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STATE AND MUNICIPAL DEBT: THE COMING

CRISIS?

HEARING

BEFORE THE

SUBCOMMITTEE ON TARP, FINANCIAL SERVICES

AND BAILOUTS OF PUBLIC AND PRIVATE PROGRAMS

OF THE

COMMITTEE ON OVERSIGHT

AND GOVERNMENT REFORM

HOUSE OF REPRESENTATIVES

ONE HUNDRED TWELFTH CONGRESS

FIRST SESSION

FEBRUARY 9, 2011

Serial No. 112–40

Printed for the use of the Committee on Oversight and Government Reform

(

Available via the World Wide Web: http://www.fdsys.gov

http://www.house.gov/reform

(II)

COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM

DARRELL E. ISSA, California, Chairman

DAN BURTON, Indiana

JOHN L. MICA, Florida

TODD RUSSELL PLATTS, Pennsylvania

MICHAEL R. TURNER, Ohio

PATRICK T. MCHENRY, North Carolina

JIM JORDAN, Ohio

JASON CHAFFETZ, Utah

CONNIE MACK, Florida

TIM WALBERG, Michigan

JAMES LANKFORD, Oklahoma

JUSTIN AMASH, Michigan

ANN MARIE BUERKLE, New York

PAUL A. GOSAR, Arizona

RAU ́ L R. LABRADOR, Idaho

PATRICK MEEHAN, Pennsylvania

SCOTT DESJARLAIS, Tennessee

JOE WALSH, Illinois

TREY GOWDY, South Carolina

DENNIS A. ROSS, Florida

FRANK C. GUINTA, New Hampshire

BLAKE FARENTHOLD, Texas

MIKE KELLY, Pennsylvania

ELIJAH E. CUMMINGS, Maryland, Ranking

Minority Member

EDOLPHUS TOWNS, New York

CAROLYN B. MALONEY, New York

ELEANOR HOLMES NORTON, District of

Columbia

DENNIS J. KUCINICH, Ohio

JOHN F. TIERNEY, Massachusetts

WM. LACY CLAY, Missouri

STEPHEN F. LYNCH, Massachusetts

JIM COOPER, Tennessee

GERALD E. CONNOLLY, Virginia

MIKE QUIGLEY, Illinois

DANNY K. DAVIS, Illinois

BRUCE L. BRALEY, Iowa

PETER WELCH, Vermont

JOHN A. YARMUTH, Kentucky

CHRISTOPHER S. MURPHY, Connecticut

JACKIE SPEIER, California

LAWRENCE J. BRADY, Staff Director

JOHN D. CUADERES, Deputy Staff Director

ROBERT BORDEN, General Counsel

LINDA A. GOOD, Chief Clerk

DAVID RAPALLO, Minority Staff Director

SUBCOMMITTEE ON TARP, FINANCIAL SERVICES AND BAILOUTS OF PUBLIC AND

PRIVATE PROGRAMS

PATRICK T. MCHENRY, North Carolina, Chairman

FRANK C. GUINTA, New Hampshire, Vice

Chairman

ANN MARIE BUERKLE, New York

JUSTIN AMASH, Michigan

PATRICK MEEHAN, Pennsylvania

JOE WALSH, Illinois

TREY GOWDY, South Carolina

DENNIS A. ROSS, Florida

MIKE QUIGLEY, Illinois, Ranking Minority

Member

CAROLYN B. MALONEY, New York

PETER WELCH, Vermont

JOHN A. YARMUTH, Kentucky

JACKIE SPEIER, California

JIM COOPER, Tennessee

(III)

C O N T E N T S

Page

Hearing held on February 9, 2011 ......................................................................... 1

Statement of:

Gelinas, Nicole, Searle Freedom Trust fellow, Manhattan Institute; Professor David Skeel, S. Samuel Arsht professor of corporate law, University of Pennsylvania Law School; Eileen Norcross, senior research fellow, Social Change Project at the Mercatus Center; and Iris Lav, senior

advisor, Center on Budget and Policy Priorities ........................................ 14

Gelinas, Nicole ........................................................................................... 14

Lav, Iris ...................................................................................................... 43

Norcross, Eileen ......................................................................................... 28

Skeel, David ............................................................................................... 19

Letters, statements, etc., submitted for the record by:

Cummings, Hon. Elijah E., a Representative in Congress from the State

of Maryland, prepared statement of ............................................................ 81

Gelinas, Nicole, Searle Freedom Trust fellow, Manhattan Institute, prepared statement of ........................................................................................ 16

Lav, Iris, senior advisor, Center on Budget and Policy Priorities, prepared

statement of ................................................................................................... 45

McHenry, Hon. Patrick T., a Representative in Congress from the State

of North Carolina, prepared statement of ................................................... 4

Norcross, Eileen, senior research fellow, Social Change Project at the

Mercatus Center, prepared statement of .................................................... 30

Quigley, Hon. Mike, a Representative in Congress from the State of

Illinois, prepared statement of ..................................................................... 8

Skeel, Professor David, S. Samuel Arsht professor of corporate law, University of Pennsylvania Law School, prepared statement of ..................... 21

(1)

STATE AND MUNICIPAL DEBT: THE COMING

CRISIS?

WEDNESDAY, FEBRUARY 9, 2011

HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON TARP, FINANCIAL SERVICES AND

BAILOUTS OF PUBLIC AND PRIVATE PROGRAMS, COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM, Washington, DC.

The subcommittee met, pursuant to notice, at 9:30 a.m., in room

HVC–210, The Capitol Visitor Center, Hon. Patrick T. McHenry

(chairman of the subcommittee) presiding.

Present: Representatives McHenry, Guinta, Buerkle, Amash,

Meehan, Walsh, Gowdy, Ross, Quigley, Maloney, Welch, Yarmuth,

Cooper, and Cummings (ex officio).

Staff present: Lawrence Brady, staff director; John Cuaderes,

deputy staff director; Peter Haller, senior counsel; Christopher

Hixon, deputy chief counsel, oversight; Robert Borden, general

counsel; Joseph Brazauskas and John Zadrozny, counsels; Tyler

Grimm and Ryan Hambleton, professional staff members; Michael

Bebeau and Gwen D’Luzansky, assistant clerks; Molly Boyl, parliamentarian; Katelyn Christ, research analyst; Drew Colliatie, staff

assistant; Adam Fromm, director of Member liaison and floor operations; Justin LoFranco, press assistant; Linda Good, chief clerk;

Laura Rush, deputy chief clerk; Suzanne Sachsman Grooms, minority chief counsel; Jason Powell and Steven Rangel, minority senior counsels; Davida Walsh, minority counsel; Ronald Allen, minority staff assistant; Jesse Feinberg, minority legislative assistant;

Lucinda Lessley, policy director; and Carla Hultberg, minority chief

clerk.

Mr. MCHENRY. The committee will come to order. This is our

first meeting of the TARP, Financial Services and Bailout to Public

and Private Programs. I will begin by making an opening statement.

I certainly appreciate the panel of witnesses being here and taking the opportunity to be here. Today’s hearing is an opportunity

to discuss growing concerns over the potential fiscal crisis looming

for States and municipalities. Over the past 3 years, we have seen

a culture arise where every institution claimed it was too big to

fail. An all-too-eager President and an all-too-compliant Congress

kept putting taxpayers on the hook for trillions of dollars. Our

budget deficit has reached an all-time high and the national debt

is crippling our economy.

Now we are facing the consequences of bad government policy in

yet another way. State and municipal governments who are preVerDate 17-JUN-2003 16:19 Oct 13, 2011 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 C:\KATIES\DOCS\68362.TXT KATIE PsN: KATIE
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paring for aggregate budget shortfalls totaling roughly $125 billion

this year are struggling under a trillion dollar burden of unfunded

pension liabilities, plummeting tax revenues and an unforgiving

bond market. We must understand the magnitude of this problem

to avoid the reactionary ad hoc decisionmaking that fueled the Federal action of the 2008 financial crisis.

This is not about one analyst. This is about the looming fiscal crisis in States and municipalities and the lack of transparency in

their pension obligations. Let’s be clear about this. The perfect

storm is brewing. Already State and municipal governments are

coming to Washington hat in hand expecting a Federal bailout like

so many others. But the era of the bailout is over.

That does not mean, however, that Congress must turn a blind

eye or a deaf ear to the crisis unfolding in State and local governments. The beauty of federalism lies in the fact that the National

Government does not tell the States how to manage their own affairs, at least ideally. The burden of federalism is that when one

State, or all 50 States, are in a crisis, we must work together to

solve them for the good of the country. Since 1990, State and local

government spending has increased roughly 70 percent faster than

inflation. The vast majority of the States now find themselves in

a fiscal straitjacket caused primarily of the looming burden of paying out trillions of dollars in lucrative public sector union pensions

and health care benefits that come at the expense of taxpayers.

For the last 3 years, funding from the Stimulus Act has masked the severity of the State fiscal challenges. In fact, there was $140

billion in transfers from the total government to the States included in the stimulus. States now say that more money would

help them through their current rough patch. The reality, however,

is that the money States receive from the stimulus has, in many

ways, made them worse off. A lot of the funding comes with ‘‘maintenance of effort’’ requirements that force States to keep funding

programs after Federal funding dries up this year. More money

from Washington would just delay the day of reckoning and only

further complicate State fiscal situations. Besides, we don’t have

any more money. And beyond that the simple fact is that the government has outgrown our capacity to pay for it.

There will be severe consequences for not changing course.

Young teachers fresh out of college and ready to give back to their

communities will be told that their school districts cannot provide

them with reasonable retirement benefits because they are cashstrapped to pay for the exorbitant benefits of others. Firefighters,

policemen and other public servants facing the reality that their

vital jobs offer no promise of rising standards of living for their

family or benefits will simply opt for a different career path.

In the end, people will recognize that their government has failed

them. But not only that, they believe that their government has actively hurt them.

While we have the opportunity to change that, we are responsible to try. This is why we are here today, to come to a better understanding of the crisis at the State and local government level,

to assess its causes and to consider available solutions. With that

in mind, in this hearing and I intend to shed light on how the

States arrived at their current predicament, what is the current exVerDate 17-JUN-2003 16:19 Oct 13, 2011 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 C:\KATIES\DOCS\68362.TXT KATIE PsN: KATIE
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tent of their fiscal distress, and what needs to be done in terms of

available solutions.

My friend and colleague from California, Representative Devin

Nunes, has a proposal that would require greater transparency at

the point of most urgent concern, the pension problem. I have been

happy to work with him on this legislation. I look forward to hearing from both sides on any and all possible solutions, and that is

why we have this great panel here today.

Let there be no mistake though. Much is required to get our fiscal House in order not just at the State and local levels but here

in Washington, DC.

But reckless spending fueled by bottomless borrowing and guaranteed by endless bailouts is an unsustainable course.

[The prepared statement of Hon. Patrick T. McHenry follows:]

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Mr. MCHENRY. And with that, I now recognize the ranking member, Mr. Quigley of Illinois, for 5 minutes.

Mr. QUIGLEY. Thank you, Mr. Chairman for holding this extraordinarily important and timely hearing, and congratulations on your

new post as chairman. The record should reflect that you and your

staff have been extraordinarily accommodating and cordial to myself and my staff. Obviously the issues are too important to divide

us in any light, and I also thank you for doing that. Any time I

take complimenting you shouldn’t count against my time to speak.

I want to thank our four witnesses for testifying today. And I

agree, it is really in a sense not about bailouts or bankruptcies, because I don’t think either one of those options can work, or is optimal. But as you know, I’m from Illinois, and you don’t need to tell

me about how bad its finances are and how critical these issues

are. Illinois has gone through decades of bad financial decisionmaking under both Democrats and Republicans. Illinois now has

an $8 billion backlog in payments, and a gaping $136 billion hole

in its pension system, leaving its pension less than 50 percent

funded.

It should be no surprise then that the rating agencies has downgraded Illinois bond issuances several times in the past months.

Last year Illinois bonds carried the worst credit risk of any U.S.

State and were only slightly less risky than bonds from Iraq. According to Laurence Msall of the Civic Federation, this bad rating

was costing Illinois taxpayers $551 million a year extra in interest

payments. And total debt service in Illinois is expected to increase

by 33 percent between now and the year 2017.

The only way Illinois was able to climb out from a bottom rung

was to raise State income taxes a whopping 66 percent, an outcome

no one wanted.

This tax increase brought Illinois’s bond rating back up and reduced borrowing costs, but only by passing those costs on to Illinois

taxpayers. Illinois has to reform its pension system, but it also has

to reform its whole way of doing business which has left retirees

vulnerable and taxpayers on the hook. As Professor Dershowitz

said of Harvard’s shrinking endowment after the 1990’s boom, a

lesson for all of us. People forgot the story of Joseph in Genesis,

during the 7 good years, you save for the several lean years. Illinois

didn’t save for the 7 lean years and now it has to deal with the

consequences. That said, what’s going on in Illinois is not necessarily what’s going on everywhere else.

True, most States have recently rung up large deficits thanks to

a collapse in tax revenues during the recession. But the short term

fiscal problem will improve as our economy gets going again. The

real problem is an actuarial problem unique to six to eight States,

including Illinois which suffer from long-term structural imbalances. The culprits are rising health costs, underfunded pension

plans, and poor financial management.

Some of these pension plans look particularly bad right now because of the collapse in the value of pension assets. But even an

appreciation in asset value will lead several State pension plans

underfunded.

The municipal bond market is now responding to legitimate concerns about the long-term structural imbalances in these six to

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eight States. But I believe we would be correct to distinguish these

bad apples from the other 40-some States that have been relatively

well managed and only have temporary deficits. That is why a onesize-fits-all approach like bankruptcy for States could do more

harm than good.

What we have to avoid is any rash actions that would contribute

new risk factors to the bond market. State and local governments

across the country need to continue building roads and bridges, and

we don’t want to make the financing any more expensive than it

already is. So we need to be crystal clear that although there are

national interests at stake, the onus must be on those State governments to reform themselves. And they need to reform sooner

than later, a default on payments would make it obscenely expensive for all States to borrow. Taxpayers would bear the brunt of

these costs either through higher taxes or through reduced public

services and a move toward austerity.

Mr. Chairman I don’t want an Illinois problem or a New Jersey

problem to become a national problem. These States have to institute commonsense reforms to shore up their finances. At the same

time government’s mission matters, and successful reform will ensure that workers get the pensions they have earned through their

years of service. All we need is the political will to get it done.

I look forward to hearing from our witnesses on this matter and

the discussions of the next possible steps. Thank you and I yield

back.

[The prepared statement of Hon. Mike Quigley follows:]

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Mr. MCHENRY. I thank you, Mr. Quigley, and you certainly have

been wonderful to work with and we certainly appreciate that. This

certainly isn’t a shirts versus skins or Republican versus Democrat

issue. I think trying to understand the depths of this problem certainly behooves both the Parties and the American people and their

right to know. I want to begin, before we introduce the panel, we

have the mission statement of the Oversight Committee, and at the

chairman’s request, I would like to read that for all that are here

today:

We exist to secure two fundamental principles: First Americans

have the right to know that the money Washington takes from

them is well spent. And second, Americans deserve an efficient effective government that works for them. Our duty on the Oversight

and Government Reform Committee is to protect these rights. Our

solemn responsibility is to hold government accountable to taxpayers because taxpayers have a right to know what they get from

their government. We will work tirelessly in partnering with citizen watchdogs to deliver the facts to the American people and

bring genuine reform to the Federal bureaucracy.

This is the mission of the Oversight and Government Reform

Committee.

So with that in mind, I would like to introduce today’s panel. Nicole Gelinas is the Searle Freedom Trust fellow at the Manhattan

Institute and a contributing editor of City Journal. Gelinas writes

an urban economics and finance, municipal and corporate finance,

and business issues. She is a Chartered Financial Analyst, charter

holder and member of the New York Society of Securities Analysts.

Her most recent book, ‘‘After the Fall: Saving Capitalism from Wall

Street—and Washington’’ was about the financial crisis of 2008 and

was published in November 2009.

David Arthur Skeel is the S. Samuel Arsht professor of corporate

law at the University of Pennsylvania Law School. He is the author

of ‘‘Icarus in the Boardroom’’ published in 2005 and ‘‘Debt’s Dominion: A History of Bankruptcy Law in America’’ published in 2001,

as well as numerous articles and other publications.

Eileen Norcross is a senior research fellow with the Social

Change Project and the lead researcher on the State and Local

Public Policy Project. Her work focuses on the questions of how societies sustain prosperity and the role civil society plays in supporting economic resiliency. Her areas of research include fiscal

federalism and institutions, State and local governments and economic development.

Iris J. Lav is a senior adviser with the Center on Budget and

Policy Priorities. Prior to joining the Center, she was associate director of public policy for the American Federation of State, County

and Municipal Employees and senior associate at a consulting firm.

Thank you all for being here today. Members will have 7 days

to submit opening statements for the Record. It is the policy of this

committee that all witnesses be sworn in before they testify.

Will you please rise and raise your right hands?

[Witnesses sworn.]

Mr. MCHENRY. The record will reflect that all answered in the

affirmative. Thank you. And we will certainly begin, Ms. Gelinas,

with you. You will have 5 minutes to give your opening statement.

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At 1 minute remaining, the yellow light will come up. If you could

summarize your opening statements, everyone has that for the

Record, and we will begin with you.

STATEMENTS OF NICOLE GELINAS, SEARLE FREEDOM TRUST

FELLOW, MANHATTAN INSTITUTE; PROFESSOR DAVID

SKEEL, S. SAMUEL ARSHT PROFESSOR OF CORPORATE LAW,

UNIVERSITY OF PENNSYLVANIA LAW SCHOOL; EILEEN NORCROSS, SENIOR RESEARCH FELLOW, SOCIAL CHANGE

PROJECT AT THE MERCATUS CENTER; AND IRIS LAV, SENIOR ADVISOR, CENTER ON BUDGET AND POLICY PRIORITIES

STATEMENT OF NICOLE GELINAS

Ms. GELINAS. Yes. Good morning, Chairman McHenry, Ranking

Member Quigley, members of the subcommittee. Thank you for inviting me to testify today on this important topic.

Congress is right to worry about the choice between bailing out

States and watching as they risk repudiating their long-term obligations to bond holders and other creditors, including union members. The good news is that Congress can still act to avoid this difficult choice. The bad news is that a State bankruptcy statute is

not going to be the answer. Sometimes arriving at a solution means

eliminating the bad solutions. So I will talk for a few moments

about why State bankruptcy is not the answer and talk for my remaining moments about what are some of the answers.

Proponents of a bankruptcy statute for States say that special interests have taken over the State budgeting process, that there is

no prospect of States getting their long-term pension obligations,

health care obligations to retirees and debt obligations under control absent an external force outside the State political process.

Proponents believe that this could be the external force. In this scenario, States could threaten bankruptcy to wring concessions from

their creditors, particularly labor unions, changing future pension

benefits, health care benefits, and the like. Bondholders who would

be worried about this prospect would force States to do this before

they get into a crisis situation.

As a practical matter, though, bankruptcy is unlikely to help

States solve their fiscal problems and actually would add new problems. One reason is how States have structured their bond obligations. When many people think of money that a State owes, they

think of a State’s general obligation bonds, bonds against which the

State has pledged its full faith and credit to pay back its debt.

States do not issue only general obligation bonds, though. They

issue bonds through hundreds of public authorities. New York

State, for example, owes nearly $80 billion in debt, only about $31⁄2

billion of that is through general obligation debt. The remainder is

through hundreds of these public authorities, special purpose vehicles and so forth. Each of these authorities is its own corporation.

It is not an agency or an arm of the State. It has its own board

of directors, its own covenants with bondholders, its own legal and

contractual agreements with not only bondholders, but employees

and retirees.

There is no practical way for a State to pool all of this debt together in one place along with pension and health care obligations

15

handed over to a judge and pare it back, at least not without violating thousands of preexisting covenants, contracts with bondholders and State laws. And this gets to Congressman Quigley’s

points that the Congressman made in his opening statements,

changing the rules mid-game would affect not only States that

have gotten themselves into trouble with their own decisions, such

as New York, California, Illinois and New Jersey, but also States

that are not running these long-term deficits.

Introducing a bankruptcy statute would force bondholders to all

States to question the legal regime. It would take many months to

sort out the uncertainty. During those months, it is quite likely

that States would have to pay more on their debt.

Another practical problem with bankruptcy is that States are not

like corporations where one person can be authorized to speak for

the State. In a corporate bankruptcy, you have a CEO, an agent

of the CEO and a small board of directors all speaking as one. In

a State bankruptcy, hundreds of State lawmakers could not give

their power to a Governor to speak in one voice. If bankruptcy

would not eclipse the normal processes of democracy, you would

still have hundreds of lawmakers speaking in different voices before a judge, no way for a judge to simply take over this process

of democracy solve a State’s obligations from on high.

Another problem is that States do not owe pension benefits for

the most part. States administer pension benefits on behalf of local

governments, cities, towns and school districts. So bankruptcy for

the State would not take care of pension obligations. Municipalities

can do that through changes in State law, require changes in State

law but municipalities can already declare bankruptcy if that is a

way for them to deal with their pension obligations. So this does

not add a benefit to municipalities who owe pension and health

care benefits.

What are some of the other solutions that Congress can look to

to help States and municipalities pare back their benefits? One

thing is making sure to States that Congress understands that

States already have the tools to deal with these things themselves.

States can change their laws that govern pensions. States can

change their laws that govern contracts, health care benefits. They

do not need to look to Congress to do this for them.

And with that, I will conclude my opening remarks. Thank you.

Mr. MCHENRY. Thank you, Ms. Gelinas.

[The prepared statement of Ms. Gelinas follows:]

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Mr. MCHENRY. Mr. Skeel.

STATEMENT OF DAVID SKEEL

Mr. SKEEL. It’s a great honor to appear before you, and I’m

tempted to say everything that Nicole just said, ‘‘not.’’ Not exactly

that. But I will just make one comment at the outset, and that is

we have lots of experience dealing with complicated bankruptcies.

So the fact that it is a multitude of entities is not news in the

bankruptcy context. I’d be happy to address questions about that

or either of the other issues that were just raised if folks are interested.

Currently, if a State’s functional crisis spirals out of control, we

really only have two options: The first is that a State might simply

default on some of its obligations, declaring itself unable to pay.

The second option is for the Federal Government to bail out one

or more of the States as it bailed out financial institutions like

Bear Stearns, Fannie Mae, Freddie Mac and AIG during the recent

financial crisis. I believe that both of these alternatives are deeply

problematic and that Congress should enact a bankruptcy law for

the States, not as a first resort, but as an absolute last resort in

the event that everything else fails.

The claim that we don’t need a bankruptcy law for States strikes

me as a little bit like saying there’s no need for a fire department

because most homeowners have never had fires in their houses, if

and one starts the homeowner can probably stop it before the crisis

gets out of control. Each of these things is true, but we still need

fire departments for the rare case when a fire does burn out of control.

In the remainder of my discussion, I would like to make three

simple points: First, bankruptcy would provide several enormously

important benefits that we don’t have in the absence of bankruptcy. Second, it is constitutionally permissible, in case you all are

concerned about that, as well you should be. Third, the law could

be tailored to address any particular concerns you might have

about things like it being too easy for a State to file or there be

the bankruptcy law being too harsh for particular kinds of constituencies.

So let me say, to the extent I have time, a brief word about each.

First the benefits that bankruptcy would provide for a troubled

State. One of the main benefits bankruptcy would provide is a way

to restructure some kinds of obligations that probably can’t be restructured outside of bankruptcy. And I would include pensions in

that. There are real limits on what can be done with pensions outside of bankruptcy. I would include bonds in that category as well.

The other huge benefit of bankruptcy is if it is necessary as an

absolute last resort, is it brings everybody to the table. We don’t

just have one or two constituencies that get singled out to make

sacrifices. We get everybody to the table, and we ask how can we

distribute the sacrifices so that it makes sense and we can put our

finances on a fiscally sustainable course.

My second point is that bankruptcy is fully constitutional, even

with respect to States. All that needs to be done there, there are

genuine State sovereignty concerns, and they need to be honored,

but they can be honored so long as we make sure the bankruptcy

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law is entirely voluntary, meaning that a State couldn’t be thrown

into bankruptcy against its will, and the bankruptcy law would

also need to ensure that State decision, governmental decisionmaking functions were not interfered with. All of these are things

we already do with respect to municipal bankruptcy.

My final point is that the law can be tailored to deal with any

concerns you may have. A lot of the discussion, a lot of the criticism of State bankruptcy seems to assume there’s only one possible

State bankruptcy law we can have, and it’s going to require us to

cut everything down to zero. That’s not the case. If you’re worried

about States being too anxious to file for bankruptcy, that there

will be strategic use of bankruptcy, I think that is a not really a

serious worry. But if you are worried about it, all you have to do

is put some entrants requirements on bankruptcy. We already do

this with municipal bankruptcy.

If you’re worried about the bond markets, you’re worried the

bond markets are going to be concerned because they’re afraid that

bonds are going to be written down to zero, you put restrictions as

a prerequisite to doing anything with bonds.

So the final point is simply that we can tailor the bankruptcy law

to address any concern we may have. My bottom line is bankruptcy

is not a perfect solution. It would be messy. It is an absolute last

resort, but it’s better than the other last resorts which are States

simply defaulting on their obligations or a Federal bailout.

Mr. MCHENRY. Thank you, Mr. Skeel.

[The prepared statement of Mr. Skeel follows:]

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Mr. MCHENRY. Ms. Norcross.

STATEMENT OF EILEEN NORCROSS

Ms. NORCROSS. Chairman McHenry, Ranking Member Quigley,

and members of the subcommittee, thank you for inviting me to

testify today on this important topic. The recent recession exposed

several longstanding problems in State budgets that, if left

unaddressed, the underlying causes for these short-term budget

gaps, including public sector pension benefits and the rising cost of

health care, are certain to worsen States’ prospects for stability and

economic growth. But with reform today, States can mitigate the

worst while meeting their promises to employees and taxpayers.

The recent downturn is only one cause for recent State budget

gaps. State and local spending has grown faster than States’ own

source revenues and the private economy over the past several decades. The fastest growing area of State budgets is Medicaid. States

have avoided showing deficits in part due to Federal funds, and an

increasing reliance on debt finance, and in some cases, by deferring

their contributions to pension systems, not funding health care

benefits or borrowing to make pension payments. These techniques

help States show balance, grow spending and pass the costs on to

the future.

Without any changes, GAO anticipates State and local governments will require an annual and sustained reduction in spending

of 12.3 percent or an equivalent increase in revenues between 2009

and 2058, to close a projected $9.9 trillion fiscal gap.

In addition, State and local governments face a large funding gap

in their pension systems. Governments report the unfunded liability for State and local pensions at $1 trillion but economists estimate it closer to $31⁄2 trillion.

According to government accounting standards, the discount rate

used to value plan liabilities may be based on what the assets are

expected to return when invested, an average of 8 percent annually. This violates economic theory which says the value of the liability is independent from how it is financed. Choosing the discount rate requires matching that rate with what’s being valued,

in this case, a public sector pension which is safe, government

guaranteed and thus should be matched with a rate that reflects

that safety, such as the yield on Treasury bonds, currently at 4

percent.

The circular logic of government pension accounting standards

has had several consequences for pension funding. It has lead to

the undervaluing of pension promises and amount necessary to be

set aside to fund the promise, plans have been encouraged to embrace more investment risk, including increasing their risk exposure after the recent market downturn to make up for losses.

Union leaders and politicians in negotiations in the 1990’s when

the market was booming, often boosted benefit formulas because

plans looked overvalued on paper. Governments have also, as mentioned, deferred payments to the system and issued bonds.

When are plans likely to run out of assets? Economist Joshua

Rauh of Northwestern University estimates under the generous assumption, the State’s own assumption, of an 8 percent annual return on pension assets that by decade’s end, eight States will run

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out of assets to pay their beneficiaries. Illinois will require $11 billion annually beginning to 2019 in this scenario. New Jersey will

require $10 billion annually in 2021.

A less dire scenario is offered by the Center for Retirement Research at Boston College to remain funded by 2014, Illinois will require 13 percent of its budget to ensure fund solvency, New Jersey

will require 121⁄2 percent of its budget. This requires choices these

States have, to date, have avoided making. Other economists and

actuaries have reduced equally dire scenarios as Dr. Rauh. But ultimately I stress it is incumbent upon State Governors and treasurers to ask actuaries to stress test their pension systems under

a range of assumptions.

I believe the biggest impact the Federal Government can have in

helping the States is in the area of Medicaid reform and mandate

relief. For State pensions, I have two recommendations, first, transparent and accurate accounting. Governments must stress test

their pension systems and model the cash-flows to determine what

will be needed to set aside to pay these promises. These scenarios

should include the risk free discount rate as recommended by

economists. The data, method and assumptions should be made

available to the public.

Second, stabilize public sector pension systems, to pay what has

been promised by minimizing the burden on taxpayers, States

should consider freezing and reducing the cost of living adjustment

in current defined benefit plans, increasing the retirement age, increasing contributions from workers and importantly close the defined benefit plan and move workers to defined contribution plan.

The last reform will allow workers more flexibility, shift risk

away from taxpayers and end the political and fiscal manipulation

of worker benefits which has turned what was supposed to be a

safe investment for public sector workers into a gamble for both

employees and taxpayers. Accurate accounting will enable States to

know the tradeoffs necessary today and delay will only ensure

what is a big problem turns into a crisis by decade’s end. Thank

you. I look forward to your questions.

Mr. MCHENRY. Thank you, Ms. Norcross.

[The prepared statement of Ms. Norcross follows:]

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Mr. MCHENRY. Mrs. Lav.

STATEMENT OF IRIS LAV

Ms. LAV. Mr. Chairman, Mr. Quigley, members of the subcommittee, thank you for the invitation to appear before you today.

I believe that predictions that States throughout the country will

have to bail out localities or that the Federal Government will have

to bail out the States are substantially exaggerated, and I think

they are producing unnecessary alarm among policymakers and the

public at large.

I would like to untangle some of these claims today about cyclical

issues, bonds and pensions.

First, cyclical issues. States are projecting large operating defi- cits as you said of about $125 billion for the 2012 fiscal year, which

begins in July in most States. Unemployment remains high. Revenues remain below pre-recession levels, and there is rising demand

for public services due to the weak economy and growing population. Figure one please. Moreover, the fiscal relief provided

through the American Recovery and Reinvestment Act in 2009 is

ending. That’s not mine. That’s someone else’s.

It has been enormously helpful in allowing States to avert potential budget cuts and tax increases. States have used the fiscal relief

to cover about one-third of their budget shortfalls through the current fiscal year, but only about $6 billion will be available for next

year, covering less than 5 percent of these shortfalls.

As difficult and painful as the choices are, States and localities

will balance their upcoming budgets through budget cuts, tax increases and use of reserve funds. That’s what they do. And remember, it’s a cyclical problem that will shrink in size as the economy

continues to recover and State revenues continue to grow.

Second, bond. So there’s no credible evidence of a bubble or crisis

in State and local bonds.

If we could go to figure 3 please.

First interest payments on State and local bonds absorb just 4

to 5 percent of current State and local expenditures, no more than

they did in the 1970’s. And the historical default rates since 1970,

through several recessions, has been about one-third of 1 percent.

Finally, there’s no large increase in bond issuance nor are their

exotic securities that hide the underlying value of the assets

against which the bonds are issued, as was the case with the

subprime mortgage bonds.

Third, pensions, which, of course, is a little more complicated.

There are shortfalls, we all said, in pension funding for future

State and local retirees. States will have to address them over the

next three decades or so.

Figure 4 please.

Pensions were fully funded in 2000 before the last two recessions

using standard accounting. The recessions reduced the value of assets and some jurisdictions didn’t make the required deposits. So

as was mentioned, the Center for Retirement Research at Boston

College finds that States and localities have about $700 billion in

unfunded liabilities. That implies they have to increase their contributions on average over the next 30 years from about 3.8 percent

of budgets to 5 percent of budgets. Now that’s on average, it’s not

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Illinois. But changes to pension plans could reduce that cost, and

3.8 percent to 5 percent is not a crisis.

The major controversy is over whether these traditional account- ing standards are appropriate. And that $3 trillion number which

comes from economists who measure future costs assuming a riskless rate of returning such as in Treasury bonds about 4 percent.

Figure 5 please.

But pension funds do invest in a diversified basket of private securities. The average historical rate of return has been about 8 percent, as you can see in that chart. It may or may not be a little

lower going forward, but it’s quite unlikely to be just 4 percent. So

the $3 trillion numbers of construct doesn’t represent the amount

that pension funds have to invest to meet their obligations. The

States in trouble are basically those that skipped their payments.

To summarize, cyclical problems are serious but will abate as the

economy improves. The muni bond market is not in a bubble or in

danger of experiencing widespread default, and pensions need attention but in most cases are not in crisis.

I see no need for Federal intervention in these areas. States do

not want or need the power to declare bankruptcy. Nor is there a

need, as Mr. Nunes has suggested, for Federal legislation to require States and localities to report their pensions on a riskless

rate as a condition for issuing tax exempt bonds. And I should note

there’s a process going on in the Governmental Accounting Standards Board to reform already going on 2 years to reform the way

pensions are reported and to put all States reporting on the same

basis which would be a transparency improvement, so you could

see what’s going on and to have a reasonable actuarial method for

reporting and Mr. Nunes’s proposal would short-circuit that. Thank

you.

Mr. MCHENRY. Thank you, Ms. Lav. I certainly appreciate that.

[The prepared statement of Ms. Lav follows:]

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Mr. MCHENRY. And we will begin the questioning with the vice

chair of the subcommittee, Mr. Guinta of New Hampshire.

Mr. GUINTA. Thank you very much, Mr. Chairman, and thank

each of you for coming and testifying before us today. I have a couple questions for each of you so I’m going to try to be quick. First

with Ms. Lav. You had stated that there is no impending or looming crisis at the moment. I guess the first question I would have

is how would you define a crisis if what we are seeing with the

States and their obligation requirements at the levels they are at?

How would you define a crisis?

Ms. LAV. I would define a crisis as something States had no way

of digging themselves out of. States have many, many tools in

which to do this. So if you have to raise your pension contributions

from 3.8 percent of expenditures to 5 percent of expenditures,

that’s probably, you can accommodate that within budget particularly after the economy recovers. And certainly, they are cyclical

deficits. States are finding ways to close those cyclical deficits. We

don’t appreciate some of a lot of the budget cuts States are making

which are harming low income people and residents, but that’s

what they do. States have balanced budget requirements and that’s

what they do. They manage their finances.

Mr. GUINTA. I think the concern that I and others share is that

as States ‘‘manage their finances’’ they are spending an extraordinarily higher amount of money percentagewise of borrowed dollars to get us through these ‘‘lean or challenging’’ economic times.

My State of New Hampshire has done that to pay expenses, New

Jersey has done that to pay expenses, which is not either good

GASB accounting standard practices, or it is just not good business

standards of practice. And I don’t know that you had a chance to

touch upon it in your verbal remarks, but I note that in your written remarks, you talked about the GASB standards. My concern is,

at some point, there is this potential of States wanting to come to

the Federal Government for a ‘‘bailout’’ because of what they define

as an economic challenge that they’re having.

I would argue something a little bit different. Any responsible

Governor, legislature or administrator should be anticipating these

challenges, and it doesn’t appear that has been done in a responsible way.

So I understand your point. But can you speak to those States

that are borrowing money essentially to pay for ongoing expenses?

And I’m not even talking about stimulus money they have received.

I’m just talking about borrowing money.

Ms. LAV. Very few States borrow for operating expenses. Illinois

has borrowed a number of times, floated bonds to make its pension

contributions, which is very bad practice.

By and large, States borrow money for infrastructure, and you

don’t see in the data any substantial run-up in borrowing as a percent of gross State product. We have a chart there that I provided

some information to you behind my testimony some graphics and

State-by-State information on that. You don’t really see any runup in borrowing. It isn’t good practice for States to borrow to pay

their operating expenses. They should borrow for infrastructure,

because that is what makes sense to do economically. So we don’t

approve of borrowing for operating expenses usually. And in the

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longer paper that I refer to in my written testimony, we do have,

the whole last section does suggest that States do have, as I believe

Mr. Quigley referred to in Illinois, some structural deficits and mismatch between their expenditures and their revenues and part of

that, and they do need to take some steps to fix those mismatches.

There is no question about that. But a lot of that mismatch comes

from the rate of growth of health care costs in the economy. States

spend a lot of their money on health care, and health care costs are

growing faster than the economy, all throughout the economy in

the private sector and in the public sector and so States which

have revenues that very often go somewhat slower than the economy because of the structure of their tax system have a very hard

time meeting their responsibilities to provide health care to those

people in the States that need it, the elderly and the disabled and

the poor.

Mr. GUINTA. I would agree that States need to better manage the

pie in the budgetary challenges they are having. But it sounds like

you are making an argument now for bankruptcy when in your

comments, you suggest that it’s not necessary at this point because

of the looming fiscal challenges that they’re having.

Ms. LAV. They don’t need bankruptcy to fix these problems.

Mr. GUINTA. I do want to ask Ms. Norcross if you would be able

to comment a little bit on the testimony we just heard.

Ms. NORCROSS. I would like to explain the discount rate controversy a little more than by way of analogy and it’s important because it has informed decades of policy within the pensions systems, which I believe we are seeing the results of that today. And

the analogy is this, the reason you can’t choose a discount rate

based on what you think your assets will return to value the liability is, if you consider you have a mortgage and you have, let’s say,

a mutual fund, your broker says, we think, I think you’re going to

return 10 percent annually on your mutual fund. That doesn’t enable you to slice your mortgage in half. The bank doesn’t send you

a different mortgage statement based on that.

So what that circular logic has produced over the years and certainly, yeah, in the 1980’s and the 1990’s some of these pension

plans looked fine, A, they have undervalued the size of the promise

so they’re sort of expecting that rate of return will be taking care

of the necessary contributions that they should be making to fund

the system.

And No. 2, when plans look overfunded on paper, it led some

States to grant these really generous benefit enhancements without

even doing the math. In New Jersey, in 2001, the State granted a

9 percent benefit increase and didn’t even figure out what it would

cost them. And that’s one of the areas the Governor is trying to address right now.

And remarkably, it violates another principle, which is you can

secure a guaranteed investment with a high risk stream of investments, and in the short term, you’re going to realize more volatility

in your investments, and yet that promise is due within 15 years.

So they’re basically trying to secure a guaranteed pay-out with

a high-risk investment, and that is the flaw of logic. But Joshua

Rauh, in his paper, he uses the 8 percent discount rate. And he

says even that, even if we grant you that, we’re looking at funds

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starting to run out of assets with 3 percent revenue growth by the

end of the decade. New Jersey’s actuaries also released a paper on

their new reports on Friday using the 8.25 discount rate and they

say we have 12 years in the police officer’s plan. So I hope those

comments help.

Mr. MCHENRY. I thank you for your testimony. The gentleman’s

time has expired. At the request of the subcommittee ranking

member he is deferred to the full committee ranking member.

Mr. Cummings, you are recognized for 5 minutes.

Mr. CUMMINGS. Thank you very much, Mr. Chairman. I want to

thank you and our ranking member, and I thank you for working

in a bipartisan way to address this problem.

Ms. Lav, it is interesting after listening to the vice chairman of

our subcommittee speaking just a moment ago, I find it interesting

that the National Governors Association, that is, Republican and

Democratic Governors through their chairmen and vice chairmen,

said this on February 4, 2011: ‘‘Allowing States to declare bankruptcy is not an authority any State leader has asked for nor would

they likely use. States are sovereign entities in which the public

trust is granted to its elected leaders. The reported bankruptcy proposal suggests that a bankruptcy court is better able to overcome

political differences, restore fiscal stability and manage the finances of a State. These assertions are false and serve only to

threaten the fabric of the State and local finance.’’

Ms. Lav do you agree with these Governors that the State bankruptcy proposal threatens the fabric, and these are their words of

State and local finance? Can you be brief please? I have several

questions.

Ms. LAV. Yes, I do agree. States have all the tools they need to

manage their finances. Occasionally, one State doesn’t, but they

have the tools they need.

Mr. CUMMINGS. And what would you recommend as to how those

States might improve their fiscal situations?

Ms. LAV. I think there are many ways that States can improve

their fiscal situations. They can move to taking a longer term look,

many of them only look 1 year ahead or 2 years ahead. They can

improve their revenue systems and be sure their revenues match

with their expenditures. They can have processes in place where

there are consequences of skipping a pension contribution, which

has caused a lot of the problems we are talking about today.

There are many things that they can do to make it clearer to policymakers and the public about their own situations and allow

some oversight. But I think that States themselves have the ability

to do that, and that this recession has just been so very long and

so very deep that some of the flaws have become apparent, but it’s

not going to be forever, and I think they will adjust their revenues

and their expenditures to manage these problems.

Mr. CUMMINGS. Our House Budget Committee chair, Paul Ryan

and the Republicans proposed cutting the Federal budget domestic

discretionary non-military non-security spending approximately

$40 billion this year and much more in the future. Wouldn’t this

significantly worsen the State and local governments’ fiscal problems because a lot of that money flows to the State, is that right?

Ms. LAV. Yes. That’s right.

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Mr. CUMMINGS. And this is no gift is it? It’s not a gift to the

States?

Ms. LAV. No. It’s not a gift. It’s a penalty for the States basically.

It is about a third of non-security spending that Mr. Ryan wants

to cut is our grants that flow through to State and local governments, and so depending we don’t have the exact number, but

somewhere probably between about, don’t hold me exactly to it, but

$10 and $13 billion would be money that the States would have to

scramble on top of their existing deficits, additional deficits they

would have to close because of these cuts.

Mr. CUMMINGS. Isn’t most underfunding of State pensions due to

recent dramatic declines in the stock market which hurt investment portfolios of almost all American investors including hedge

funds, regular working people, and probably most lawmakers and

staff, reporters and attendees here today, given the recent emerging recovery market up turn and projected future gains, don’t you

agree with the analysis expecting future long-term gains equally

over the next 30 years to smooth out today’s current problems?

And the reason why I raise this, and any of you all can answer

this, is that when the storm is over, I don’t want to see situations

where our employees, by the way a lot of them are working in this

room today, may have lost their pensions and now going to the

States, State pensions have been diminished, States come out of recovery, and then because some States fail to make their pension

payments on time, and you got to keep in mind the employees, they

pay, they have to pay, right? They have to pay.

Ms. LAV. Yes. The contributions come in on time.

Mr. CUMMINGS. So one of my concerns is when the storm is over,

then these folks have been locked out of a lot of money that they

were due. So I will start with you, Ms. Lav, and then maybe some

of the others may have a comment on that.

Ms. LAV. Of course the improvement in the economy and the improvement in the market will have a lot to do with improving the

outlook of pensions over time, and for most States, that have not

provided retroactive benefits without funding them or have not

seen a pension payment contributions in the past, they will be fine.

So the vast majority of States will be fine when that occurs, as that

occurs.

Ms. NORCROSS. I would say that the only reason why workers

may lose some of the benefits that are promised is because the investments have been treated as a gamble rather than secured as

they should have been secured. They’ve been misvalued and therefore the investment strategies have not been appropriate for the

plan. I share the view that what’s been promised has been promised, and that people have worked for this and they have contributed for it. I also caution, and as Ms. Lav mentioned, every State

pension system and every local pension system has a little bit

something different going on. We know about the worst funded

plans.

But I would caution that Josh Rauh’s paper is extremely important because again he is saying OK, I grant you 8 percent returns

and he shows you a time table of when if there is no change to policies, these plans can expect to run out of assets.

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Mr. MCHENRY. Thank you, Ms. Norcross. The gentleman’s time

has expired.

Mr. CUMMINGS. Thank you very much, Mr. Chairman.

Mr. MCHENRY. Thank you. I certainly appreciate that. And if I

could call up slide No. 1. This is a representation of the difference

between inflation, the 1950 baseline, the difference, the blue line

would be private spending increases since 1950 to now versus State

and local government spending increases in the red line. Private

spending has increased 5 times, but local and State government

spending has increased 10 times. So it’s not a question of a funding

shortfall, it’s a spending problem. Would you concur with that Ms.

Norcross?

Ms. NORCROSS. I would say that’s a big part of it yes.

Mr. MCHENRY. Now in terms of the discussion about public pensions, understanding the magnitude of the problem is one thing we

want to understand here today, if it is knowable. Ms. Gelinas, you

mention in your testimony a funding shortfall. Is there a range, is

there an agreement on what the funding shortfall is for public pensions?

Ms. GELINAS. Thank you, Chairman. There’s not an agreement,

a rough range would be $700 billion to $3 trillion as you can see,

that’s a large range. This involves predicting things that are very

difficult, really impossible to predict. You have to predict the performance not only of the U.S. stock market, but of global equity

and bond markets. You have to predict the course of future inflation and also predict how long people and their survivors are going

to live.

Mr. MCHENRY. Ms. Norcross, do you concur with that range?

Ms. NORCROSS. Yes, well, under a range of assumptions yes.

Mr. MCHENRY. What would——

Ms. NORCROSS. Meaning the $700 billion would be under the current assumptions of the 8 percent discount rate range. That’s why

advocating for stress testing the pensions and granting economists

how they would value the plan.

Mr. MCHENRY. What is the upward end?

Ms. NORCROSS. $31⁄2 trillion.

Mr. MCHENRY. OK. Now, to this point, Ms. Gelinas, is there a—

under current government accounting standards, is it sufficient? Do

we have enough transparency in understanding the unfunded liabilities of these State and local government pensions?

Ms. GELINAS. No, it’s not sufficient. I would advocate asking the

States and large municipalities to report the assumptions—report

the liabilities under a range of assumptions. Report it under a

lower what used to be called a risk free rate, maybe 3 percent annual return, report it under the 8 percent return if they like to continue to do that and allow investors to make up their mind.

I don’t think there’s a big—there’s a problem with disclosure, but

it is not the biggest problem because investors can do their own

calculations on these liabilities. We’ve seen Dr. Rauh and others do

it on their own. If the investors do not like what is reported, they

can simply not invest in the debt.

So again, we should have more disclosure. But the problem is not

that we don’t understand the magnitude of the issue. It is getting

the political will within States to change State constitutions which

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govern pension benefits for future workers, people who have not

been hired, change State laws governing collective bargaining,

wages, health care and so forth.

Mr. MCHENRY. Would you concur with that Ms. Norcross?

Ms. NORCROSS. I agree.

Mr. MCHENRY. That’s simple enough. That’s reasonable.

Are the government accounting standards for pensions similar or

dissimilar to what public companies are required to disclose? Ms.

Norcross.

Ms. NORCROSS. They’re a little bit different in private sector defined benefit plans, they do use something closer to a risk free rate,

and they’re valuable but different than the public sector plans.

Mr. MCHENRY. Ms. Gelinas, would you like to add anything to

that?

Ms. GELINAS. No.

Mr. MCHENRY. Wow. Going pretty smoothly. So in terms of, Ms.

Norcross, in your testimony, you discuss that State spending grew

faster than States’ own revenue sources in 47 States from 1977 to

2007. And to this point, can you explain the danger of States reporting budgetary imbalances when they are actually using Federal

funds and debt to fund these expenditures?

Ms. NORCROSS. I think that just highlights the pie and what’s in

the pie, so you have States’ own source revenue, you have Federal

funds debt and other, and a deficit if you’re just considering what

a State can support on its own, that can be papered over if you

then sort of discount that they’re getting Federal funds which can

stimulate sometimes greater spending or cause a State to need to

raise taxes to support that spending and also the rising use of debt.

And I agree that debt is not a very large portion of budgets,

we’ve seen some techniques recently where States will bond, they’ll

dump a trust fund bond to replace it and use that to balance the

budget. So maybe they’re not bonding directly for operating expenses, but they are.

Mr. MCHENRY. To that point, have States changed the nature of

what they use bonds for? The nature of rather than building a

road, are they changing it to plug a pension fund promise, has that

changed?

Ms. NORCROSS. We’ve seen more bonding for stuff like that. Also

the definition of capital can be pretty flexible.

Mr. MCHENRY. Thank you for your testimony. My time has expired. And now Mr. Quigley, the ranking member, is recognized for

5 minutes.

Mr. QUIGLEY. Thank you, Mr. Chairman.

So far the problems that we have seen with these States, these

8 or 10 States that are in particular trouble, seem to be self-contained. I would like to ask any one of you, if you can, what the potential systemic risk are. I guess if the last economic crisis taught

us anything is that everything is interconnected. In terms of the

market or what have you, if there is a big hiccup, and there certainly are threats with some of these States, defaulting or having

some other problem, missing payments and so forth, the impact on

other States, the impact on bond ratings, but also the bond market

itself. So while there may be only 8 to 10 States, that is 25 percent

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of the country’s population. What are the impacts on the rest of the

States?

Mr. SKEEL. I will jump in on that really quickly. I think the risk

of contagion is much less severe than it was in 2008 with the financial institutions. I think the bond markets know the difference between the States that are in real trouble and the States that are

not.

Mr. QUIGLEY. Do you think their investors do?

Mr. SKEEL. I do. I do.

I think we have to have some confidence in the ability of the

markets to make those distinctions. That is my first point.

My second point would be that a lot of the problems with the financial institutions was hot money. It was that they depended

really heavily on short term financing which was subject to immediate withdrawal. States are not subject to financing that is going

to disappear instantly. They have tax revenues coming in. They are

likely to be able to continue borrowing. So I think it is a very different kind of crisis.

Ms. LAV. It is possible to panic markets in the short term. Meredith Whitney has succeeded in doing that in the municipal bond

markets by claiming——

Mr. QUIGLEY. That is the first time the name was mentioned

today.

Mr. SKEEL. You violated our rule.

Ms. LAV. Sorry about that. But in the long run, people realize

what the fundamentals are and you can see that there is beginning

to be some improvements in that markets now that her comments

have been put to rest.

So I think that there are distinctions among States. You know,

the last time a State defaulted was in the Great Depression, and

even in the Great Depression, only one State, Arkansas, defaulted.

Only four cities or counties have actually defaulted since 1970. We

are talking, you know, I don’t think we are going to have a major

default crisis. I think that there will be ways. You are going to

have some sewer districts and some revenues bonds that were tied

to the housing bubble and so forth that are going to have trouble

paying, and those districts are going to have some problems, and

the States will probably step in, as Pennsylvania stepped in in

Harrisburg, and sort that out in a reasonable way. I just cannot see

a scenario of major default and contagion.

Ms. GELINAS. If I may add to that, I would say one issue that

risks courting a bond market crisis would be changing the statute

to allow for Federal bankruptcy because if I am a bond holder, and

for example, take New York’s Metropolitan Transportation Authority, an entity with $30 billion worth of debt, I have lent money to

this entity based on a long list of covenants, including a State law

that says that for as long as these bonds are outstanding, this entity will not declare bankruptcy.

That is what New York lawmakers have determined under the

democratic process. If there is any question that you have a new

Federal statute that would somehow supersede that, or this idea

that you could take away promises made to these bondholders to

give to bondholders or unions at another State entity, this risk

would take many months to sort out.

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I would also add maybe not the potential for an acute crisis that

we saw in September 2008, but the potential for the risk of losses

at banks where you don’t need a default for the market value of

these securities to decline. You’ve got more than $200 billion of municipal debt in banks, similar amounts in money markets and insurance funds. If banks worry that the value of these securities

have declined, they may pull back on lending to the rest of the

economy, again, not a crisis or panic, but makes the recovery more

difficult. The question is what are you getting for making it more

difficult. You are not getting much benefit because States have the

tools to fix these problems.

Mr. SKEEL. I would just add one brief response, and that is, this

is all assuming that the States wouldn’t default on these bonds. I

think the question we have to ask is what are the possibilities?

One possibility is no bankruptcy, they simply default completely.

Mr. QUIGLEY. Let me ask one other question to Ms. Norcross.

You talk about the rate of return and you advocate to reducing it

to what you judge is a much more realistic figure. The same sort

of question, a quick shift from perhaps 8.25 to 8.4 would have to

have some sort of impact, pretty traumatic obviously from a fiscal

point of view and how much the contributions would have to be increased, but also within, again, the market that looks at this,

would you see this being done through a slower period of time, an

adjustment period, or how would you see that work?

Ms. NORCROSS. Well, I agree with what Ms. Gelinas said, you

should probably grant a range of assumptions. But the liability is

the liability. So simply targeting a rate that makes it look a little

bit better, it only masks over the underlying reality of what is

owed. Also, if you’re going to pay this out over 15 years, my concern is that in cases like Illinois where they are going to take on

more risk in their investment strategy to make up for what was

lost. So that is why I would caution you.

Mr. MCHENRY. I thank the ranking member.

Mrs. Maloney of New York is recognized for 5 minutes.

Mrs. MALONEY. I thank the chairman and ranking member for

organizing this important hearing and all of the panelists for their

thoughtful testimony.

I would like to gain a deeper understanding of the magnitude of

the challenge. I would first like to ask Ms. Norcross and Ms. Lav

to qualify and expand on a statement in Ms. Lav’s testimony where

you stated that States and localities devote 3.8 percent of their operating budgets to pension funding. First, I would like to know

where you got this number from, and is this an accepted number

universally. And if that, in fact, is the correct number, based on

this number, how can you suggest that public pension costs are the

large costs of the State and local financial problems. As we know,

we are just digging our way out from the great recession that has

impacted our entire country and there are many costs there. Could

you comment first, Ms. Norcross, and then Ms. Lav.

Ms. NORCROSS. I believe Ms. Lav gets that figure from the Alicia

Munnell paper, and that is what her estimate is on what States

have been contributing on average. So that would be all plans. She

estimates if you use the 8 percent discount rate, you would have

to raise that to 5 percent of budget on average.

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Ms. LAV. That is correct, we worked with the Boston College people, Alicia Munnell, using our expertise on State and local finance

to help them come up with that figure.

Mrs. MALONEY. So how can you suggest that this is the cause of

the local and State financial problems if the contribution is just 3.8

percent?

Ms. LAV. It isn’t. It isn’t the cause. Pension contributions come

from general funds. And the big deficit number is $125 billion that

you are hearing about, is a general fund number. But pension contributions, neither pension contributions nor interest on bonds are

the major component of that. The major component of the deficits

is the expenditure States have—Medicaid, health care and education and so forth. So that is why I said it is not a crisis to raise

from 3.8 percent to 5 percent in the way that the State budgets,

the State and local budgets are put together. You can do that over

time. It is not a big crisis.

You know, all of this talk about the riskless rate, that is one way

to look at it. The Munnell paper says you have to go to 9 percent

which would be a big problem if you use the riskless rate. But

there is a distinction between valuing the liabilities and how much

you have to deposit to make the pension whole. I would say that

those are two different things.

Mrs. MALONEY. Well, on the riskless rate that a number of you

testified on, I would like some clarification from it. Is it true that

this rate is different from what the private sector pension plans

use? Is it different?

Ms. NORCROSS. Private sector pension plans admit they have a

little more risk because the company can go bankrupt. They use

the corporate bond rate to reflect the risk.

Ms. LAV. It is higher than the riskless rate. The corporate bond

rate is, I don’t know, 51⁄2 percent, 6 percent, that they use.

Mrs. MALONEY. Why should there be a different rate for public

pensions and private pensions?

Ms. LAV. Well, because private pensions have to be a little more

conservative because a private company can go out of business and

then they dump their liabilities for their pensions on the Public

Benefit Guaranty Corp. So ERISA, so the Federal Government,

doesn’t have to bail out the private corporation and pay those pension liabilities, insists that it uses a more conservative rate. But a

public entity is not going out of business, and the public entity has

taxing power and can adjust its taxes and expenditures. It is going

to be an ongoing entity. You know, there have been GAO reports

and other observers, most people who look at this say you do not

need as stringent standards for a public entity as you do for a private.

Mrs. MALONEY. So would the riskless rate increase the perceived

pension shortfall?

Ms. LAV. Yes, substantially.

Mrs. MALONEY. How does it increase it?

Ms. LAV. Well, 60 percent of pension assets come from return on

assets, from investment income. So if you are going to say you only

are going to get 4 percent on that investment income, and you are

projecting that 30 years into the future, you make up a much larger hole that you have to fill. But if you say you are going to get

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4 percent and you continue to invest in equities, you are saying

something that is not true. And you are sort of saying you have to

overfund the pension in the front end because you are saying it is

only going to be 4 percent, but if you get 7 or 8 percent, you are

actually going to have more in it. That will be, I hate to say it, but

it could end up with even more temptation for an overfilled pension

fund to not have consistent contributions every year.

It is much more realistic to say what you are going to gain and

consistently contribute the amount you need rather than having

the feast or famine.

Mrs. MALONEY. My time has expired, but would anyone else like

to comment?

Ms. NORCROSS. I would just like to add, if I may, the logic behind

that discount rate has again to do with the safety or risk of what

you are valuing. And so a private sector plan reflects some of the

risk involved that a company can go out of business; whereas the

government is guaranteeing 100 percent saying you are going to

get paid.

Again, the long time horizon gets back to the idea you have 15

years in which the majority of your obligations come due, and you

are securing that with high volatile investments where you are

lessening the likelihood that the money will be available to pay it

out.

Ms. GELINAS. If I can comment as to the magnitude of pension

liabilities, the reason they don’t show up as much at the State level

is because these are the responsibility often of the local governments. They are set by State law but paid by the locality. For example, New York City will pay about $81⁄2 billion in pension obligations this year. That is more than 10 percent of the entire budget,

including Federal funding for the city. So it is a much bigger problem at the local level than the State level.

Ms. LAV. My figures were State and local.

Mr. MCHENRY. Thank you.

Mr. Quigley is recognized for a unanimous consent request.

Mr. QUIGLEY. Mr. Chairman, I ask unanimous consent to enter

into the record a statement from the Governor of the State of Massachusetts.

Mr. MCHENRY. Without objection, so ordered.

Mr. Cooper is recognized for 5 minutes.

Mr. COOPER. Mr. Chairman, I would like to ask unanimous consent to insert into the record an article by Jeb Bush and Newt

Gingrich in the Los Angeles Times entitled ‘‘Better Off Bankrupt.’’

Mr. MCHENRY. Without objection.

Mr. COOPER. I think in finance hearings, it is really important

to keep things simple. To my understanding, almost 80 percent of

municipal bonds are owned by individuals in some form; is that

your understanding? These are more widely held?

Ms. LAV. The tax exempt bonds, yes. I’m not sure about the others.

Mr. COOPER. Yes, the tax-exempt bonds.

And what most investors hate is a nasty surprise, a down side

surprise. So in markets that function well and you have transparency, you have a heads-up on oncoming bad news, people are

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usually less alarmed. I want to ask a couple of questions about the

transparency of these markets.

What are we missing today comparing these obligations between

States that would enable an investor, an individual investor, to better evaluate these investments? It is my understanding that some

of these get packaged up in bond funds and they just want a tax

break. That is the way they diversify their risk, but you don’t want

that bond fund to be harmed either. What are we missing in terms

of transparency between the States?

Ms. LAV. With respect to bonds, I don’t think there is anything

missing. I think the bond raters have a great deal of information

about the States and the financial analysts, and follow them very

closely. So I’m not aware of anybody complaining about the transparency of bonds among the States. Moody’s just put out a new

kind of analysis where they added together the outstanding bond

debt and the pension obligations so you could look at it in one

place. I think that is a good thing.

With respect to pension obligations, I think there is a problem

of not being able to look at State-by-State pensions on the same

basis.

Mr. COOPER. Exactly what are those problems?

Ms. LAV. They use different standards. There are a range of actuarial standards and it is pretty arcane as to how you measure future liabilities and so forth. And States can choose which ones they

want.

I mentioned at the beginning of this hearing that the Governmental Accounting Standards Board is very close to issuing a new

standard that no longer will allow that and that will require——

Mr. COOPER. Then after GASB has a new standard, we will have

an apples-to-apples comparison between the States?

Ms. LAV. I believe so, yes.

Mr. COOPER. On pension obligations?

Ms. LAV. Yes.

Mr. COOPER. Do all the panelists agree with that?

Ms. NORCROSS. I believe that is so.

Mr. COOPER. So this is pending, it is about to happen, it doesn’t

require legislation?

Ms. NORCROSS. If I might clarify, is that a rule that is going to

require them to use the ABO versus the PBO, or are you referring

to GASB 25? Because GASB is also working on the discount rate

rule, but I don’t think that they have solved that problem.

Ms. LAV. Yes, they are looking both together.

Mr. COOPER. So in the next few months, we will have greater

comparability between the States so an investor, an individual investor, can evaluate the risk involved in the most complex aspect

of this which is valuing pension obligations?

Ms. LAV. That is my understanding. Of course, they haven’t put

out the final rule yet; but they are working on it.

Mr. COOPER. Are all of the panelists equally hopeful that GASB

is about to do this positive step?

Ms. NORCROSS. I know they are looking at it, so I am hopeful.

Ms. LAV. They have taken all the comments. They had a draft

rule in September, and they are very far down the line.

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I think it is appropriate because all of the stakeholders have had

a chance to comment. It is not something that is being imposed by

fiat. Various people object to various parts of the rule, but it is

going to be a standard rule, and better than the one we have.

Mr. COOPER. So does the Manhattan Institute and the University

of Pennsylvania Law School concur in this?

Mr. SKEEL. I’m not following this that closely, so I will be agnostic on this.

Ms. GELINAS. I will be as well. I have no prediction on how they

will come out.

Mr. COOPER. You mentioned earlier rating agency analyses. The

rating agencies don’t have the credibility that perhaps they once

had prior to the housing crisis. Are the rating agencies on top of

these developments between and among the States and municipalities?

Ms. LAV. I think they are. There are rating agencies, and then

there are a whole host of other financial analysts out there that

specialize in looking which are not the rating agencies, which I

agree have lost some credibility, who look at this and who have

specialists who spend all of their time looking at State and local

finance. I mean, I think they have a pretty good handle on what

is going on.

And to the one, which I cite in my report, they are saying there

is no major chance of a contagious default. If there are a couple

extra defaults, they are likely to be in small things, like sewer districts and not in major areas.

Mr. COOPER. I see that my time has expired. Mr. Chairman, I

thank you.

Mr. MCHENRY. I thank the gentleman.

If it is OK with the panel, we have an opportunity to go for a

second round of questions if there are no pressing concerns this

morning. So with that, I recognize myself for 5 minutes.

So the definition of default is to fail to fulfill a contract, agreement or duty. To fail to perform, paying or make good. So if we

look at default in the bond market, does the bond market define

that narrowly which is to make good on your payment to me, or

can we as policymakers define it more broadly, which is failure to

fulfill an obligation to the people you are serving, to pension holders, for instance, and not being able to pay pension holders? Or

could it be not making good so you have to sell a city or State asset

in order to pay bondholders, which is an interesting piece here. But

beyond that, as Federal policymakers, are we making the matter

worse through our transfer payments to the States? There has been

some point of reference in testimony here today that is, in fact, the

case. Ms. Norcross, your written testimony includes some discussion of this. But to the tune of hundreds of billions of dollars a

year, there are Federal transfers to States. There are also Federal

mandates on the States that are cost drivers to government. Can

you touch on this and the implications it has obviously for the bond

market and indebtedness of the taxpayers.

Ms. NORCROSS. Well, of course the most well-known maintenance

of effort would be currently with the Medicaid requirements on the

States. And there are many other grants and aid that are handed

out to the States that occasionally come with maintenance of effort

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requirements or may encourage that municipality or government to

need to raise taxes to support the spending.

I don’t know if I answered your question.

Mr. MCHENRY. You did.

Now, there are certain States that are in difficult fiscal situations. I know some research has been done on this. So does that,

the difficulty of policymakers to balance the budget, does that have

a bearing on their credit rating? Certainly it does, one would believe.

Ms. Gelinas, in terms of your discussion of various sub-groupings

of the State, not the general obligation bonds, but obviously the

dormitory authority or a road authority, does that have a bearing,

the State revenue sources, whether or not they are sustainable?

Can you touch on that?

Ms. GELINAS. Sure it does. Without saying whether or not the

ratings agencies are right or wrong, either on the broad issues or

narrow credits, the ratings agencies do have a good understanding

that each bond is different even at the State level.

So California, for instance, they have said very clearly paying

debt service on general obligation bonds, this is one of two top priorities for the State. That even if California has massive budget

deficit, they pay these bonds first before they pay anything else. So

ratings agencies look at that, see the structure of the law and

precedents, and that goes into the analysis.

Other States it may not be as high a priority, but it is a very

high priority in every State. And then when you look at things like

bonds that are tax secured where the State has said we pledge this

sales tax to pay bonds before we use the sales tax for anything else.

That is actually higher than a general obligation bond. That gets

AAA ratings in a lot of cases because of that.

So you have to look at each of the payment streams, the character of the State, the willingness of the State to pay the debt. And

sometimes, frankly, the willingness of the State to make bad decisions.

We saw in Illinois, the State raised taxes to give comfort to the

bondholders. So trying to get more market discipline in getting the

bondholders to care more about the fundamentals, it doesn’t necessarily get you the good, long-term decision for the State. If the

response of the State is to raise taxes, it may make the long-term

situation worse, not better.

Mr. MCHENRY. I certainly appreciate that. And in today’s Wall

Street Journal, there is a story about this hearing, and they reference that California borrows billions of dollars each year to cover

seasonal shortfalls in its cash-flows. Illinois is proposing to issue an

$8.7 billion debt restructuring bond to pay past due bills, and a

$3.7 billion bond to make required pension contributions to its pension system.

There is a larger discussion here about whether these States will

be able to afford higher interest rates on these bonds following the

end of quantitative easing and the impacts that will have on their

pension fund gap. So I can just ask the panel to make comments

on that briefly, and we would certainly like to hear your testimony.

Ms. GELINAS. Right. Higher interest rates are certainly a risk not

having to do with the fundamentals of the municipal bond market,

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but also how do global investors feel about the prospects of inflation in the United States? If Treasury bond rates go up, it is likely

that municipal bond rates will go up at the same time.

Mr. SKEEL. I will just add those effects are likely and already are

disproportionately borne by the States that are in big trouble. So

California’s interest rate is much higher than other States’ interest

rates. That is what we would expect. And I think in the long run,

that is what we want. That is what we want the bond markets to

be doing.

Ms. NORCROSS. I concur with what Professor Skeel said.

Ms. LAV. I would distinguish those different things. California

issues revenue, and a few other States issue anticipation notes.

They pay them back within the same year. That is not borrowing

for operating expenses, it is just changing the timing of their borrowing; whereas the Illinois bonds are actually borrowing for operating expenses, which is a big distinction.

Of course, the expenses will go up if interest rates go up. And

as I showed, that total interest on bonds are, depending on the

source used to calculate, only 4 or 5 percent of total State and local

expenditures. So again, this is not something that is going to break

the bank if it goes up from 4 percent to 5 percent to 6 percent of

expenditures. It is on the margin. They will have to accommodate

it, but it is not going to break the bank.

Mr. MCHENRY. Thank you.

Mr. Quigley is recognized for 5 minutes.

Mr. QUIGLEY. Again, thanks to our panelists and the chairman

for participating in this. It is a very good first step by the chairman

and the committee on an important issue.

Before I ask you my last question, the thoughts for local governments, State and local governments, is, from my point of view, the

mission matters. We often hear so much that people don’t like government. But when it comes to local government, when they call

911, they want a fireman or an ambulance or a police officer to respond, and they want to know that when they cross a bridge, it is

safe.

So much of local government strikes so close to home. It is where

the wheels hit the streets. So what we are talking about today is

so important because poor financial management can put all of

those things at risk. So beyond the financial management dealing

with pensions and so forth, it is really the notion that governments

need to look at themselves and reinvent themselves. And I am not

just speaking as a Congressman, but I was a Cook County commissioner for 10 years. All local governments need to reinvent themselves, streamline and consolidate, not because they don’t matter,

but because they matter very, very much. So there is a lot at stake

here.

I want to commend the panelists. With one exemption, you kept

your bond that you weren’t going to mention the name, and shall

not be mentioned. But it is still a big question. The public wants

to know to what extent could there be significant defaults or significant bond defaults in the year 2011 or 2012?

Ms. LAV. I don’t think there will be a city or a county that defaults. I think there will be some defaults in special districts and

on revenue bonds. So, for example, in Florida, there were bonds

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issued for sewers in a development that never got built because the

housing bubble burst. Well, there is no way—you can’t pay back

those bonds because there is no sewer revenue coming in. There

are those kinds of things around the country that are going to be

a bit of a problem and there could be defaults or restructuring.

As the chairman said, the term ‘‘default’’ is being used in a number of different ways. I use it as you don’t make the interest payment on the bond, not that you find some other way to provide it.

Again, there are always some projects that go back in a bad economy. But I don’t think there will be any major, large city or county

that defaults. And I think by and large, that even for smaller ones

that the States will step in. And, you know, we have a control

board now in Nassau County, New York. We will see quite a number of control boards, I think, where States come in and impose

control boards on localities that are trouble and make them figure

out a plan for working their finances out.

Mr. SKEEL. I also don’t think there will be 50 to 100 defaults.

But I think it is really important to keep in mind we don’t know.

Probably 50 States will survive, but if only 48 States survive the

current crisis, we are in trouble. And I think we really need to plan

for that. We need to plan for surprises in a way that 2008 we had

not planned for surprises.

Ms. GELINAS. As a democratic people in each State, we don’t

have to wait for the bond market to make commonsense decisions

today. We know State by State and for the Nation as a whole, we

have to control our health care costs for public employees, as well

as other people as well; retiree pension liabilities. These are all

things that if we do not get a handle on them, we will not be building or repairing roads, bridges, transit because we are paying these

growing retiree costs. These are things we can fix today. We

shouldn’t and don’t have to wait for bond markets to tell us what

we should be doing already.

Ms. NORCROSS. I would concur with what Ms. Gelinas said.

Mr. QUIGLEY. Thank you. I yield back the balance of my time.

Mr. MCHENRY. Mr. Cooper is recognized for 5 minutes.

Mr. COOPER. Thank you, Mr. Chairman. I would like to thank

you again and the ranking member for this excellent hearing.

Back to the question of individual investors. If I am an individual bondholder today or a local taxpayer who is thinking about

maybe buying some of these bonds, what is the easiest way for me

to find, on the Web or another source, the credit status, credit rating, financial soundness of the entity in which I am investing or

am living?

Ms. LAV. Bond prospectus have a whole lot of information about

the finances of a State or locality. It depends.

Mr. COOPER. A prospectus is a big, long, legal document, sometimes hundreds of pages. It is very different for the average person.

What is the best way for a consumer who is maybe at the broker’s

office saying I want a tax-free bond, tell me what I should buy?

How do you find out that information? How do you tell whether

you are living in a creditworthy jurisdiction or not? This is the information age. Is there a Web site that you can go to and find out

with relative ease, small town U.S.A., is it worthy or not?

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Mr. SKEEL. I think it is fairly difficult. You have to piece together

information. But all of the brokerages publish reports or put out reports on individual bonds. Certainly if you go to a broker, you can

get that kind of information. But to assemble it together yourself,

I think, it is difficult.

Ms. LAV. That is why most people do rely on financial advisers

and on brokers rather than make their own decisions. Or at least

for information.

As Ms. Gelinas said, it depends on what kind of a bond it is. You

may be wanting to know about the possibility of are the tolls going

to pay back the bond on this highway. Or it may be full credit, in

which case you need to have some sense about the budget of the

entity and its long-term prospects.

Mr. COOPER. When Ms. Gelinas said earlier that individual citizens should take it upon themselves to get ahead of the bond markets and anticipate bad practices, it is very difficult to do that. You

really have to be a student of this to understand what is going on.

Ms. LAV. Right. And I think people, just like I go to a lawyer or

I go to a doctor. I mean, I am a public finance person, but everybody isn’t and they need to go to an adviser.

Mr. COOPER. But for the individual investor, it should be made

relatively easy. And it is my understanding that some of the brokerage houses may be affiliated with investment banks that help

underwrite the bonds, and they have an interest in making those

bonds look good.

Ms. LAV. Yes, that may be the case. You know, there is not a lot

of ways that an individual can investigate. Most towns have their

budgets on the Web site. I can find them, but it may not tell you

everything you want to know.

Mr. COOPER. We can compare almost everything else in life

through easily accessible Web sites. These important financial instruments, why can’t we get an easy handle on these?

Ms. LAV. There are 80,000 jurisdictions in the United States—

some people say 90,000—that issue bonds. It is quite a large undertaking and one that maybe somebody would want to undertake.

But it would be a big deal.

Mr. COOPER. Perhaps a more relevant question is so many people

buy a bond fund, which may have a few bad apples in it. How do

you tell what is in your bond fund? It is my understanding that

with the housing crisis, they bundled subprime credits and when

a few more went under than expected, that tainted the whole package.

Ms. LAV. That was a different kind. Those were kind of what

people call sliced and diced securities where people couldn’t know

what the origin is.

Mr. COOPER. That is not done with muni bonds?

Ms. LAV. No. Never. It is not done ever.

Ms. GELINAS. The bond funds, without endorsing or not endorsing them, there is at least something there, unlike with something

like a collateralized debt obligation built on mortgage bonds built

on more mortgage bonds. Some of these things were rated AAA.

They ended up being worth literally nothing. I don’t see how that

would be the case here, even if we did see small scale municipal

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and project defaults. It is hard to conceive waking up and having

a AAA rated municipal bond fund being worth nothing.

However, I think your other point is very important, that individuals own these bonds, but they don’t own them directly. They own

them through money markets, $300 billion worth of State and local

debt in money market funds, and there is an issue here of financial

intermediation and the dealers responsibility, that these are the

large investment banks. They run these funds, they hold many

holdings on their own books. And if we haven’t succeeded in getting

financial discipline into these firms that still believe, in many

cases, that they are too big to fail, they are not going to be worried

about State and local debt because they think Congress will bail

them out, not the States.

Mr. COOPER. Would any of you invest today in a bond fund in

the hunt for yield with higher tax-free interest rates of project

funds in Nevada, southern California, Florida? Would you put your

lifesavings or your pension fund in a fund like that, especially since

it is apparently quite difficult to find out about the merits of each

individual project?

Mr. SKEEL. I would be careful, but I certainly wouldn’t steer

away from the muni market.

Mr. COOPER. I asked about project funds because those would be

most likely to have problems.

Mr. SKEEL. You would have to look at the project.

Mr. COOPER. But apparently, that is almost impossible to do unless you are a bond lawyer and are willing to read 200 pages per

project.

Mr. SKEEL. Well, I mean, if you are going to invest in a particular project——

Mr. COOPER. But this would be a bond fund with lots of these

projects. It just seems to me that we are not giving consumers, individual investors, enough information here. At least that is easily

accessible. But I see that my time has expired. I appreciate the

chairman’s patience.

Mr. MCHENRY. I certainly appreciate the gentleman’s line of

questioning. If the panel wants to go through, the question was:

Would you invest in State municipal bond funds; you, yourself? Yes

or no; maybe, if you all want to answer, that would be great.

Ms. GELINAS. I think there is a very real problem with trust, people’s trust in the financial industry and in trusting their financial

advisers and trusting the managers of these bond funds, and that

issue is not going away any time soon.

Mr. MCHENRY. Ms. Norcross.

Ms. NORCROSS. I would probably ask my financial planner.

Ms. LAV. I have never actually invested in municipal bonds. It

is just not my style of investing.

Mr. MCHENRY. I thank the gentleman from Tennessee for his

line of questioning.

With that, we will go to Mr. Walsh of Illinois.

Mr. WALSH. Thank you, Mr. Chairman. And thank you for holding such an important hearing. Like the ranking member, I am

from Illinois as well. Illinois is a mess. We all know that. No way

is the Federal Government going to bail out my State. My voters,

our constituents won’t allow it. I feel like I left the movie right beVerDate 17-JUN-2003 16:19 Oct 13, 2011 Jkt 000000 PO 00000 Frm 00078 Fmt 6633 Sfmt 6633 C:\KATIES\DOCS\68362.TXT KATIE PsN: KATIE
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fore the good part, and I am sure the case was being made that

bankruptcy is not feasible. So no bailout. Bankruptcy isn’t feasible.

Let me start out with a quick round-robin question. Give me

your 20-second solution just so I can walk out of here with that

take away. We are not going to bail you out. Bankruptcy is probably not feasible, so what are the States going to do? Give a quick

one to that.

Ms. GELINAS. Well, I think voters in many States are already

doing the right thing. We have new Governors from both parties

that are starting to address what do we do about pensions for future employees? What do we do about Medicaid costs? Something

Congress can certainly help with. These are questions for voters in

the individual States pressuring their own lawmakers to change

State laws and, in some cases, State constitutions, not something

that the Federal Government can or should do for them. So in some

ways the system is working, if imperfectly.

Mr. WALSH. I guess my question is if there is going to be no bailout from us and a bankruptcy is not feasible, a State is falling off

the cliff, let’s imagine that one in the next 3 or 4 months literally

is going to fall off the cliff. We can change laws that will impact

things in the future, but what do you do for that State that has

just fallen off the cliff?

Mr. SKEEL. My answer is going to be I really think we need to

put a bankruptcy regime in place to deal with precisely that problem. That is the only problem we absolutely need bankruptcy for.

I would add one thing to that: I agree that States are doing the

right thing. I hope the optimism that we have heard today is correct, that most of them can muddle their way through. But some

measures are a lot tougher than others. For instance, pension reform in a State, while there is a lot of debate in Illinois about what

can and can’t be done right now, but in many States it does require

a constitutional change. I think that is pretty unrealistic. So some

of the options are more feasible than others.

Mr. WALSH. Ms. Norcross, your State is falling off a cliff; what

are you going to do?

Ms. NORCROSS. I would say close the defined benefit plan and figure out how you are going to pay out what has been accumulated.

Mr. WALSH. Ms. Lav.

Ms. LAV. I think States can use their normal processes of dealing

with their taxes and their expenditures to set themselves on a

right path. Illinois has a particularly deep hole. I have been writing

and talking about Illinois’ problems for the last 25 years of its fiscal mismanagement. I am a native Chicagoan. But it just needs to

do those things it needs to do to get out of it and to bring itself

back to balance. It has the tools. It just needs to use them.

Mr. WALSH. Thank you. In my remaining time, let me quickly

ask one quick question about market risk. Bill Gross who manages

PIMCO, one of the largest mutual funds in the country, he stated

that a low or negative real interest rate for an extended period of

time is the most devilish of all policy tools. It is interpreted to

mean, what he is saying is that the Fed’s action to lower interest

rates helps our debtors, such as States and municipalities, while

harming all those who worked hard and saved money.

76

Ms. Norcross, Ms. Gelinas, quickly, in effect, the Fed is enabling

debtors to reduce their debt on the backs of those that saved

money; is that right?

Ms. NORCROSS. I would hesitate to say that right now.

Mr. WALSH. Ms. Gelinas.

Ms. GELINAS. There is complacency. States and cities have borrowed at very low rates not just for the past couple of years in extreme conditions, but really for two decades now. If rates go up, including possibly way up, they will have to get used to a very different environment very quickly.

Mr. WALSH. Could you argue that the Fed’s quantitative easing

program is in effect, has in effect been a bailout for States and municipalities?

Ms. GELINAS. Sure this is a bailout for anyone who owes money.

States and municipalities may not be the biggest proportionate

benefitter from this, but it certainly helps them.

Mr. WALSH. Ms. Norcross, you concur?

Ms. NORCROSS. I concur.

Mr. WALSH. Thank you.

Mr. Chairman, I yield back. Thank you.

Mr. MCHENRY. Ms. Buerkle from New York is recognized for 5

minutes.

Ms. BUERKLE. Thank you, Mr. Chairman, for hosting this very

important meeting. Coming from New York State, as you can imagine, this is a concern on many of our minds. I apologize, we’ve had

a number of hearings today for being in and out. I appreciate your

time this morning.

The first question I want to ask is regarding actually the stimulus money and the fact that so much of it was paid to the States.

Do you think that was a way the States were sort of—it put the

States off, they didn’t have to really face these issues head on, and

so it actually delayed and now the States have to reckon with the

situation? That is a question for any one of you.

Ms. LAV. I am happy to respond to that. When that money first

came out in 2009, we would have seen it covered about a third of

the State’s deficits. In that year, we would have seen very sharp

cuts in education and health care. We would have seen millions of

people losing their health insurance, and the States were poised to

cut people. We would have seen many, many more layoffs of teachers and other public employees, which would, in fact, have potentially delayed recovery because you take that demand out of the

economy, and the stimulus actually provided a boost to the economy that was very important.

So now, as the stimulus is ending, at least State revenues are

beginning to grow again. They are still below 2008 levels, but they

are beginning to grow again. So States have a little more ability

to absorb the end of the stimulus. They are proposing very major

cuts in budgets this year. But it is probably better that they are

doing it now as the economy is at least on something of a growth

path than if they did it in the depths of the recession which could

have been very damaging to the economy.

Ms. BUERKLE. But it seems to me those decisions they are making now, they should have made a year ago and actually got their

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fiscal houses in order. It appears the stimulus just delayed reckoning with the reality of the situation. Mr. Skeel.

Mr. SKEEL. I agree. There is some case for some of the stimulus

money going to the States, but there is no question in my mind

that it has delayed the restructuring.

Ms. GELINAS. Yes, I would agree with that. There was a missed

opportunity in that Congress might have considered saying to the

States: we will give you a dollar today in 2009 if you take steps

to cut your future liabilities by a dollar 10 years from now. So fix

the pensions, fix the health care and Medicaid costs, give them operating aid now, but use it as leverage to work on the long-term

problems. That was something that was not done.

Ms. NORCROSS. I would add to that some of the stimulus expanded some spending and is leading to cuts that need to be taken

today. States, Virginia, New Jersey, deferred their pension payments. They were not making the tough choices.

Ms. BUERKLE. Thank you. While I still have some time, if I could

ask another question.

Mr. Skeel, regarding the possibility of bankruptcies in some of

the States that are so financially strapped, if, in fact, they did declare bankruptcy, would that affect the borrowing abilities of

healthier States? Does that impact a State that kept its fiscal

house in order, and now they are going to be impacted by some of

the States that did not?

Mr. SKEEL. I think the impact would be very limited. As I was

saying a few minutes ago, the bond markets have the ability to distinguish between States that are in good fiscal shape and States

that are not. It is really not like the big banks in 2008 which were

really connected to each other, had the same kinds of assets, the

same kinds of problems. The States really are independent. So I

think a State that is in good fiscal health would continue to be able

to borrow just fine.

Ms. BUERKLE. Thank you.

Ms. Gelinas, I think in your opening statement you addressed

that. Would you like to address that issue as well?

Ms. GELINAS. Sure. I would respectfully disagree. Markets can

distinguish among States, but they cannot do it instantaneously or

even in a few weeks or even months. So changing the law in this

way, really sweeping away half a century’s worth of precedents, it

would take a long time for markets to adjust to that and healthier

States would suffer during that timeframe as well.

Mr. SKEEL. If I may add one last remark on that, when you look

at countries that have run into trouble, Argentina, for instance,

which is about as profligate as you can get, it is remarkable how

quickly they can go back to the markets. I really believe markets

respond a lot more quickly than people tend to think.

Ms. BUERKLE. Thank you. I yield back.

Mr. MCHENRY. Thank you so much for your line of questioning.

I have just three more questions that I wanted to pose to the panel,

if that is all right with you all.

If you look at the public sector employee unions versus private

sector employee unions, the public sector unions now account for

more than private sector unions. It is an interesting crossover we

have had just in the last 2 years. On average, public sector workers

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make $14 more per hour in total compensation, wages and benefits,

than their private sector counterparts.

Ms. Gelinas, you have written about this, I know, but if you can

testify and say here today, it seems to me that public sector employees and private sector employees are living in two separate

economies. What are the ramifications of that, and what is really

the root cause of that disparity?

Ms. GELINAS. Yes, and I should be clear that it differs from State

to State. Some States, particularly the northeastern States, Illinois,

California, offer much greater power to employees to collectively

bargain. Their benefits are commensurately much higher. Generalizing the problem, it would not be so much the wages as it is the

benefits because these are open-ended liabilities that States and localities are taking on. Right now they are uncontrolled.

So one aspect of getting these under control is to start to switch

new civilian employees, a good first start, into 401(k)-style pension

plans, just as the private sector has. So you are getting rid of an

open-ended liability for the State in the future.

The same thing with health care benefits. In many municipalities, certainly not all of them, workers do not pay a share or anywhere near the share of their own health care benefits that private

sector workers pay. Asking workers to pay more for their own

health care do much to help States and cities with these liabilities.

Mr. MCHENRY. So you mention switching from a defined benefit

plan to a 401(k) style which most Federal employees have, for instance, just as a for instance. That is one policy change that we

could—that the States could enact. What are the prescriptions that

the Federal Government can take action over to help stem the tide

that we see coming? Ms. Lav talked about the loss of revenue, and

the fact that stimulus funds sort of relieved the States of that burden of having to lay off workers. But if you look at local school

boards right now, with the loss of stimulus funds, you are having

hundreds of people show up at school board meetings because they

are talking about layoffs.

What I believe I saw and I believe a lot of folks saw was that

the day is coming, the day of reckoning is coming when those stimulus funds run out. And rather than realizing it 2 years ago and

making changes, they are having to do it now. What are the things

that we here in Congress, what policy changes can we make to help

stem this crisis? I will pose that for everyone. We will start with

Ms. Gelinas.

Ms. GELINAS. One area where it may be most straightforward for

Congress to help States is in Medicaid because this is not an issue

where Congress would be telling States you have to change your

pension plan; you have to change the way you govern yourself.

Medicaid is currently a program that encourages States to spend

more, because when a State spends a dollar more, sometimes it

gets more than a dollar back from Washington. Gradually changing

Medicaid into a block grant program where you offer a set amount

of money, increases on the set formula, and the States are encouraged to innovate and cut costs within that, reward them for cutting

costs rather than raising costs. This would approach another big

chunk of their costs, current and future.

Mr. MCHENRY. Mr. Skeel.

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Mr. SKEEL. I agree that Medicaid is the most obvious place to do

things. There are real limits on what you all can do say with pensions and things of that sort simply for State sovereignty reasons.

So places where there is already Federal funding are the places

where I think you look first.

Mr. MCHENRY. Ms. Norcross.

Ms. NORCROSS. I concur that Medicaid and other areas, K

through 12 education and where there are mandates that increase

fiscal pressure on States.

Ms. LAV. I don’t think on the areas we are talking about today

that there is any need, as I said, for Federal intervention.

Mr. MCHENRY. Other than money?

Ms. LAV. Well, I am not asking for the extension of the stimulus.

I mean, it was unfortunate that it was designed so that the economy be recovered when the stimulus ended. Revenues are still

below their 2008 levels, so of course, at the end of the stimulus,

States were not able to get back to where they were. So helping

the economy, there is not much you can do to help the economy

right now either, necessarily.

But with respect to Medicaid, I think you can easily talk about

a block grant, but Medicaid is actually more efficient in many ways

than private insurance per individual matched for health conditions. So I think that the best thing would be to figure out how to

control the rate of growth of health care costs in the economy wide.

Those scary GAO numbers that Ms. Norcross mentioned are entirely driven by the rate of growth of health care costs. If health

care costs continue to grow faster than GDP, States are going to

have trouble coping with that. So will the Federal Government. It

is a major driver of the Federal deficit, and figuring out how to

bring them under control is the best thing to do.

Mr. MCHENRY. The final question of the day, and this is something that I intend to ask future panels as well. We are going to

have a series of hearings about this fiscal crisis at the State level

and the ramifications of not addressing it, and this is the opening

of it. We wanted to hear from informed individuals to start this

process. But I would like for you all, if you could, I’m asking you

on the spot, but in the future as well, tell us who we should hear

from next: bond market participants, credit rating agencies, pension holders, unions? If you could, tell me one, two, three people

or entities we should hear from. Ms. Lav? We will go right down

the line.

Ms. LAV. Yes, that was a pretty good list. Financial analysts.

There are several who have a very good handle on this. I can suggest a few and send them to you. And of course, unions have a

major stake in this. You should hear from them. I mean, I think

you also should listen to the Governors and the mayors.

Mr. MCHENRY. Ms. Norcross.

Ms. NORCROSS. I concur, that is a good list to start with. And

also consider calling those who are involved in education finance

and financing other policy areas.

Mr. SKEEL. I would just add, I think you all should talk to pension lawyers because these issues are both economic and legal. I

think you need to see the whole picture.

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Ms. GELINAS. All of those people, and I would also suggest speaking with infrastructure people, because the other side of this is that

States have to grow. The private sector can’t create jobs when we

have infrastructure that is decaying, and so how can States spend

Congress’ money and their own money, get the biggest bang for

their buck in infrastructure and help grow States so these liabilities can be better controlled from that end as well.

Mr. MCHENRY. Thank you. And I certainly appreciate your testimony, and I appreciate the opportunity to hear from you. Thank

you for your time. Thank you for spending the morning with us.

Thank you so much. And this meeting is adjourned.

[Whereupon, at 11:25 a.m., the subcommittee was adjourned.]

[The prepared statement of Hon. Elijah E. Cummings follows:]

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