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Cities, counties, and states are dangerously close to defaulting on their bonds — so they say.

The problem is widespread because tax revenues (income & even property) are as volatile as the local economy, but spending needs to be stable. Streets must be plowed and fires must be put out regardless of what income levels & property values did last year. Demand for government services ratchets up as well: wealthy people typically want more from their government, and that demand doesn’t decrease when their incomes do.

On the other hand, municipalities can’t really “save up for inevitable hard times because that would amount to extra taxes. Paying to renovate the sewers is valid; holding this year’s residents’ money for seven years and investing it according to the State’s bureaucratic investment criteria is invalid.

 

But there does seem to be an obvious solution to the problem. If you can’t save, buy insurance. And if you can’t buy insurance, hedge. States could lever up a short against themselves or against things that correlate to high tax revenue for them. If the price is right, then states will pay only a little in good years to cover a lot of loss in bad years.

For example, the State of Oregon could short Portland’s Case-Shiller index, and short stocks of AFMS, Henningsen, LIME Financial, Samaritan, and Walsh Construction— or any correlate of tax revenue. The State could also be direct: call up a bank and ask them to write a swap directly on tax revenue outcomes. We all know the bulge bracket loves to synthesise new products to sell.

The state in question could buy enough “insurance” to mitigate e.g. 70% of revenue loss under a pessimistic scenario, or choose the amount of insurance by another benchmark.

We know there is a long side to this bet because

  1. people buy municipal bonds
  2. people buy and improve houses where they live
  3. people are always trying to make more money

Insurance is justifiable to taxpayers where government “savings” are not. In my experience watching a liberal city government’s debates, “insurance” is a trump: it’s seen as “something you must have”. Even if that view were uncommon, after seeing California declare a literal emergency because of its budget problems, surely voters would agree there is a real danger to insure against.

 

Am I missing something here? Or are future State fiscal-ratchet problems actually preventable?

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