The Irish Independent reports that Ireland’s biggest bank will respond to its latest taxpayer bailout by raising mortgage rates by 1.5pc this year, the newspaper has learned.
Allied Irish Banks (AIB) is preparing to hit customers with two more interest rate hikes on top of the 0.5pc rise confirmed yesterday before the end of the year. The revelation comes as AIB and other crisis-hit lenders prepare to be bailed out by a further €16bn in the banking sector’s biggest overhaul yet.
By this evening almost all of the entire banking sector will be under state control. Permanent TSB will be the only bank not to get a bailout. Finance Minister Brian Lenihan will today signal the Government’s intention to take a majority stake in AIB as the first details of the loans to be taken on by the National Asset Management Agency (NAMA) are also released. For the first time, the public will learn how much the banks’ toxic loans are actually worth.
Discounts or ‘haircuts’ on these loans will range from 35pc to 60pc. That means NAMA will pay the banks up to 60pc less than they value the loans themselves.
Mr Lenihan was last night putting the finishing touches to the plan to change the entire banking sector. He will brief the Cabinet on his strategy this morning before announcing the plan in the Dail. He said yesterday that it was essential that the Government acted now after gaining credibility internationally for managing its own finances.
“We need to translate all that international confidence into the banking sector as well and sort it out once and for all,” he said.
But, in a surprise move, the Government will put money into Anglo Irish Bank and Irish Nationwide by using IOUs rather than hard cash.
In an attempt to save money, it will instead invest the money over a 10-year period, rather than upfront.
It will commit to a certain amount and then pay by installments as is deemed necessary.
Meanwhile, taxpayers who are coming to the rescue of the banks will be hit on the double as lenders pass on a raft of interest rate hikes to their customers.
In survival plans presented to the European Commission, both AIB and Bank of Ireland confirmed they planned to push through several mortgage rate hikes.
AIB yesterday hit existing mortgage holders with interest rises just hours ahead of the expected announcement of the nationalisation of the bank and its latest bailout.
Bank of Ireland is now expected to push up its standard variable rates for existing customers by 0.5pc within a fortnight.
This is set to be followed by EBS Building Society hitting existing standard variable rate customers with higher rates.
In all, an estimated 300,000 homeowners have standard variable rate mortgages.
Existing customers of AIB will now have to pay 0.5pc more for their mortgages, a move that will add €65 a month to the repayments on a €250,000 mortgage.
AIB is also hiking its fixed rates from the start of business today. The bank had the lowest fixed- and variable-rate mortgages before the rises.
AIB would not comment on the viability plan it gave to the EU Commission, saying the document was “confidential”.
However, the Irish Independent understands that the bank has promised to push up standard variable and fixed rates by 1.5pc by the end of the year in a bid to return to profitability.
Yesterday’s move by AIB will hit existing customers who have standard variable rate mortgages. A homeowner who borrowed more than 80pc of the value of their home will see their interest rate rise from 2.65pc to 2.99pc, a rise of €80 a month or almost €1,000 a year in repayments on a €300,000 mortgage.
AIB’s fixed rates, which were the most competitive in the market, are all rising. The changes will have no impact on those who have tracker mortgages and fixed-rate deals.
AIB last night insisted that it took the decision itself to hike its mortgage rates just days ahead of an expected partial nationalisation of the bank.
A Department of Finance spokeswoman said the home-loan rise was a matter for AIB.
She denied Mr Lenihan wanted the rate hike out of the way ahead of the State moving to take a majority stake in the bank in a bid to avoid opposition claims that taxpayers were being punished on the double.
Bank of Ireland, when asked when it was hiking its standard variable rates, would only confirm it was monitoring its rates on a daily basis. However, it is expected to push up its standard variable rates by 0.5pc within the two weeks.
Intentions
Ulster Bank, EBS and National Irish Bank said they had no immediate plans to hike their standard variable rates. Irish Nationwide Building Society did not return calls.
AIB, which recently stopped accepting mortgage switchers, has also changed the way it calculates what a first-time buyer can borrow, meaning most will qualify for smaller mortgages.
Consumer watchdogs said the increases would push many homeowners over the edge financially.
Dermott Jewell, chief executive of the Consumers’ Association of Ireland, accused AIB of exploiting the fact that its customers were trapped and unable to move their mortgages.
The Irish Independent also reports that Allied Irish Banks was last night trying to convince the Government it could launch a multi-billion euro share sale in the autumn on top of selling some of its foreign assets in a last-ditch attempt to fight off majority state ownership.
The Irish Independent has learned that the Financial Regulator is now looking for AIB to raise up to €7bn in equity by the end of the year to ‘bombproof’ its balance sheet.
Banking analysts had originally estimated that AIB would need €4.5bn.
The bank will also be required to hold a further €1bn on its balance sheet but not as equity.
The much-bigger-than-expected capital requirements are the result of three key developments:
The new financial watchdog Matthew Elderfield is demanding that lenders hit higher capital targets, which means they have to put aside extra money to cover losses.
The banks will also have to undergo massive stress tests of banks’ loan books to ensure that they can cope with further loan defaults.
And NAMA discounts are running much deeper than originally anticipated.
AIB would not comment beyond a stock market announcement, which confirmed it was in talks with the regulator “in order to agree its capital requirements”.
Some observers described as “penal” the level of capital AIB is being required to raise.
“You’re basically looking at an Armageddon scenario where the regulator sees the bank writing off €17bn over loans over four years — wiping out its existing equity reserves,” one analyst said.
All banks and building societies have strongly resisted the new capital targets. But Mr Elderfield has made it clear he is not for turning as he seeks to make the industry among the best-capitalised in Europe.
Bank of Ireland will need to raise about €3bn, according to sources.
About half of this is expected to come from the State as part of a massive capital-raising deal.
The State is poised to take a 40pc stake in BoI, while it is speculated that it could end up with a holding of as much as 70pc in AIB.
It is believed AIB’s first batch of NAMA loans face a discount in excess of 40pc, while BoI’s is running north of 35pc.
Mr Elderfield is insisting the banks make sure they raise enough cash this year so that their equity capital ratios, a key measure of lender’s financial stability, do not fall below 7pc at the bottom of the cycle.
It is believed they are being forced to hit an 8pc ratio by the end of 2011. AIB managing director Colm Doherty’s argument the bank could reach a 5pc figure through asset sales this year, before rising to 7pc through retained earnings before 2012, has failed to win over the regulator.
Worse
The financial watchdog has also called on the banks to stress test their non-NAMA loans against much worse unemployment, economic and house price figures than economists are currently predicting.
The stress test has focused, in particular, on their mortgage books and property and construction loans below the €5m cut-off point for inclusion in the bad bank.
It is understood AIB has come out pretty badly in the test of its remaining property and construction loans, which stand at more than €12bn.
Rather than go out and raise fresh money to pump into AIB and BoI, the Government will look, in the first instance, to convert part of its existing €3.5bn investment in the banks into actual ordinary shares.
It is likely to convert all its investment in AIB, though the timing of this is not yet clear.
The bank is expected to try and flog its stake in US bank M&T as well as its UK business banking arm as quickly as possible. A major question mark remains over whether AIB’s valuable Polish unit Bank Zachodni WBK will be put on the block.
Brussels is likely to have the final say on this over the coming weeks, as it finalises a review of the bank’s restructuring plan.
The Irish Times reports that the National Asset Management Agency (Nama) will issue dollar and sterling bonds in addition to euro securities to financial institutions in return for loans it is acquiring, according to documents published by the agency.
Nama plans to acquire loans of up to €81 billion from the five participating institutions at a discount price – 95 per cent of which will be paid with State-guaranteed bonds and 5 per cent with subordinated bonds.
Citibank is managing the issuing of the bonds for Nama.
About 30 per cent of the loans moving to Nama are denominated in currencies other than euro.
The issuing of dollar and sterling bonds to the institutions will “mitigate foreign exchange risk” within Nama’s loan portfolio, said Michael Cummins, a director at fixed-income firm Glas Securities.
Nama has said in documents just posted on its website that it will issue a maximum of €51.4 billion in Government-guaranteed bonds. If the agency acquires a total of €81 billion in loans as expected, this means the average discount on the loans will be 33 per cent, higher than the 30 per cent originally estimated.
The State will pay a coupon twice a year – on March 1st and September 1st – starting next autumn on the guaranteed bonds at the six-month Euribor or Libor rates at which banks lend to each another in euro, sterling or dollar.
This equals a rate of about 0.945 per cent on euro bonds if paid today. The subordinated bonds will pay a coupon based on the 10-year Irish Government bond rate on the date of issue plus a margin of 75 basis points or 0.75 per cent.
This would total 5.25 per cent if the coupon was paid on yesterday’s 10-year bond rate.
The payment will be made each year starting on March 1st, 2011, depending on whether the institutions help Nama to recover loans.
The subordinated debt will be withheld from the institutions as an incentive to assist Nama.
The Irish Times also reports that Irish banks will require up to €22 billion to cover losses on property loans moving to the National Asset Management Agency (Nama) and higher future losses on other loans as they meet strict new rules set by the Financial Regulator, the newspaper has learned.
However, not all of this requirement will involve direct investments from the State, sources close to the process stressed. Some of the money will come from asset sales by the financial institutions.
The State will also convert some of its existing €7 billion indirect investments in the State’s two largest banks, Allied Irish Banks (AIB) and Bank of Ireland, into direct stakes.
This will dilute the investments of existing shareholders and possibly lead to the State taking majority ownership of AIB and a minority shareholding in Bank of Ireland.
AIB requires some €6 billion to €7 billion, while Bank of Ireland will need €2.5 billion to €3 billion.
Irish Nationwide will require well in excess of the €2 billion it had first estimated and possibly close to €3 billion, while rival building society EBS is expected to need between €750 million and €850 million.
Both building societies will end up in effective State control as they are relying solely on the Government for investment to keep them afloat.
State-owned Anglo Irish Bank has said it will need an additional €6 billion to €9 billion, on top of €4 billion already invested by taxpayers.
On the eve of today’s series of major announcements on the future of five key financial institutions, Minister for Finance Brian Lenihan said Nama had allowed the Government to quantify the “black holes” at the banks caused by toxic property loans.
He said he would unveil a recapitalisation plan for the banks today that would draw a line under the financial crisis “once and for all”.
Fianna Fáil TD Ned O’Keeffe criticised Mr Lenihan, saying that Nama would not work and would destroy the banking system. He argued that AIB should remain in private hands.
AIB’s capital requirement is far higher than previously thought, reflecting a higher discount being applied to its loans moving into Nama and the stress tests applied to the bank’s remaining loans.
The regulator will demand that the banks meet a core equity ratio of 7 per cent by the end of this year, undermining AIB’s “self-help” options to raise cash from shareholders or outside investors, or by selling its foreign businesses.
The higher ratio, which boosts the banks’ most loss-absorbing capital buffers, is being applied across the Irish-owned banks as the regulator forces them to set aside more cash to cover likely and stress-case losses.
Details of the recapitalisation of the banks will be announced this evening in the Dáil by Mr Lenihan.
Nama will release details of the discounts on the first loans transferred from the institutions before the Minister’s statement.
Irish Nationwide and EBS will transfer the first loans today.
The regulator waived capital rules for EBS, allowing it to incur losses on transferring Nama loans this week and to fall below the minimum capital levels until May 31st.
Nama’s statement will be followed by a statement from the regulator detailing new capital rules.
AIB will move €23 billion in loans to Nama, of which about €3 billion will be in the first tranche of loans owing by the 10 biggest borrowers.
A discount of 40-50 per cent is expected to be applied to the bank’s first loans moving to Nama. The discount on the first loans from Bank of Ireland and EBS will be about 35 per cent, while Irish Nationwide will face a discount of up to 60 per cent. Shares in the two big banks fell sharply following reports that the State could take a stake of more than 70 per cent stake in AIB and 40 per cent of Bank of Ireland following the recapitalisation.
Bank of Ireland will try to keep the State’s stake below 40 per cent by raising cash from shareholders and another restructuring of its debts.
The State owns all of Anglo Irish, has an indirect stake of 25 per cent in AIB and an effective stake of 34 per cent in Bank of Ireland.
The final figures relating to the recapitalisation and the Nama loan discounts were being worked on last night between the Government, the institutions, the regulator, Nama and the National Treasury Management Agency, which is leading the recapitalisation programme for the State.
AIB yesterday raised its variable mortgage interest rates in a well-flagged move, saying it was no longer sustainable for the bank to continue losing money on its home loans.
The half-point increase on AIB’s standard variable rate, which has risen to 2.75 per cent, will add €78 a month on a €300,000 mortgage with a term of 30 years.
Mr Lenihan said that the move was necessary due to the bank’s cost of funding. “It’s yet another example of why we have to put our banks into the right shape. And that’s what tomorrow’s announcement is about.”
The Irish Times reports that the National Asset Management Agency (Nama) will issue dollar and sterling bonds in addition to euro securities to financial institutions in return for loans it is acquiring, according to documents published by the agency.
Nama plans to acquire loans of up to €81 billion from the five participating institutions at a discount price – 95 per cent of which will be paid with State-guaranteed bonds and 5 per cent with subordinated bonds.
Citibank is managing the issuing of the bonds for Nama.
About 30 per cent of the loans moving to Nama are denominated in currencies other than euro.
The issuing of dollar and sterling bonds to the institutions will “mitigate foreign exchange risk” within Nama’s loan portfolio, said Michael Cummins, a director at fixed-income firm Glas Securities.
Nama has said in documents just posted on its website that it will issue a maximum of €51.4 billion in Government-guaranteed bonds. If the agency acquires a total of €81 billion in loans as expected, this means the average discount on the loans will be 33 per cent, higher than the 30 per cent originally estimated.
The State will pay a coupon twice a year – on March 1st and September 1st – starting next autumn on the guaranteed bonds at the six-month Euribor or Libor rates at which banks lend to each another in euro, sterling or dollar.
This equals a rate of about 0.945 per cent on euro bonds if paid today. The subordinated bonds will pay a coupon based on the 10-year Irish Government bond rate on the date of issue plus a margin of 75 basis points or 0.75 per cent.
This would total 5.25 per cent if the coupon was paid on yesterday’s 10-year bond rate.
The payment will be made each year starting on March 1st, 2011, depending on whether the institutions help Nama to recover loans.
The subordinated debt will be withheld from the institutions as an incentive to assist Nama.
The Irish Times also reports that Irish banks will require up to €22 billion to cover losses on property loans moving to the National Asset Management Agency (Nama) and higher future losses on other loans as they meet strict new rules set by the Financial Regulator, the newspaper has learned.
However, not all of this requirement will involve direct investments from the State, sources close to the process stressed. Some of the money will come from asset sales by the financial institutions.
The State will also convert some of its existing €7 billion indirect investments in the State’s two largest banks, Allied Irish Banks (AIB) and Bank of Ireland, into direct stakes.
This will dilute the investments of existing shareholders and possibly lead to the State taking majority ownership of AIB and a minority shareholding in Bank of Ireland.
AIB requires some €6 billion to €7 billion, while Bank of Ireland will need €2.5 billion to €3 billion.
Irish Nationwide will require well in excess of the €2 billion it had first estimated and possibly close to €3 billion, while rival building society EBS is expected to need between €750 million and €850 million.
Both building societies will end up in effective State control as they are relying solely on the Government for investment to keep them afloat.
State-owned Anglo Irish Bank has said it will need an additional €6 billion to €9 billion, on top of €4 billion already invested by taxpayers.
On the eve of today’s series of major announcements on the future of five key financial institutions, Minister for Finance Brian Lenihan said Nama had allowed the Government to quantify the “black holes” at the banks caused by toxic property loans.
He said he would unveil a recapitalisation plan for the banks today that would draw a line under the financial crisis “once and for all”.
Fianna Fáil TD Ned O’Keeffe criticised Mr Lenihan, saying that Nama would not work and would destroy the banking system. He argued that AIB should remain in private hands.
AIB’s capital requirement is far higher than previously thought, reflecting a higher discount being applied to its loans moving into Nama and the stress tests applied to the bank’s remaining loans.
The regulator will demand that the banks meet a core equity ratio of 7 per cent by the end of this year, undermining AIB’s “self-help” options to raise cash from shareholders or outside investors, or by selling its foreign businesses.
The higher ratio, which boosts the banks’ most loss-absorbing capital buffers, is being applied across the Irish-owned banks as the regulator forces them to set aside more cash to cover likely and stress-case losses.
Details of the recapitalisation of the banks will be announced this evening in the Dáil by Mr Lenihan.
Nama will release details of the discounts on the first loans transferred from the institutions before the Minister’s statement.
Irish Nationwide and EBS will transfer the first loans today.
The regulator waived capital rules for EBS, allowing it to incur losses on transferring Nama loans this week and to fall below the minimum capital levels until May 31st.
Nama’s statement will be followed by a statement from the regulator detailing new capital rules.
AIB will move €23 billion in loans to Nama, of which about €3 billion will be in the first tranche of loans owing by the 10 biggest borrowers.
A discount of 40-50 per cent is expected to be applied to the bank’s first loans moving to Nama. The discount on the first loans from Bank of Ireland and EBS will be about 35 per cent, while Irish Nationwide will face a discount of up to 60 per cent. Shares in the two big banks fell sharply following reports that the State could take a stake of more than 70 per cent stake in AIB and 40 per cent of Bank of Ireland following the recapitalisation.
Bank of Ireland will try to keep the State’s stake below 40 per cent by raising cash from shareholders and another restructuring of its debts.
The State owns all of Anglo Irish, has an indirect stake of 25 per cent in AIB and an effective stake of 34 per cent in Bank of Ireland.
The final figures relating to the recapitalisation and the Nama loan discounts were being worked on last night between the Government, the institutions, the regulator, Nama and the National Treasury Management Agency, which is leading the recapitalisation programme for the State.
AIB yesterday raised its variable mortgage interest rates in a well-flagged move, saying it was no longer sustainable for the bank to continue losing money on its home loans.
The half-point increase on AIB’s standard variable rate, which has risen to 2.75 per cent, will add €78 a month on a €300,000 mortgage with a term of 30 years.
Mr Lenihan said that the move was necessary due to the bank’s cost of funding. “It’s yet another example of why we have to put our banks into the right shape. And that’s what tomorrow’s announcement is about.”
The New York Times reports that nine hundred days after putting their house on the market, Andrew and Jane Palestini were beginning to think they might be stuck in Iowa forever.
The looming expiration of the government’s housing tax credit pushed them into action. They dropped their price by an additional $10,000, to $235,000. Somewhat to their shock, a buyer emerged. The house is now under contract.
“I can’t feel happy,” said Mr. Palestini, a retired administrative law judge with the Social Security Administration. “Just relieved.”
After several disastrous months for home sales across the country, when volume dropped by 23 percent, the pace appears to be picking up again. The number of Des Moines homes under contract in February rose by a third from the January level. The number of pending contracts jumped 10 percent in Naples, Fla., 14 percent in Houston and 21 percent in Portland, Ore.
These deals will be reflected in the national sales reports when they become final, this month or next. There is no evidence that prices have begun to move in response to the higher volume. Indeed, so many homes are coming on the market that prices might well fall further.
Real estate agents say buyers and sellers are hurrying to take advantage of the tax credit, which is worth up to $8,000 for home buyers. But the last-minute rush is also prompting some foreboding about what will happen to the market on April 30 when the credit ends — and whether it is too risky to let it end at all.
James M. Poterba, an economist at the Massachusetts Institute of Technology, calls this “the exit strategy problem.”
“If you have a short-run program to stimulate demand, it’s always tricky to figure out how you gently remove it without going off a precipice,” he said.
Arguments for extending the tax credit a second time are just beginning. Robert Shiller, a professor of economics at Yale and co-developer of the Standard & Poor’s/Case-Shiller housing price index, is an early advocate. He thinks the credit was a bad idea that nevertheless the market cannot do without.
“You don’t make drug addicts go cold turkey,” Mr. Shiller said. “The credit interferes with the market in an arbitrary way, but ending it now would be psychologically powerful. People will be in a bad mood about buying a house.” He advocates phasing it out gradually.
In some states, worries about the housing market are trumping fiscal considerations. They are adopting or extending tax credits or other supportive measures in hopes of bringing the market to life.
California last week renewed a $10,000 credit that proved popular last year, allocating $200 million for it despite a state budget crisis. New Jersey legislators just introduced a bill that would give buyers a $15,000 credit spread over three years. South Carolina recently announced a $7,000 down payment assistance program for teachers, police officers and firefighters.
As it has been for several years, housing remains the most coddled and the most troubled sector of the economy. Outside the realm of real estate, many of the government banking programs created to deal with the crisis have ended, and credit markets have largely returned to normal. On March 8, the Federal Reserve held its final auction in a two-year-old program that offered banks emergency short-term loans.
A few days earlier, however, government regulators extended a refinancing program for homeowners whose properties had plunged in value. Originally due to expire in June, the program has been renewed to the middle of 2011 “to support and promote market stability,” the Federal Housing Finance Agency said.
On Monday, just three days after substantially expanding its antiforeclosure programs, the Obama administration announced another $600 million to finance innovative measures to help defaulting families in five hard-hit states: North Carolina, Oregon, Ohio, Rhode Island and South Carolina. The first round of financing, announced last month, provided $1.5 billion to states including California and Florida.
Supported by an array of government programs aimed at both reducing foreclosures and encouraging traditional sales, housing was supposed to be on the road to a solid recovery.
An earlier version of the tax credit created a rush to buy in the fall, when people thought it would expire Nov. 30. The housing industry argued that sales would fall off a cliff if the credit were not extended and broadened, so Congress went along.
Stan Humphries, the executive in charge of data and analytics at the housing site Zillow.com, said government support was crucial in breaking housing’s acute fall in 2007 and 2008, but that it had also obscured the actual weakness of the market.
“Many people got the sense last year that we had bottomed out and were going to rebound in a V-shaped recovery,” he said.
Instead, the sales volume of existing homes declined in December more steeply than in any month in the four decades that such numbers have been tracked. Sales dropped again in January and February. Meanwhile, the sales volume of new homes fell in January to the lowest level since record-keeping began in 1963, a record broken again in February.
Buyers who want the tax credit must sign a deal by April 30 but would have until June 30 to close. Consequently, if sales volume is going to plunge after the credit expires, it will not show up until the numbers for July are reported. While Mr. Humphries says he does not expect sales that month to fall by December’s record rate, he predicts a long period of merely “dragging along the bottom,” with prices to match.
That was just what the Palestinis were worried about.
If they did not sell by April 30, they anticipated having to lower their price yet again, to compensate any buyer for the credit he would no longer get. It also meant they would not get a credit themselves on buying a new home in Philadelphia, pushing down what they could afford to pay.
It has been an unexpected ordeal. The Palestinis bought their spacious ranch house in the Des Moines suburb of Clive for $185,000 in 1995, after looking for only three days. “My feeling was it would never be a problem selling,” said Jane Palestini, a retired specialist in adoptions from China. “Ha, ha, ha.”
In early 2007, the house across the street sold in three days, but the Palestinis spent the summer getting their place ready. By the time they put it on the market that September for $265,000, prices were falling.
For months, they lived in a state of readiness for prospective buyers. To minimize clutter, they carted off many of their possessions to self-storage. They bought new pillows and kept them mounded on the beds. They bought fresh flowers and baked hundreds of cookies.
The months became years. They know their mistake: They should have kept cutting the price until they sold. But every dollar they dropped their price was one dollar less for a down payment in Philadelphia.
Their house is under contract for $225,000. After paying the agent’s commission and subtracting the cost of remodeling the kitchen, the Palestinis are at best breaking even. “You just have to ignore how much it’s going to hurt,” Mr. Palestini said.
At least they have escaped whatever trouble is to come this summer.
Their agent, Jim Heldenbrand, told them he hoped the credit would “get the momentum going.” But he also mentioned the plans of a colleague in real estate: As soon as the credit expires, the man plans to get on his Harley and just keep riding south.
The NYT also reports that California, New York and other states are showing many of the same signs of debt overload that recently took Greece to the brink — budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes, and armies of retired public workers who are counting on benefits that are proving harder and harder to pay.
And states are responding in sometimes desperate ways, raising concerns that they, too, could face a debt crisis.
New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million.
Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated.
Some economists fear the states have a potentially bigger problem than their recession-induced budget woes. If investors become reluctant to buy the states’ debt, the result could be a credit squeeze, not entirely different from the financial strains in Europe, where markets were reluctant to refinance billions in Greek debt.
“If we ran into a situation where one state got into trouble, they’d be bailed out six ways from Tuesday,” said Kenneth S. Rogoff, an economics professor at Harvard and a former research director of the International Monetary Fund. “But if we have a situation where there’s slow growth, and a bunch of cities and states are on the edge, like in Europe, we will have trouble.”
California’s stated debt — the value of all its bonds outstanding — looks manageable, at just 8 percent of its total economy. But California has big unstated debts, too. If the fair value of the shortfall in California’s big pension fund is counted, for instance, the state’s debt burden more than quadruples, to 37 percent of its economic output, according to one calculation.
The state’s economy will also be weighed down by the ballooning federal debt, though California does not have to worry about those payments as much as its taxpaying citizens and businesses do.
Unstated debts pose a bigger problem to states with smaller economies. If Rhode Island were a country, the fair value of its pension debt would push it outside the maximum permitted by the euro zone, which tries to limit government debt to 60 percent of gross domestic product, according to Andrew Biggs, an economist with the American Enterprise Institute who has been analyzing state debt. Alaska would not qualify either.
State officials say a Greece-style financial crisis is a complete nonissue for them, and the bond markets so far seem to agree. All 50 states have investment-grade credit ratings, with California the lowest, and even California is still considered “average,” according to Moody’s Investors Service. The last state that defaulted on its bonds, Arkansas, did so during the Great Depression.
Goldman Sachs, in a research report last week, acknowledged the pension issue but concluded the states were very unlikely to default on their debt and noted the states had 30 years to close pension shortfalls.
Even though about $5 billion of municipal bonds are in default today, the vast majority were issued by small local authorities in boom-and-bust locations like Florida, said Matt Fabian, managing director of Municipal Market Advisors, an independent consulting firm. The issuers raised money to pay for projects like sewer connections and new roads in subdivisions that collapsed in the subprime mortgage disaster.
The states, he said, are different. They learned a lesson from New York City, which got into trouble in the 1970s by financing its operations with short-term debt that had to be rolled over again and again. When investors suddenly lost confidence, New York was left empty-handed. To keep that from happening again, Mr. Fabian said, most states require short-term debt to be fully repaid the same year it is issued.
Some states have taken even more forceful measures to build creditor confidence. New York State has a trustee that intercepts tax revenues and makes some bond payments before the state can get to the money. California has a “continuous appropriation” for debt payments, so bondholders know they will get their interest even when the budget is hamstrung.
The states can also take refuge in America’s federalist system. Thus, if California were to get into hot water, it could seek assistance in Washington, and probably come away with some funds. Already, the federal government is spending hundreds of millions helping the states issue their bonds.
Professor Rogoff, who has spent most of his career studying global debt crises, has combed through several centuries’ worth of records with a fellow economist, Carmen M. Reinhart of the University of Maryland, looking for signs that a country was about to default.
One finding was that countries “can default on stunningly small amounts of debt,” he said, perhaps just one-fourth of what stopped Greece in its tracks. “The fact that the states’ debts aren’t as big as Greece’s doesn’t mean it can’t happen.”
Also, officials and their lenders often refused to admit they had a debt problem until too late.
“When an accident is waiting to happen, it eventually does,” the two economists wrote in their book, titled “This Time Is Different” — the words often on the lips of policy makers just before a debt bomb exploded. “But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”
In Greece, a newly elected prime minister may have struck the match last fall, when he announced that his predecessor had left a budget deficit three times as big as disclosed.
Greece’s creditors might have taken the news in stride, but in their weakened condition, they did not want to shoulder any more risk from Greece. They refused to refinance its maturing $54 billion euros ($72 billion) of debt this year unless it adopted painful austerity measures.
Could that happen here?
In January, incoming Gov. Chris Christie of New Jersey announced that his predecessor, Jon S. Corzine, had concealed a much bigger deficit than anyone knew. Mr. Corzine denied it.
So far, the bond markets have been unfazed.
Moody’scurrently rates New Jersey’s debt “very strong,” though a notch below the median for states. Moody’s has also given the state a negative outlook, meaning its rating is likely to decline over the medium term. Merrill Lynch said on Monday that New Jersey’s debt should be downgraded to reflect the cost of paying its retiree pensions and health care.
In fact, New Jersey and other states have used a whole bagful of tricks and gimmicks to make their budgets look balanced and to push debts into the future.
One ploy reminiscent of Greece has been the use of derivatives. While Greece used a type of foreign-exchange trade to hide debt, the derivatives popular with states and cities have been interest-rate swaps, contracts to hedge against changing rates.
The states issued variable-rate bonds and used the swaps in an attempt to lock in the low rates associated with variable-rate debt. The swaps would indeed have saved money had interest rates gone up. But to get this protection, the states had to agree to pay extra if interest rates went down. And in the years since these swaps came into vogue, interest rates have mostly fallen.
Swaps were often pitched to governments with some form of upfront cash payment — perhaps an amount just big enough to close a budget deficit. That gave the illusion that the house was in order, but in fact, such deals just added hidden debt, which has to be paid back over the life of the swaps, often 30 years.
Some economists think the last straw for states and cities will be debt hidden in their pension obligations.
Pensions are debts, too, after all, paid over time just like bonds. But states do not disclose how much they owe retirees when they disclose their bonded debt, and state officials steadfastly oppose valuing their pensions at market rates.
Joshua Rauh, an economist at Northwestern University, and Robert Novy-Marx of the University of Chicago, recently recalculated the value of the 50 states’ pension obligations the way the bond markets value debt. They put the number at $5.17 trillion.
After the $1.94 trillion set aside in state pension funds was subtracted, there was a gap of $3.23 trillion — more than three times the amount the states owe their bondholders.
“When you see that, you recognize that states are in trouble even more than we recognize,” Mr. Rauh said.
With bond payments and pension contributions consuming big chunks of state budgets, Mr. Rauh said, some states were already falling behind on unsecured debts, like bills from vendors. “Those are debts, too,” he said.
In Illinois, the state comptroller recently said the state was nearly $9 billion behind on its bills to vendors, which he called an “ongoing fiscal disaster.” On Monday, Fitch Ratings downgraded several categories of Illinois’s debt, citing the state’s accounts payable backlog. California had to pay its vendors with i.o.u.’s last year.
“These are the things that can precipitate a crisis,” Mr. Rauh said.
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