Fed Report: Threat of Municipalities Defaulting May Be 'Overblown'

(April 19, 2011) — A Federal Reserve economist is challenging the widespread assertions that municipalities are on the brink of disaster and heading for bankruptcy, claiming that the argument is overblown and lacks perspective of past recessions.

In the midst of a challenging fiscal environment, with underfunded public pensions demanding larger annual contributions to return to stability, a new study released by the Federal Reserve Banks of Chicago — titled “Local Governments on the Brink” by economist Richard H. Mattoon — asserts that few municipalities will default on their debt. While there is little disagreement that 2011 will be a tough year in terms of local government finance, the study claims that given the mounting challenges of the current environment and the perceived threat of a wave of local government bankruptcies and credit defaults, the concerns about bankruptcy and default may be overblown.

The reasoning: “For one, the fiscal resources of local governments are deeper than commonly believed. Also, local governments often can take intermediate corrective budgetary action (usually at the insistence of the state) to avoid bankruptcy. Finally, in most cases this corrective action is preferable to the stigma that bankruptcy creates, particularly with regard to the issuance and performance of municipal bonds,” the report asserts, noting that municipalities appear to have reserves that can be tapped in the short-run. The report argues that a potential default would severely limit a local government’s access to credit.

“There is clear statistical evidence that since 1999, local governments, in aggregate, have been increasing their debt. However, it is hard to make the case that this debt is reaching an unmanageable level,” the report says, noting that municipalities have been aided by infrastructure. “…Municipalities tend to issue debt for infrastructure projects, and evidence suggests that they tend to match the term of the debt to the life of the project.”

The report echos findings of a previous paper released in March titled “Municipal Bond Woes,” authored by Atlanta Fed economist Gerald Dwyer, which stated that data on state and local governments “do not support a forecast of widespread defaults and losses on municipal bonds.”