will prevent them from taking losses. If the debt they are buying has a higher yield than Treasuries, then they should know it is riskier than Treasuries.

If the feds feel they have to cover such losses, at the very least they should not give an investors a higher return than equivalently-termed Treasuries. What I would like to see is a penalty based on the the excess yield; if an investors buys debt at 5%, and the Treasury debt for the same term is 3%, then the federal government limits any cover to 3 – (5-3) = 1% yield. It is insane that we are allowing investors to reach for yield because the ‘safe’ Treasury yield is too low, and then grant them the same safety that they spurned.

Posted by MattJ | Report as abusive

Just a minor quibble. In the case of California, the state-issued scrip was issued partially because state law mandates that bond holders be paid on time.

So when cash was running low, the people who had money due them who were not bond holders, such as contractors who did work for state agencies, etc., got paid in scrip so that there was actually money left over to pay bond holders on time. Because of the way that the state constitution is written, if it really comes down to it, bond holders will in almost every case be paid on time and before anyone else owed money, including employees. Unless armageddon actually arrives, California simply can’t default on general obligation bonds.

Posted by Strych09 | Report as abusive

It’s easy but almost too late to start worrying about debt on the balance sheets run up by former State employees to satisfy external corporate financing for (often fictional) things that never did the State residents any good. That legacy of bean-shuffling is what’s brought State after State to its knees: viz. Enron et seq in the case of California – from which there’s no synthetic way forward, only down.

While it would have been much better not to have indulged in such practice in the first place, it’s still not too late for States to draw sovereign lines in the sand, to go tabula rasa on the privateers leeching off State budgets.

Then we can talk about the merits of thrift, how to live accordingly, etc.

Posted by HBC | Report as abusive

..actually, I told my California elected reps to go ahead and let default on G.O. bonds happen..first people, next bondholders, PIMCO, GoldmanSachs and stuff..if the PIMCO’s and bondholders try and take the furniture, bad things could happen..they took a chance on the State, they lose..so it goes..

Posted by gramps | Report as abusive

This is a real problem, before retirement our company cleaned fleets of vehicles, and about 30% of our business was fleets owned by government agencies (all levels of government) and in the 80s, I cannot tell you how bad the receivables had gotten, 120-180 days out was common, it was a nightmare. Many small businesses think they are set to have government contracts, not so, you become their bank, and when they cut budgets or run out of money, you don’t get paid, it’s crazy. Most people don’t realize how they use the business community, state governments are the worst, your money comes out of another area or region usually, and they don’t care, and when they cut staff, they don’t return calls either.

Posted by LanceWinslow | Report as abusive