The Coming Biden Bailout of Blue States and Cities Taxpayers will be on the hook for mismanaged pensions and projects from stadiums to subways. By Allysia Finley
The Federal Reserve’s latest interest-rate hike paired with the continuing bank panic is causing credit conditions to tighten. State and local governments could be the next sinking ships that Washington gets called on to rescue.
More than a decade of near-zero rates allowed state and local governments to borrow cheaply. At the same time, the Fed’s quantitative easing inflated asset values and prompted pension funds chasing high returns to pile into riskier higher-yielding investments. Now that the music has stopped, the bills for years’ worth of monetary exuberance are coming due.
The balance-sheet risks for mismanaged states and municipalities have been hiding in plain sight just as they were at Silicon Valley Bank. Continued financial-market turmoil and a prolonged economic downturn could cause some pension funds to collapse and cities to declare bankruptcy. Taxpayers will invariably wind up on the hook for politicians’ bad financial bets.
Local government economic-development projects are already growing more expensive and less attractive to private investors owing to rising rates. Consider the $124 million minor-league soccer stadium in Pawtucket, R.I., set to receive about $60 million in state tax credits, federal Covid aid and public debt. Construction started over the winter, but the project’s developer is struggling to raise money to complete it as credit conditions tighten. That means taxpayers could wind up paying more of the costs, which explains Rhode Island Gov. Daniel McKee’s outburst at the central bank last week.
“I have taken a very strong position that what the Fed is doing accelerating interest rates is not in the best interest of the people of the state of Rhode Island,” Mr. McKee said. “They need to stop the increases, halt any increases, and start decreasing that interest rate.”
If the Fed is to blame, it’s for leaving interest rates too low for too long, which spurred states, localities and private investors to bankroll dubious projects like a 10,500-seat stadium in a city with a population of some 75,000. The country is littered with profligate public-works projects that politicians use to buy votes.
Take San Francisco’s 1.7-mile Central Subway, which opened in January at a cost of $1.95 billion, three times as much as initially estimated. The subway is drawing fewer than 3,000 daily riders, no doubt because the design doesn’t make sense: Riders have to walk the equivalent of three football fields to connect to other transit lines and take three escalators to reach platforms 12 stories underground. That didn’t stop Rep. Nancy Pelosi, other San Francisco Democratic power brokers and their union friends from championing the project. When borrowing is dirt cheap, why not max out the taxpayer credit card?
Now that credit is more expensive, states and localities have come up with a creative new way to finance their political investments more cheaply: Market their bonds as “ESG.” New York City last autumn floated $400 million in “social impact” bonds to fund construction of affordable housing. Enormous demand from investors reduced yields the city had to pay.
Taxpayers will be stuck paying debt costs on political pet projects for years to come at the same time as public worker pensions bleed them dry. A report by the research shop Equable estimated that the 228 largest public retirement systems were running a $1.4 trillion unfunded liability at the end of last June.
But stock prices haven’t increased much, and the values of other pension-fund investments are falling. Fixed-income assets such as government bonds used to make up about half of pension-fund portfolios but now are only about 20%. To meet their targeted investment return rates—typically between 7% and 8%—pension funds loaded up on higher-yielding stocks and “alternative investments” such as real estate, hedge funds and private equity, which rely heavily on leverage.
These alternative investments now make up about 30% of pension-fund investments and are getting slammed by rising interest rates. Defaults on office buildings are increasing while property values fall, which will ding pension funds and make it harder for local budgets to fund retirement obligations. About 80% of property-tax dollars in Chicago go to pensions.
Yet Chicago’s four pension systems have only enough assets to cover about 25% of what they owe workers and retirees, which is less than Detroit’s pension funds had when the Motor City declared Chapter 9 bankruptcy a decade ago. Pension funds in states like Illinois, New Jersey and Connecticut aren’t in much better shape.
Insolvent cities could declare bankruptcy, but states as a matter of federal law can’t. That means their taxpayers will inevitably have to pay more to cover the pension shortfalls. In Illinois 25% of general tax revenues pay for pensions. Many states—including Illinois—can’t afford to bail out their underwater cities, but they also may not want the stain of allowing them to go bankrupt.
The most likely outcome: A cascade of bailouts by some combination of U.S. taxpayers, the Fed and municipal bond investors. Democratic-run states and big cities are simply too politically important for the Biden administration to let fail.
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