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State News: August 2009



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Tumult on Wall Street Takes Toll on State Finances

By Sujit M. CanagaRetna
The turmoil on Wall Street in the last few weeks continues to befuddle policymakers and citizens alike. As the Bush Administration and members of Congress tussle with the details of the Emergency Economic Stabilization Act of 2008, including $700 billion to buy up the toxic assets of financial institutions, Americans across the country anxiously monitor their own perilous financial positions. In the last few weeks, those of us who track fiscal trends at the state level remain concerned about the impact of all this turmoil on state finances.
Even though state revenues had begun to recover from the recession that swept the country at the beginning of this decade, several disturbing fiscal signs began to appear by late 2006 and early 2007. The nation’s housing market, which had been a major contributor to the surge in economic activity in the aftermath of the 2001 recession, began to crumble as a result of a mortgage meltdown.
As housing values sank from the inflated levels they had soared to in many states and the number of mortgage defaults escalated, the startling news that vast segments of the financial services industry had exposure to noxious mortgage-backed securities proved to be a harbinger of fiscal doom. A record number of banks, more than a dozen, went into federal receivership this year and were taken over by the Federal Deposit Insurance Corporation (FDIC), or had their banking operations transferred to other entities such as Washington Mutual to JPMorgan Chase and Wachovia to Citigroup.
How does all this affect states? In my opinion, state finances are impacted by the ongoing turmoil and collapses on Wall Street in the following ways:
  • If the state’s investment portfolio , such as its retirement plan, had exposure to Lehman Brothers, AIG, Washington Mutual, Wachovia, Freddie Mac or Fannie Mae stock, the collapse in the stock price of these entities has negative implications on the state’s bottom line.
In the past 15 years or so, states have moved aggressively away from the more staid but secure U.S. Treasury bills to greater exposure in non-governmental equities, such as stock in the financial firms listed above. So, it is a safe assumption to say most states have some exposure and their overall portfolios have eroded.
In fact, we already know some state pension funds had exposure to the troubled financial firms, although the amounts represent a fraction of their total portfolios: Wisconsin’s pension fund had more than $420 million in these firms out of an overall portfolio of $79.4 billion; Washington state’s Lehman exposure is about 0.17 percent of the state’s total portfolio of $78 billion; and, the massive California pension plans, CalPERS (employees) and CalSTRS (teachers) have about $226 billion and $155 billion in total respectively and their Lehman exposure, for instance, was about $350 million cumulatively.
  • If a state had an ongoing relationship with Lehman in its role as an investment bank, all those deals will now be up in the air as state and federal regulators scramble to come up with an alternative plan. In this decade, states have increasingly resorted to issuing debt to bolster their financial positions, given that raising taxes is politically radioactive, and the role of firms like Lehman became increasingly important. Florida is one such state with important ties to what used to be the nation’s fourth largest investment bank, Lehman Brothers.
Specifically, the State Board of Administration (SBA), which handles investments for the Florida retirement system and 32 other funds, faces hundreds of millions in potential losses from mortgage-related securities it bought last year from companies that used Lehman Brothers as a broker; through the SBA, state and local governments in Florida are heavily invested in Lehman's own securities; and finally, Lehman manages the assets in two SBA funds. Hence, Florida is one example of a state that retained Lehman to assist with its financial operations that will face adverse implications as a result of the collapse.
  • States such as New York, New Jersey and Connecticut, where a large number of the Lehman and other employees of Wall Street firms work and live, face the immediate negative consequences of diminishing corporate, personal income and sales tax revenues with the collapse of these companies and the ensuing layoffs. New York City, in particular, will face serious negative effects because for every 1,000 jobs lost in the financial sector, the city loses $50 million in revenues. Current estimates call for financial sector layoffs on Wall Street that could reach 30,000.
Citigroup acquiring Charlotte, N.C.-headquartered Wachovia Bank this week contains disturbing news for this Southern location with layoffs in the thousands expected to follow. As it is, most states are reeling from severely depressed revenues and the turbulence on Wall Street with the disintegration and shrinking of numerous financial entities will only mean that the states’ bottom lines will be negatively affected.
  • Lehman Brothers and AIG, for instance, have branch operations scattered across the country and the tremendous financial setbacks experienced by these firms could have negative effects in these settings far from Wall Street. An AIG subsidiary, for example, American General Life and Accident, employs 900 in Nashville, Tennessee; similarly, Lehman Brothers’ subsidiary, Neuberger Berman, has operations across the country, including one in Tampa, Fla.
  • Perhaps most influentially, the ongoing turmoil has had the unfortunate result of freezing up credit markets. Access to credit remains the life blood of our economy and every entity in our economy, including states, counties and cities rely on credit to engage in both routine operations and capital projects. Along with companies that issue bonds and short-term debt for their corporate survival, public entities rely on short-term notes for tasks ranging from payroll to local projects. According to reports, for the week ending Sept. 26, 2008, of the $6 billion in new municipal debt issues that were expected, only about $100 million came to the market; the rest were postponed, a clear indication of the evaporating credit possibilities for these public entities. In addition, Erie County, N.Y., could not complete a $75 million issue because of the unavailability of investors last week, jeopardizing the county’s $12 million payroll and forcing the county to secure alternate funding.
Then, the state of Massachusetts sought to borrow $400 million this week to make its routine quarterly local aid payments to cities and towns but frozen credit markets left the state $170 million short. Consequently, the state had to deploy its own already depleted funds to complete the local aid payments.
While the events cascading through the nation’s financial industry roil federal and state government finances and Americans in every corner of our nation, it is appropriate to review some of the factors that precipitated the ongoing turmoil on Wall Street and the potential direction of where all this turmoil will lead us to. The Council of State Governments’ Financial Services Working Group session Dec. 4, from 3 p.m. to 5 p.m. at the 2008 Annual Conference in Omaha, Neb., will do exactly that.
The session, Mortgage Meltdown: The Saga Continues, will feature presentations by Michael Greenberger, a professor at the University of Maryland’s School of Law and former director of trading and markets at the Commodity Futures Trading Commission. Greenberger was prescient several years ago in predicting the ongoing mortgage meltdown and the ongoing turbulence in the financial markets. Also speaking at this session will be Jason R. Henderson, vice president, Federal Reserve Bank of Kansas City, who will provide the Federal Reserve Bank’s perspective on the ongoing turbulence.
Sujit M. CanagaRetna is a senior fiscal analyst at The Council of State Governments’ Southern Office, The Southern Legislative Conference.



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