Seminar raises concern over US state debt

Cayman should be concerned over the
increasing debt burden of US states, Professor Andrew Morriss from the
University of Illinois has warned during a seminar, investigating the impact of
the spiralling deficit of US states.

In the seminar ‘The implosion of US
state finance and its effect on the Cayman Islands’, hosted by local law firm
Stuarts and RBC Wealth Management at the Ritz-Carlton on Monday, Professor
Morriss described the deficit of individual state governments as a direct
consequence of both revenue and cost problems, compounded by a worrying state
and local pension crisis.

There is no hope that individual
states that spend too much and do not raise enough revenue will be bailed out
by the federal government, because federal debt is simply too high, Mr. Morris

The state pension crisis comes
after years of underfunding, which have now resulted in a conservatively
estimated pension gap of US$1 trillion.

The extent of the problem is, in
some cases, masked by “financial chicanery” and accounting tricks that would be
illegal, if employed by a private enterprise, Mr. Morris said.

Worse still, most states have not
even begun a discussion about the problem.

He urged the audience to consider
US states as individual economies, likening them to countries in terms of their

Cayman should particularly care,
because state officials impact federal initiatives in financial regulation,
state and local pension funds are major institutional investors and ultimately
the state financial meltdown will impact the US economy.

The problem of state deficits is so
bad that some states are simply no longer paying the bills, he said.

“Do worry about the future value of
government debt issued by US states. They can’t pay it back,” he warned.

Cayman’s financial services
industry should be concerned over state officials looking for scapegoats to
explain the economic demise of their states. At the same time local and state
pension funds may in the future have less money to invest.

Inflation caused by government debt
will also be a real issue for Cayman, as its currency is pegged to the US
dollar, he stated.

But Cayman’s financial services may
benefit from “cleaning up after our mess,” he concluded.

This notion was supported by
Christopher Culp, adjunct professor of finance at the University of Chicago and
senior advisor with Compass Lexecon.

Professor Culp spoke about the role
structured finance may play in solving the public debt crisis.

Certain structured finance
products, which are essentially securities that are customised to the meet
specific needs of an issuer or investor, were a main driver of growth in Cayman,
before they suffered from an image problem in the aftermath of the financial
crisis. Before then almost all US-based collateralised debt obligations were
issued by Cayman special purpose entities, he showed.

“Structured financing techniques
are not dead and buried. In fact they provide an opportunity that is particular
valuable to you here in the Cayman Islands,” Mr. Culp said.

Using the analogy of the state
government debt, he explained that “if these states blow up we don’t want the
risk associated with those defaults concentrated in one or two places.”

“It is desirable to allocate risk
to those parties willing to bear those risks and you in the Cayman Islands are
in the centre of the pipeline of that production process, because of the role
you play in the CDO market,” he added.

While these instruments are not
going to fix the underlying problem of states overspending relative to the revenue
they raise, CDOs are a great way to purchase assets that are in trouble, to get
the market to assign the right price to them and to distribute the risk to
participants most willing and able to bear it, for example through diversified
portfolios, he stated.

Mr. Culp noted signs of life in
certain structured market products, such as European investment grade corporate
CDOs, auto loan-backed asset-backed securities, project finance loans or natural
catastrophe insurance-linked securities. 

Collateralised loan obligations and
leveraged loans in general are also fairly close to making a turn. “We are
starting to see new activity there,” he said, and “we are beginning to see a
strong interest in the revitalisation of CDOs based on municipal and sovereign

Although the CDOs and CLOs of the
future will be different, for example in terms of collateral, credit
enhancements or rating criteria, the legal documentation and technology in the
securitisation process will remain the same. As a result Cayman has every
opportunity to recapture the CDO business as a domicile when the market rebounds,
he concluded.


(l-r) Professor Andrew Morriss, Stuarts Director and Head of Corporate Law Chris Humphries, Professor Christopher Culp.
Photo: Michael Klein