While the warning flags are raging in Illinois and Connecticut, JPMorgan's Michael Cembalest states that New Jersey's problems are "not mathematically solvable." The stunning admission from a status-quo-sustaining bank that is “very focused on the total indebtedness of US states," should be worrisome enough but as Cembalest explains the answer to a debt problem is not always piling up more debt; the issue is to address the root of the problem, which can be a delicate and at times politically incorrect topic.
Reviewing the JPMorgan research might lead to several conclusions, one of them being that when any government starts to get ahead of logical debt ratios investors might best be advised to proceed with caution. As ValueWalk.com's Mark Melin continues, Cembalest takes a step back and looks at the servicing cost for the mounting state debt.
What he does is look at unfunded liabilities and given several formula factors, including an allowance to return 6% on assets. Using this formula, he projects what starts are currently paying and what they might be paying on a 30-year accrual basis. Such forward modeling helps investors determine debt sustainability much more so than does an institutional research report that might seem to omit or de-emphasize material facts.
Using this as a measure a group of bad-boy states that have been abusing their debt privileges appears to emerge. On top of this list and over the projected danger threshold of 25% are heavyweight states such as Illinois, New Jersey, Connecticut who sit next to relatively rural Kentucky.
In these states, a unique battle is being fought with very real and legitimate arguments on each side.
State debt requires understanding “The Arc of The Covenants”
When he starts to look at state debt and the economic reality, Cembalest has deft insight to recognize that while math is unemotional, he is about to wade into a deeply emotional argument involving trust and promises made to government employees.
He starts the sometimes delicate task of wading into an issue that rips deep into the social contract by addressing “The ARC and the Covenants.” This refers to the need states have to fulfill their very real obligations to public employees, and Cembalest explains this using an incredible touch:
Public sector workers form a critical part of American civil society. They rescue and protect us when we’re in danger; they make our lives safer, cleaner and more efficient; they educate our children; they enforce the rule of law and provide remedies when laws are broken; they ensure access to clean air, water and food; and they heal us when we’re sick. The legal, medical, environmental and educational problems sometimes found in other countries are a reminder of what life might be like without them. They earned the benefits they accrued and which were granted by state legislatures, and have the right to expect them to be paid.
That said, math and the fiscal responsibility of a lender not to overburden the logical constraints of the borrower can be determined non-emotionally and mathematically.
Cembalest models the problem using shared sacrifice as the solution
The gist of the state debt problem can be summed up in one sentence and it applies to municipal as well as sovereign debt as well. When debt reaches a certain level, the can kicking is over and difficult decisions need to be made.
For Cembalest this means “states would need to raise substantial funds from increased tax revenues, cuts in non-retirement spending or increases in public sector worker contributions.”
Here Cembalest looks at the solutions and one realizes the difficult task ahead.
Tax increases are difficult on a political level. This is especially true given some states with the highest debt burden already have effective tax rates ranking among the highest in the US, which includes Illinois, Connecticut, Kentucky and Hawaii.
Cembalest then considers the appropriate solution of shared sacrifice – a non-emotional approach but one that, when placed through a political ringer, might come out lopsided in the end. He looks at the revenue burden given an equal contribution from all participants. He develops a revised ratio that splits the state’s revenue needs equally across tax increases, spending cuts and worker contributions to develop a solution.
“Whether this kind of comprise is feasible will only be revealed with the passage of time,” he says, as residents of most of the states continue to live their wonderful lives as if the problem doesn’t exist. In reality, the problem will be upon them and once they realize it, once the knowledge is widely disseminated into the mainstream, it will likely be too late to act.