Are U.S. States the Next Federal Bailout?

By: Jim_Farrish

In an interview with Meredith Whitney of Meredith Whitney Advisory Group on Bloomberg last week, she stated, some states are a ticking time bomb. She published a detailed report rating the finances of the 15 largest U.S. states. California has one of the largest deficits that exists relative to their budget gap by size, but it has a real estate problem as well with a large amount of foreclosures. Florida has a bigger issue relative to foreclosures and real estate. The drain on tax receipts in Florida due to the foreclosure issue could cripple the states budget similar to California’s in the coming year. The bottom line of the report is the U.S. government may face a bailout for states within the next 12 months. This is not good news for taxpayers.

The municipal bond market is more than $3 trillion in size and it is owned by individuals and institutions. If there is a bailout from the Federal Government, it could dwarf that of the bailed out banking system in 2008. The bad news is the owners can’t take stock or preferred stock as collateral on the loans to the states. The primary concern near term is the rating on the state and municipal bonds. If these start to erode, the values will decline and investors will once again pay the price.

The good news (if there could be any) from TARP was that the final cost (according to the Treasury) was $50 billion versus the original loans of $780 billion. This of course does not include the $180 billion currently outstanding to Fannie Mae and Freddie Mac. The state bailouts could potentially be two to three times that number and to make matters worse it may never get repaid.

The challenge for the states is how to increase revenue to fill the gap of the short fall. Foreclosures have been a legal nightmare in the courts. This slows the process of getting the property sold to someone who can pay the property taxes to curtail the short falls in the municipalities. That can only mean taxes from other sources. And in states like Florida, which has no state income tax, moving trucks may be more common than cars as people exit the state to avoid a new state tax residents. Retirees make up more than 25% of the state population and are free to move to other states, like Texas, which has no income tax and similar climate opportunities. Texas also has a balanced budget and no current spending gap.

Besides the taxpayers, the pressure from the housing sector will continue to weigh on banks in these troubled states. Don’t forget about the additional challenges from commercial real estate on the banks. SPDR KBW Bank ETF (KBE) hit a high in April 2010 of $28.72 and is currently trading at $23.58, a decline of 17.8%. The prospects of a move back to those highs are not likely based on the outlook. Scanning through the 37 banks which make up the ETF, none are trading in an uptrend. SPDR KBW Regional Bank ETF (KRE) has the same result. Investors are unwilling to take the risk associated with the unknown future of profitability, let alone if they will remain in business.

One of the big Wall Street firms upgraded the banks this week based on better Q3 earnings estimates. The results will come from better consumer credit quality and stronger underwriting on new loans. Most of this activity has come as result of mortgage refinancing. The gains are expected to be offset by a weak trading environment in equities and fixed income. The challenge remains in the balance sheet. That is a result of the above issues in foreclosures. Until the mess is cleaned up, the drag on earnings will remain. Meredith Whitney referred to the sector as boring and not a compelling one for investors. The sector has set up for a short term trading opportunity, but for investors it could be dead money for the foreseeable future.

When Federal Reserve Chairman, Mr. Bernanke, stated this would be a long and slow recovery he wasn’t kidding. The financial sector remains under pressure, and reports like this don’t help the situation. Investing in stocks requires confidence the companies have an above average opportunity to execute on their business plan. That includes growing revenue and profits to benefit shareholders. The banks aren’t likely to garner much confidence if this report is the future reality.

Jim Farrish is the Founder and Editor of SectorExchange.com and TheETFexchange.com.  His primary goal is to educate people about investing.  He has taught workshops locally and nationally for over 25 years, teaching thousands of individuals, business owners, and advisors how to focus on achieving financial independence.  Jim Farrish is the CEO of Money Strategies, Inc., a Registered Investment Adviser with the SEC. The company and/or its clients may hold positions in the ETFs, mutual funds and/or index funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. Investors who are interested in money management services may visit the Money Strategies, Inc., web site.

© 2010 Copyright  Jim Farrish

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