As Debt Ceiling Isn't Raised, 'Headache' For Cities, States Begins Friday

NEW YORK -- As the federal government approaches its legal debt ceiling and scrambles to avoid default, the first losers will be cities and states.

Starting Friday, the U.S. Treasury will stop issuing special securities that help state and local governments pay for their debt, Treasury Secretary Tim Geithner announced in a letter to Congress this week. This freeze, the first in a series of "extraordinary measures" undertaken by the Treasury to avoid a federal default, could pose difficulties for local governments nationwide, making it more complicated for strapped localities to manage their already weak finances.

"I could see it being a real problem for those guys, on top of all the headaches they have already," said David Johnson, a partner at the Chicago-based ACM Partners, a boutique financial firm that advises struggling municipalities.

Congress has been mired in a months-long gridlock, as lawmakers debate proposals to reduce the federal deficit. This stalemate in the highest echelons of American political power nearly shut down the federal government in April, when Republicans and Democrats clashed over a few billion dollars in spending cuts. Now, Republican lawmakers who advocate for budget austerity are saying they will not vote to raise the debt limit unless their demands are met.

The federal government continually issues new debt to pay for principal and interest on older debt, meaning that if it's legally barred from borrowing above a limit, it will eventually have to default on its obligations, an event that would likely spark a devastating financial crisis worldwide. Government officials and independent economists have sharply criticized the seeming game of chicken going on in Congress, as lawmakers are essentially threatening to lead the global economy into catastrophe, simply to advance a political agenda.

But it appears Congress will not raise the federal debt limit before that ceiling is reached on May 16, Geithner said in his letter. In anticipation of this inaction, the Treasury will begin shutting down certain types of debt issuance this week, a process that will kick into higher gear in mid-May if the limit isn't raised. A default, which would likely cause borrowing costs to skyrocket and credit markets to freeze, will come in early August if Congress doesn't vote to raise the limit, Geithner said in the letter.

When the "extraordinary measures" begin Friday, the first casualty will be a category of non-marketable bonds known as State and Local Government Series securities, or SLGS (pronounced "slugs"). These securities are tailor-made for state and local governments, designed to help them pay for their debt.

Local governments regularly issue bonds and then invest this borrowed money into U.S. Treasury securities. The process allows them to collect interest from the federal government, and use that yield to pay their own bondholders. By law, local governments can't earn arbitrage profits -- meaning, they can't make a profit by collecting more in Treasury yields than they pay to their own investors.

So, the federal government issues SLGS, which are customized to match the specifics of a local government's need. Ideally, the process is a wash.

State and local governments have bought $23 billion in SLGS so far this year, and they have issued $62 billion in debt, according to Thomson data provided by Matt Fabian, managing director of the Concord, Mass.-based Municipal Market Advisors. These specialized securities are a handy tool for governments, Fabian said.

"It's probably the most efficient way to do refinancings," said Howard Cure, director of municipal research at Evercore Wealth Management. Without SLGS, he said, governments face "a headache."

Losing SLGS temporarily is not a major hardship, but it is an annoyance, experts said. In the absence of SLGS, a local government will likely put its money in marketable Treasury debt, paying an outside advisor to craft a Treasury investment that allows it to comply with the law preventing arbitrage. When the federal government issues SLGS, it takes care of this customization. Without SLGS, a banker does that job.

From the federal government's perspective, cutting SLGS does not actually lower the total debt burden. Rather, it makes debt issuance more predictable, and it helps reduce increases in debt. The Treasury issues most of its debt according to a pre-determined schedule; SLGS, though, are issued as local governments request them.

Geithner, who has persistently warned Congress of the dangers of not raising the debt ceiling, acknowledged the difficulty that comes from this first step in the process of preventing default.

"It is not without costs," he said in the recent letter to Congress. "It will deprive state and local governments of an important tool to manage their outstanding debt expenses."

Already, local government officials are frustrated by the federal lawmaking process. Last week, during a conference in Chicago, Philadelphia mayor Michael Nutter struck a confrontational tone with the federal officials who sat with him on stage, saying, "Mayors could never get away with the kind of nonsense that goes on in Washington."

Other mayors heartily agreed, as some stood up during the question and answer session to express their disappointment with the federal government. Local governments can efficiently create jobs, but they lack resources from Washington to help them do so, these mayors said.

Lawmakers on the Hill, meanwhile, are showing no sign of progress on the debt ceiling debate.

"In a way, we are engaged in a political game," said Gary Burtless, a former Labor Department economist and a current fellow at the Brookings Institution, in Washington. "Will a miscalculation occur that leads to a real disaster?"