Bloomberg News

Hedge Funds Failing to Deliver Taxes to Connecticut: Muni Credit

June 05, 2012

Connecticut Governor Dannel Malloy

Dannel Malloy, governor of Connecticut. Photographer: Peter Foley/Bloomberg

Connecticut Governor Dannel Malloy is learning you can’t always count on the rich.

The Democrat last month deferred debt payments, trimmed programs and diverted funds as tax revenue came up short and opened a $200 million budget hole. The gap emerged about a year after Malloy, 56, who was elected in 2010, signed a $2.6 billion tax increase, the biggest in state (STOCT1:US) history.

Connecticut, the wealthiest U.S. state, joins California and New Jersey in facing a deficit as income-tax revenue is the most volatile in at least 30 years, according to the Federal Reserve Bank of Chicago. Connecticut counts on the levy for almost half its revenue, with the biggest chunk coming from the hedge fund capital of Greenwich. Connecticut debt has posted the weakest returns this year among U.S. states, Barclays data show.

The shortfall “is just the consequence of loading up on high-income individuals,” said Philip Fischer, who runs eBooleant Consulting LLC in New York and formerly headed municipal-bond research at Bank of America Merrill Lynch. “It is destabilizing. They have very volatile incomes. The states have that reflected in their budgets.”

Increasing volatility in tax collections is complicating local governments’ emergence from the worst fiscal crisis since the Great Depression. States projected or dealt with a combined $54 billion of deficits in the fiscal year starting July 1, according to a report from the Center on Budget and Policy Priorities, a nonprofit group in Washington focusing on issues affecting lower-income Americans.

Brown’s Estimate

California Governor Jerry Brown, a Democrat, last month cut the most-populous state’s revenue forecast by $4.3 billion after capital gains receipts fell 5 percent, instead of gaining 15 percent as forecast. In response, he proposed steps such as reducing government employees’ workweek by 5 percent.

In New York, personal income taxes dropped about 7 percent in April from a year earlier, the first month of its fiscal year, though the decline was smaller than expected. David Rosen, the New Jersey Legislature’s chief budget analyst, estimated last month that revenue may trail Republican Governor Chris Christie’s forecast by as much as $1.3 billion through June 2013.

“The real volatility in the income tax has to do with the high income folks, which is directly or indirectly tied to Wall Street and the movement in the market,” Rosen said in an interview.

The Standard & Poor’s 500 Index (SPX) of shares was little changed last year after gaining about 13 percent in 2010 and 24 percent the prior year.

Market Trailer

Connecticut’s per-capita personal income of $56,889 in 2011 compared with the national average of $41,663, according to U.S. Commerce Department data. Its state and local debt has earned 2.3 percent this year through June 1, compared with about 4 percent for the $3.7 trillion municipal market, Barclays data show. Similarly rated muni debt has earned 3.6 percent.

A one-step rating cut in January by Moody’s Investors Service, to Aa3, has contributed to weakness in Connecticut debt, said Brian Steeves, a portfolio manager at Belle Haven Investments in White Plains, New York. The rank is Moody’s fourth-highest.

Moody’s cited pension and debt costs as well as the state’s susceptibility to “financial market fluctuations,” given the dependence on capital gains.

Bonds Rally

The state last month cut $474 million from its projection for personal income-tax collections in the year starting July 1, according to the governor’s office.

Still, a fixed-income rally driven in part by Europe’s debt crisis has helped keep municipal interest rates near the lowest since the 1960s and shielded issuers from being punished by investors. Mutual funds focusing on muni debt have added about $13 billion this year through May 30, the best annual start since 2009, Lipper US Fund Flows data show.

“There are not enough bonds to buy,” said Robert Miller, senior portfolio manager in Menomonee Falls, Wisconsin, for Wells Capital Management, which oversees $28 billion in munis.

Investors demand about 0.27 percentage points of extra yield on 10-year debt of Connecticut issuers compared with AAA bonds, about 0.03 point less than the one-year average, data compiled by Bloomberg show.

Changes in state tax collections have become more dramatic since 2000 relative to the previous two decades, according to Leslie McGranahan and Richard Mattoon, senior economists at the Chicago Fed. While government revenue has always fluctuated with the economy, states’ receipts have become more volatile as they depend more on investment income, their report said.

Tax Cuts

The outlook for George W. Bush-era tax cuts is complicating states’ calculations. Income taxes from 2010 may have surged in anticipation that the lower rates would end on Jan. 1, 2011, Daniel Carroll, research economist at the Federal Reserve Bank of Cleveland, wrote in a report last year. The reductions were ultimately extended and are set to expire at year-end.

After Malloy took office in January 2011, Connecticut was flush with income-tax collections and bypassed a plan to borrow about $1 billion to close a budget gap inherited from Republican Governor Jodi Rell. Now the state is scaling back revenue estimates.

“It’s ridiculous,” Ben Barnes, head of Malloy’s budget office, said in an interview. “The volatility is so high.”

Following are pending sales:

DETROIT plans to sell $575 million of debt secured by sewer revenue as soon as next week, data compiled by Bloomberg show. Proceeds will help finance upgrades to the city’s wastewater treatment system, refinance debt and end swap agreements, according to offering documents. The swap termination fees total about $288 million, according to Fitch Ratings. Fitch last month cut the system’s senior lien bonds to A-, seventh-highest, from A. (Added June 5)

PUERTO RICO PUBLIC BUILDINGS AUTHORITY is set to sell $500 million of revenue bonds backed by lease payments and the commonwealth’s guaranty as soon as this week to refund debt, according to offering documents. (Updated June 5)

To contact the reporters on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net; William Selway in Washington at wselway@bloomberg.net.

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net


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