The good, the bad and ugly of US economy

Part II:

The good, the bad and ugly of US economy

As the US economy struggles to kick into recovery mode, Cayman’s financial services industry heard last month that the US is heading for even deeper problems once the 2011 budget takes a hold and the dire state of each State’s public finances are revealed. On the upside, new opportunities are being revealed within the structured finance markets which may prove to be a much needed boost for Cayman’s own financial services industry. Business Editor Lindsey Turnbull reports.  First in a two-part series.

Attorneys-at-Law Stuarts recently joined forces with RBC Wealth Management hosting a seminar entitled ‘The Implosion of US State Finance and Its Effect on the Cayman Islands’ at The Ritz-Carlton, Grand Cayman, which provided an important platform of discussion for financial services practitioners.

The discussion was a two-part event. Firstly Professor Anew P. Morriss, the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois College of Law gave a worrying presentation entitled ‘US States Are Going Bankrupt – Why You Should Care’. In the second half of the discussion, Professor Christopher L. Culp, an Adjunct Professor of Finance at The University of Chicago Booth School of Business and Senior Advisor for Compass Lexecon, which is a subsidiary of FTI Consulting, Inc then looked at the types of securitisations emerging as leaders within the field, of which Cayman could well position itself successfully to take advantage.

Morriss worried that there was a serious financial catastrophe about to hit US public finances because States had been recklessly spending without due consideration to their archaic budgetary systems. Many States were now unable to pay for basic services such as the financing of crisis and women’s centres. And a meltdown in the US could only mean a very bad scenario for Cayman.

In particular, Morriss said Cayman ought to be troubled by structural deficits for the individual States, which are large; the fact that the State/local pension crisis is worsening and that what Morriss termed “financial chicanery” along with the politicians’ “bag of tricks” were almost empty.

“State financial meltdowns will ag down the US economy,” he said, “and this will surely impact the Cayman Islands.”

Not only that, but Cayman ought to be further worried because of the impact State officials have on federal initiatives in financial regulation, coupled with the fact that State and local pension funds are major institutional investors.

Out-of-date budget models

Morriss said the problem with State economies was that their models were hopelessly out-of-date. He highlighted a quote from Lav, McNichol, & Zahradnik, Faulty Foundations: State Structural Budget Problems and How to Fix Them (Center on Budget & Policy Priorities, 2005): “States have structural deficits largely because they have failed to modernise their revenue systems to reflect far-reaching changes in the economy. Several states have changed their revenue systems little since the 1930s or 1940s; others have revenue systems that are twenty or thirty years out of date.”

To highlight the plight of the finances of his home State of Illinois, he discussed the Fitch Analyst Karen Krop’s a March 2010 report (Fitch recently downgraded Illinois bonds to an A rating). Her company’s rating reflects: “the magnitude and persistent nature of the state’s fiscal problems and the likelihood that the budget to be enacted next year, fiscal year 2011, will not address annual operating deficits or accumulated liabilities.”

“And yet there is still no public discussion!”  Morriss said.

 Morriss blamed the fact that the US political system “doesn’t reward long-term thinking.”

“The system only rewards individuals as far as the next election,” he explained. “Governors only serve one or two terms and are scared to change the system for fear of what the impact will be.”

Scarily, it appears that US politicians don’t seem to mind that they are running their States into the ground, as  Morriss highlighted one quote from Congressman Tom Perriello (D. Va.) who he quotes as saying “If you don’t tie our hands, we’ll keep stealing.“

No end to the spend

Reckless spending by States appeared in recent years to show no signs of being abated. As a case in point,  Morriss said that 35 of 51 jurisdictions state employees’ compensation grew faster than private sector employees during the period 2001 – 2007, while in particular, California’s grew by 8 per cent, Hawaii’s by 17 per cent and Michigan’s by 10 per cent.

As far as the federal stimulus package was concerned,  Morriss said that receiving funds very much depended on which side of the fence you sat politically in the US.

He quoted from Veronique de Rugy’s Stimulus Facts, Period 2 (Mercatus Working Paper April 7, 2010) which stated: “On average, Democratic [congressional] districts received 1.53 times the amount of awards that Republicans were granted. … Democratic districts also received 2.65 times the amount of stimulus dollars that Republican districts received ($122 billion vs. $46 billion). … In total, Democratic districts received 73 percent of the total stimulus funds awarded and Republican districts received 27 percent of the total amount awarded.”

Pension deficit worsens

US State pensions were another huge area for concerned, with a US$1 trillion gap between pensions promised and available funds to pay them. Indeed,  Morriss called this enormous figure “conservative”.

He furthered: “This gap in State pension funding reflects the States’ own policy choices and lack of discipline. The State governors have bought labour peace for the last 30 years.”

Morris believed that the pension problem will be exacerbated by assumed investment returns being too high (8 per cent) and consistent underfunding of pensions across the States. In fact, 231 State and local pension funds were assuming an 8 per cent return; whereas the top 100 private pension funds were yielding around 6.36 per cent.

One rather shocking example was the State of New Jersey which required US$2.3 billion of contributions last year. The actual sum received was just a fraction of this figure at US$105 million.

The lookout for pension funds was bleak, according to Morriss. Losses will continue to mount due to smoothing, underfunding will continue due to State fiscal crisis, pension claims will increase due to retirement incentive programmes and the pressure on State budgets will worsen.

Hiding the problem: but not forever

As far as what Morriss termed “fiscal chicanery” was concerned, State governors were, in his view, creating a nightmare scenario by operating outside practices acceptable in the private sector.

As a case in point, he went on to quote Illinois’s budget director, David Vaught, as saying: “It’s a question of whether the creditors that we owe money to can actually stay in business or whether they’ll collapse.”

California’s “budget tricks” as Morriss termed them included: borrowing from local government funds; increasing payroll withholding; accelerating estimated tax payments and basing budgetary calculations on “extremely dubious assumptions”. Inflation was “one last trick”.

Emphasising that Cayman should really be taking note of events abroad, Morriss then highlighted Cayman’s own fiscal issues by quoting from the Miller Report, which stated: “The Cayman Government is on a path that is no longer fiscally sustainable.” “The Cayman Government has huge unfunded liabilities — specifically its civil servants’ defined-benefit retirement and healthcare plans.”  

In conclusion, Morriss warned Cayman “don’t become California (or Arizona or Illinois)” and do worry about the future value of debt issued by US States.” He also warned practitioners in the jurisdiction to worry about what role US State politicians will play in the future of financial regulation, as well as the future of US State and local pension funds as investors.

“You need to be worried about what the coming State meltdown will do to the US economy and its impact on Cayman,” he said.

Read Culp’s discussion in next month’s Journal.


From right, Professor Christopher L. Culp, an adjunct professor of Finance at The University of Chicago Booth School of Business and senior advisor for Compass Lexecon; Professor Andre P. Morriss, the H. Ross & Helen Workman professor of law and business at the University of Illinois College of Law; and Deanna Bidwell, managing director of RBC Wealth Management