Fate of the States: The New Geography of American Prosperity

by Meredith Whitney

  Making matters worse was the 30-plus percent decline in home prices that left nearly a quarter of all people with mortgages owing more on their mortgage than their homes were worth. So imagine your home value declines by 30 percent, but your property taxes actually rise—a familiar story all across the country. The first option used by many local politicians to offset lower tax revenues was simply to hike tax rates. This had the unintended result of actually further depressing home values—and thus property taxes—because the higher taxes did not come with better services. Imagine you’re a prospective home buyer looking at two similar and similarly priced homes in neighboring towns. The school systems are equivalent, as are town recreation programs and the fire and police departments. But one house carries a $5,000 property-tax bill, while the other’s is $10,000. Which house are you going to buy?

  From 1993 to 2007, 64 percent of all jobs in the United States—over fifteen million total—were created by small businesses.43 Credit was easy to come by, making it that much easier to start a small business. Banks rarely want to make uncollateralized loans to start-up businesses, given that the failure rate of such businesses within the first year after opening their doors is over 70 percent. What made starting a business so easy from 1993 to 2007 was the fact that small-business funding was available to entrepreneurs in the form of home equity. Soaring real-estate values were like free money. In California home prices tripled, and in 2006 over half of all nonfarm jobs in California were with small businesses.44 Six years later, California had a higher percentage of negative equity—of mortgages that were underwater—than any other state in the country. The funding spigot for small business ran dry. Throw in relatively high taxes and a generally difficult business-operating environment—in 2012 California had the third-highest cost of doing business, according to a CNBC survey—and it’s exceedingly unlikely small business will be what pulls California out of its unemployment crisis.45

  Since 2008 home prices in California have fallen almost 40 percent, and almost 30 percent of California mortgages are underwater. Credit has declined radically throughout the state, businesses have gone bust, and the unemployment rate remains the third highest in the country at over 10 percent. California has had one of the highest unemployment rates in the country for going on five years. New-business formation is next to impossible without credit, as is self-funded job training or buying a new home (which has the economic multiplier effect of job creation). The entrepreneur who ten years ago might have funded a start-up business on her MasterCard—or perhaps even on three MasterCards and a Visa, given banks’ liberal lending policies at the time—no longer has the same access to credit. The most direct impact has been on construction companies. At 25 percent, construction has the highest unemployment rate of any industry in the United States.46

  An insatiable appetite to spend put both states and consumers in the very same place: heavily in debt. California, which is home to some of the most indebted consumers in America, also has one of the most indebted state governments in the country. The problem for anyone who lives in California is that they get both bills. On an average per-capita basis, this translates into $73,000 in consumer debt and an additional $11,000 in tax-supported state obligations. New Jersey isn’t much better, with $61,000 in average consumer debt per capita and another $16,000 in tax-supported state obligations.47 Some other debt-soaked states, along with their residing consumers, are Illinois, Nevada, Michigan, and Ohio.

  Debt-to-Income per Capita (2011)

  SOURCES: NY FED, BEA, INSIDE MORTGAGE FINANCE, AND MWAG

  Much of the trouble states are in today is linked to overexposure to real estate. During the boom years, the affected states—chiefly in the Sun Belt, the Northeast, and the West—saw tax revenues soar along with real-estate prices. The numbers are striking: From 2000 to 2010, real-estate sales, rentals, and leasing provided 21 percent of GDP growth in Florida, 18 percent in California, and 22 percent in New Jersey.48 These revenues came from transaction and annual real-estate taxes, of course, as well as growth in ancillary industries such as construction and mortgage lending, which, in turn, paid taxes. Unfortunately, the states spent real estate–related revenues as quickly as they came in. Public-sector unions saw these bulging coffers as leverage to negotiate generous pay and benefits packages, many of which included automatic cost-of-living increases. Not until I studied the various pension funds of each state (more on pensions later) did I understand how public-employee pay packages constricted states’ financial flexibility. Expensive infrastructure and education projects were undertaken, each with a politically powerful interest group clamoring for its piece of the pie. The banks and bond investors financing the excess seemed unperturbed—convinced that home prices, and therefore property-tax receipts, would go up in perpetuity.

  As I have said, the pain has not been felt equally across the country. The states with the biggest real-estate booms, namely Arizona, California, Florida, and Nevada, took the biggest hit. Ironically, they were victims of their own success in luring new residents. There was a great migratory wave of Americans moving to the Sand States. Arizona, for instance, added 1.3 million people between 2000 and 2010, a 26 percent population growth.49 With all the new arrivals, a mind-set of perpetual growth took hold. Builders overbuilt, mortgages were granted to people who couldn’t afford them, and, among home buyers and real-estate investors, the proverbial and preternaturally dangerous irrational exuberance took hold. Then the delinquent mortgages grew, foreclosures followed, and the housing market collapsed.

  The birthplace of subprime lending, California was responsible for 20 percent of all mortgages underwritten in the United States, and Florida was right there behind it.50 Through the growth of securitization, small lenders made loans, large lenders made loans, and tens of millions of Americans could suddenly afford to buy a house. With credit so readily available, consumer spending increased, employment increased, and overall economic output increased. The coasts truly were driving economic growth in the United States, and loose credit was responsible for most of it.

  The positive effect of abundant credit, investment, job creation, income growth, more investment, higher tax receipts, more government spending, etc., made for mini booms all across California and other Sand States like Nevada and Florida. Retailers flooded markets with new stores, built to support burgeoning suburbs. Chains like Costco, Home Depot, and Best Buy did their biggest business in California. The music was playing loudly, and Californians couldn’t help but get up and dance. But in 2007, when the music officially stopped, it was Californians who would be hit the hardest. The debt binge so many Californians had been on for over twenty years was about to end painfully.

  By 2010—the last year for which data is available—consumer debt per capita in California hit $74,950—a debt-to-income ratio of 174 percent. By comparison, the average debt per capita in Texas was $36,000, which translates to a debt-to-income ratio of 89 percent. Even with low interest rates, a 174 percent debt-to-income ratio leaves little margin for error. It is harder to qualify for a new loan, it is certainly harder to make payments on the debt already being carried, and there are no unused credit lines that can be tapped in case of an emergency.51 This is a big deal, considering that over 50 percent of Americans use their credit-card lines to manage their monthly cash flows. Unused credit lines represent a “what if” safety net for many. What if my spouse loses his job, what if my child needs braces, what if I get sick, etc. With no credit lines, “what if” quickly becomes “what now?”

  In sharp contrast to the debt-laden coasts and Sun Belt, things look very different in the center of the country—where credit was more scarce during the boom and therefore debt loads are more benign now. Consumer debt per capita throughout the central corridor of the United States is less than $35,000, half that of California. Per capita debt-to-income levels tell the same story with dramatically lower numbers in the center of the country.52

  Consumer Debt per Capita (2000–2010)

/>   SOURCES: FEDERAL RESERVE BANK OF NEW YORK, U.S. CENSUS BUREAU, AND MWAG

  Consumer Debt-to-Income per Capita (2010)

  SOURCES: FEDERAL RESERVE BANK OF NEW YORK, U.S. CENSUS BUREAU, AND MWAG

  Because so many of the subprime lenders went belly up between 2006 and 2010, a new breed of pseudolenders has filled the lending vacuum for the credit challenged. Check cashers, payday lenders, and pawn shops have emerged as sources of quick credit, but the associated costs for borrowers are far higher than those of the more traditional banks that once served these customers. Factor in fees, and the annual interest charges associated with borrowing from a payday lender shop can range between 50 percent and 250 percent.53 Perhaps not coincidentally, the hit pawn-shop reality show Pawn Stars is filmed in a city, Las Vegas, that had the highest concentration of subprime loans during the housing boom and in a state, Nevada, that is the only one in the country in which mortgage debt owed on single-family homes exceeds the homes’ total valuations. Nationwide, since 2008 over $2 trillion in credit has been pulled from the housing-finance system, and the bulk of that credit has been pulled from areas now experiencing the greatest financial hardship. The city of North Las Vegas, for example, declared a state of emergency in June, blaming a 37 percent decline in property-tax revenue.54 In America’s nouveau pauvre states, it’s becoming a lot more expensive to be poor.

  When a community loses access to credit, it puts pressure on almost all aspects of life within that community. Remember the saying “It is harder to have had money and lost it than to have never had it at all”? Well, substitute “debt” for “money,” and that’s basically the situation many coastal and Sun Belt states now find themselves in. In just five years’ time, mortgage credit to California, Florida, Arizona, and Nevada declined by three quarters of a trillion dollars, or 10 percent, from its peak in 2006. From 2008 to 2011 mortgage credit in California collapsed by over 18 percent, and in Nevada mortgage credit collapsed by 30 percent during the same time period. With so much credit coming out of those states, it is no wonder home prices there have plummeted, posting the sharpest declines in the country.55

  States in the Midwest, which were struggling with the decline in their manufacturing base, felt the real-estate bust much less acutely. Of course, many of these states were already in recession. Wealthier regions with fewer new out-of-state residents than the Sand States, such as New England and the Northwest, saw real estate contract but not collapse.

  Then there were states that fell somewhere in the middle. In Atlanta’s exurbs, for example, weed-choked lots sit where new shopping centers and subdivisions were once planned. Dan Chapman and Jeffry Scott, writing in the Atlanta Journal-Constitution in 2010, noted that “the downturn all but killed residential development—the economic lifeblood—across Atlanta’s northern exurbs. . . . Barrow, Bartow, Cherokee, Forsyth, Hall and Jackson counties.” As recently as 2008, those counties had “notched some of the highest growth rates in the nation. . . . Property tax revenue poured into these counties.”56

  In the spring of 2012, Georgia State University’s Rajeev Dhawan forecast no net growth in Georgia employment and only 0.8 percent in 2013. “Gains in growing sectors, such as professional and business services, manufacturing and health-care services, have not been great enough to offset losses in lagging sectors such as construction, local government, and banking,” Dhawan explained. Real estate, in effect, was proving a stubborn drag on Georgia’s economy.57

  The overdependence on real estate had a profound impact on state revenues, sometimes in indirect ways. When the value of a family’s house declines—even if that family has no intention of selling and the breadwinners are gainfully employed—there is still an emotional and psychological toll. Call it the reverse wealth effect. They are less inclined to splurge on big-ticket items, they put off renovation projects, and they just generally spend less. All this leads to even further declines in tax revenue. States then have to increase taxes, cut spending, or both, which results in less discretionary income for those who are employed and the loss of all income for some with government-funded jobs. So the debt hangover is a double whammy for everyone—a gruel diet of reduced spending with a side order of higher taxes.

  Chapter 4

  Pensions: The Debt Bomb Nobody’s Talking About

  Back in the early 2000s—when Silicon Valley was still flush and the California real-estate market was soaring—Lou Paulson, then head of the Contra Costa County, California, firefighters’ union, negotiated a sweet new contract for his members. Veteran firefighters could now retire at age fifty with an annual pension equivalent to 90 percent of their final salary. “There was plenty of money around,” said Paulson. “To go back to that time, things were really good.”

  That was about to change. After the housing bust, Contra Costa’s tax revenues plummeted. In order to avoid the closure of six fire stations, the firefighters’ union proposed a November 2012 ballot initiative that, if approved, would levy a new $75-a-year tax on every county homeowner. Kris Hunt, director of the Contra Costa Taxpayers Association, was outraged that the firefighters would ask more from taxpayers when it was the spiraling cost of firefighters’ own pensions forcing the county to shutter stations. Hunt’s group responded by publishing the names of every retired Contra Costa County employee with a pension of $100,000 a year or more. As it turned out, there were 665 members of this $100K club, including 24 whose pensions exceeded $200,000. Of the 665, 268 were firefighters—which meant there were more retired firefighters with a $100,000 pension than there were current firefighters on the job (261).

  One of the $100K club members was a fifty-five-year-old retired fire captain named Jaad Ajlouny. Ajlouny said he was blindsided by the catcalls from angry voters—folks who not so long ago had gone out of their way to thank him for his service. “Just sitting around in a bar, you know, minding my own business,” Ajlouny recalled in a radio interview, “and a guy yells over: Hey, Jaad, come on over here and buy me a drink with that retirement I paid for.”

  The Contra Costa ballot measure failed. Everybody might still love firefighters, but what they did not like was retired fifty-five-year-olds taking home $100K a year at a time when many taxpayers were out of work and could not afford to put any money aside for their own retirements. One such no voter—Matt Heavy, a construction worker who had gone through a tough period—told NPR in an interview that the firefighters were being unfair: “I felt hostage . . . either pay the extra money or we’re going to start shutting down stations. And the bottom line is the reason that they’re asking for the money is because the pensions are just skyrocketing.”1

  A ballot measure that was intended to save six firehouses had morphed into a local referendum on pension reform. “After 10 years of being driven by pension costs,” said Dan Borenstein, a columnist for the Contra Costa Times who opposed the measure, “[the prevailing view was] we’re not going to let you put the cart before the horse. You’ve got to show us you’re serious about controlling costs before we’re willing to go along with the tax increase.” Stories like Contra Costa’s are sure to play out again and again and again simply because state and local governments don’t have the money to pay for the retirement packages they once promised public employees. In 2009 new Governmental Accounting Standards Board (GASB) rules finally exposed how much pension debt elected officials had incurred on our behalf. The numbers were two years old, but it was disclosure nonetheless. As of June 2008, states were on the hook for over $452 billion in unfunded pension debt on top of what they owed by way of traditional municipal debt (note, both guaranteed by the future taxes of their residents). Even scarier, those numbers were before the worst of the credit crisis—and each state seemed to have its own unique way of crunching the numbers. Indeed, the next year’s financial disclosures revealed that these unfunded pension obligations had grown 50 percent in just one year’s time, from $452 billion to $678 billion.2 Adding the amount of heath-care and other benefits states owed, and that number bal
looned to $1.3 trillion in 2009. As of 2011, that number was $1.4 trillion, and that is not counting municipal-bond obligations.3

  With not nearly enough money to go around, the impending war over public-employee pensions threatens to be one of the more vicious political debates this country has seen, pitting Americans against Americans, neighbor against neighbor. On one side there’s the public-sector employee, who worked an entire career—sometimes at a pay level below what she could have earned in the private sector—under the assumption that her job would provide a secure (and perhaps early) retirement with few financial worries. Until now, she hasn’t had to worry much about retirement. After all, a great retirement package, generous vacation days, and a better work-life balance are part of what attracted her to public-sector work in the first place. On the other side of the debate there’s the guy in the private sector who lost large chunks of his 401(k) savings in the stock market and perhaps even had to tap those savings for living expenses after losing a job. Now he’s being hit with higher taxes and continued cutbacks to basic public services. The fight is not just political but constitutional too: Courts are now deciding whether municipalities can use ballot measures and bankruptcy laws to void or change public-employee pensions.

  At the heart of the problem is a difficult truth: There’s not enough money to pay for everything, and by law, pension payments trump most other types of spending. Tax revenues are down, bills keep rising, and spending keeps growing. But based on the official pecking order, pension obligations and municipal-bond debt service must be honored before any money can be funneled to everyday expenses for education, police protection, road repair, and other essential services. Because so many baby-boomer teachers are now retiring, taxpayers are being called on to pay more but are actually getting less in return. Pension and health-care costs are increasingly crowding out other line items in state and municipal budgets. The number of retirees drawing a pension is growing, but the number of workers contributing to the pension plan is declining (which is the same scenario that led to GM’s demise). Back when overall tax receipts were rising, this disconnect went largely unnoticed. But with revenues as strained as they have been for the past five-plus years, crowding out has become a real hot button in communities across the country. “I went toe to toe with the public unions looking out for the kids of Rhode Island because if we didn’t fix those pensions, there would be no good public schools,” says Gina Raimondo, treasurer of Rhode Island.4