Unlike cities and counties, state governments cannot declare bankruptcy. In January 2016, this issue came to the forefront of political discussion as President Obama suggested making an overleveraged Puerto Rico eligible for a bankruptcy-like process. While this suggestion was quickly shut down by Republicans in Congress, many experts believe that allowing states to declare bankruptcy might encourage fiscal sustainability. Additionally, states that do declare bankruptcy could have a clear-cut process to getting themselves back on track financially, rather than counting on a bailout from the federal government.

Connecticut’s Bleak Credit Situation

Since the start of 2016, the conversation surrounding the viability of state bankruptcies has grown as credit in municipal bond markets has weakened. As of June 2016, the most recent state to feel the pressures of rising credit was Connecticut. In May, the Nutmeg State’s credit was downgraded by Fitch Ratings and Standard & Poor’s, both of which cited slow income, slow employment growth and structural deficits as the main reasons for the lower credit rating.

Fitch Ratings further notes that employment in Connecticut grew by half of that of the national average between 2012 and 2015, contributing to a two-year drop in the state’s median home value. Connecticut’s problem of slow economic growth is compounded by the fact that the state has already overextended its credit supply. To finance its future debt obligations, Connecticut needs to generate an average annual return of 13.6% in the market, which is way above the historical mean return of 10%, over the next 30 years, according to JPMorgan Chase & Co. (NYSE: JPM). Achieving that level of return over an extended period of time is unprecedented and not a viable solution, leaving Connecticut with few options to avoid default. It can either raise taxes by 14%, cut government spending by 14%, increase workers' contributions by 699% or employ a combination of the three policy reforms.

Rising Taxes, Falling Growth

Ranked number seven nationally for highest effective tax rate, Connecticut has made a huge jump in rates since their institution in 1991. In less than a decade, Connecticut’s tax rate on individuals earning more than $500,000 has increased twice from 5 to 6.5% in 2007 to 6.99% in 2015. Raising the tax rate again so soon and for a second time during his term may only compound Governor Dannel Malloy’s recent quandary. Earlier in 2016, General Electric Company (NYSE: GE) relocated its headquarters to Massachusetts, providing a huge blow to Connecticut’s state budget and economy.

However, when Ray Dalio’s Bridgewater hedge fund also expressed its intent to relocate its HQ, Governor Malloy was quick to change Dalio’s mind, gifting his company with $17 million in forgivable, low interest loans and $5 million in grants. According to the governor, this gift prevents the loss of $4.9 billion in tax revenues over the next decade, which is estimated to occur if all of Bridgewater’s employees leave the state. However, this is a temporary solution at best. In 2018, a $1.3 billion fiscal deficit, driven by imbalances primarily in workers’ pay and pensions, is predicted to bring Connecticut’s government another step closer to default.

State of U.S. Municipal Bond Market

Thanks to states’ rights, which give states complete autonomy in determining how much to spend on pensions, debt and retiree health care, the quality of state credit varies widely across the nation. Although Connecticut is on the higher terms of the credit spectrum, it is not alone in its nearly impossible situation. Together, the aggregate debt of Illinois, New Jersey, Kentucky and Connecticut accounts for roughly 20% of the total municipal bond market. This is worrisome considering that, on an accrual basis, all four of these states have to allocate 30% or more of their yearly revenues toward paying the interest on outstanding liabilities. Unless the state is able to increase its revenue relative to credit substantially, any interest-payment-to-revenue ratio above 25% creates a strong likelihood of default in the future. Despite these dismal credit conditions, even states with the most underfunded plans are unlikely to fully exhaust their assets for a decade or longer.

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