Risk and the Fisc

As the Northam administration’s point man in negotiations with the New York bond-rating agencies, Secretary of Finance Aubrey Layne spends much of his time worrying about the Commonwealth of Virginia’s credit-worthiness. The state nearly lost its sterling AAA bond rating last year. It was a close thing, he says. Even now, he adds, Virginia isn’t out of the woods.

Layne sees many things that could go wrong. The economy could slip into recession and projected tax revenues could decline. A stock market crash could boost unfunded pension liabilities by billions of dollars. The politicians in Washington could get serious about dealing with the $22 trillion national debt, curtailing the defense spending that undergirds Virginia’s economy.

The risk that “keeps me up at night,” says Layne, is of a Category 5 hurricane ripping through Hampton Roads. An Old Dominion University study published late last year found that a Florence- or Katrina-scale hurricane would cause $17 billion in wind and water damage and another $25 billion or more in lost economic activity. The state would be on the hook for evacuating and sheltering hundreds of thousands of  residents, cleaning up tens of thousands of truckloads of debris, and repairing state-maintained roads and other infrastructure, even as disruption to Virginia’s second-largest metropolitan economy cost millions of dollars in state tax revenue.

The Commonwealth faces huge risks, both short-term and long-term, but few of those risks are accounted for in Virginia’s $21 billion-a-year General Fund budget. The state’s “rainy day” fund and cash reserves are too paltry to buffer the budget from a fiscal shock of any magnitude. Under many scenarios Layne can contemplate, balancing the budget would require horrendous spending cuts.

“There’s no one looking into the future,” Layne says of the state’s biennial budget cycle. “Nobody’s looking beyond two years.” If revenue shortfalls loom more than two years out, he adds, “the attitude is, we’ll deal with that in the next budget.”

The Commonwealth has a constitutionally prescribed “rainy day fund.” If revenues come in ahead of budget estimates, a portion of the excess automatically goes into the fund. But the use of that fund, designed to help the state cope with a recession, is restricted. It can’t be tapped unless revenues actually decline. It can’t help if, say, a hurricane or other natural disaster triggers hundreds of millions of dollars in emergency expenditures.

To weather a hurricane the Commonwealth would have to draw upon cash reserves. The state constitution allows the state to accumulate reserves equivalent to 15% of General Fund budget expenditures, or about $3.2 billion currently. Virginia flirted with a bond downgrade last year because the state had let its cash reserves dwindle to $281 million — less than any other AAA-rated state. Layne’s goal is to build reserves back up to 8% of annual General Fund expenditures, or about $1.8 billion. The recently concluded budget negotiations for Fiscal 2020 adds significant new monies and will get reserves up to about 5.6%. That represents progress, Layne says. But it’s not enough.

“Government doesn’t assess risk very well,” he says.

As president of Great Atlantic Management, a real estate development firm before entering public service, Layne spent a lot of time thinking about risk. In the private sector, companies routinely take out insurance or self-insure by setting aside reserves to cover potential liabilities.

Layne introduced rigorous thinking about risk to the public sector when he signed up with the McAuliffe administration as Secretary of Transportation. The Commonwealth was planning billions of dollars in transportation mega-projects without clearly identifying which types of risk — the risk of design and construction overruns, for instance, or the risk that toll revenues might not materialize as projected — that it made sense for the state to take on itself or to slough off to a private-sector partner.

Virginia needs to think more rigorously about risk in its budget process, Layne says. In one analysis that he conducted in response to a General Assembly inquiry, he asked what the fiscal impact would be if Virginia experienced another recession like the financial crisis of 2007. That is not an unreasonable question to ask given that Moody’s the bond-rating firm, recently said that the U.S. economy has a 48% chance of falling into recession next year.

A recession as severe as the last one could wipe out $9.3 billion in revenue from a $21 billion General Fund budget over three years. And that doesn’t include the impact on Virginia Retirement System. Under a “shock” investment scenario replicating the stock market crash of the last recession, according to a different analysis, the state’s share of the unfunded pension liability would surge by $6.9 billion and contributions into the fund would have to increase by roughly 50%, creating a huge new drain on state funds while tax revenues were in free-fall.

The point is not that a recession of that magnitude will occur, it’s that Virginia is extraordinarily vulnerable if it did occur. No one foresaw the 2007 recession, so it’s not a stretch to think that the next financial crisis could catch economic forecasters unaware as well.

Similarly, it’s not “likely” that Virginia will get hit by a Category 5 hurricane. Virginia hasn’t suffered a storm of that magnitude since 1821. But some climate scientists fear that the frequency and intensity of hurricanes will increase with global warming, so anything is possible. While the Federal Emergency Management Agency would provide significant aid to Virginia in the event of such a natural disaster, it would take a couple of years for all the money to come in. With such a pitiful level of reserves, where would Virginia get the money to deal with immediate needs?

Layne also finds risks embedded in the routine budget process. Growth in sales taxes and payroll withholding has slowed this year, he says. “If our [econometric] model is wrong, we’re screwed.”

Billions of dollars in the budget are predicated upon actuarial models that may or may not prove to be accurate. The project for Medicaid spending was off by $420 million last year. Actuaries made assumptions that a certain percentage of Medicaid patients would enroll in managed care plans that would cost the state less money. The projection was way off — and nobody bothered to compare actual enrollment figures with the forecast until late in the game. “They got the report then put it on the shelf. No one paid attention to the fact that they weren’t hitting the assumptions.”

Layne will make sure that particular oversight doesn’t happen again. But he sees state and quasi-state institutions as riddled with moral hazard — from Medicaid administrators to the Virginia Retirement System to the Virginia House and Development Authority. The political pressure to increase spending is relentless. “I had $3 billion in [unbudgeted] requests from the agencies in an off-budget year.”

The Commonwealth is benefiting this year from an influx of tax revenue resulting from federal tax cuts that may or may not be extended when the current authorization expires. Layne proposed using the temporary revenues to bolster financial reserves or to fund one-time spending programs, as opposed to boosting ongoing programmatic spending or enacting tax cuts. Says he: “We’ll look back at these temporary moneys one day and regret that we didn’t use the chance to shore up our balance sheet.”

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21 responses to “Risk and the Fisc

  1. Good summary, Jim. It has been only in the last few years that the General Assembly has been willing to leave dollars on the table in the form of a cash reserve in addition to the Rainy Day Fund. It will be interesting to see what they do with the surplus that accumulates from the federal tax changes.

  2. Where would Virginia be without Aubrey Layne and Steve Moret?

    Answer: Far worse off. Like without them from 2000 to 2013.

    In Lane and Moret, McAuliffe got things right, despite all else.

  3. As important as it is to protect the rainy day fund and get cash reserves back up to 8% or higher where they belong, you say, “Billions of dollars in the budget are predicated upon actuarial models that may or may not prove to be accurate.” These same actuarial models are the basis for the determination of the need for and adequacy of all those reserves, aren’t they? It’s astounding to me that the State could be so cavalier about its forecasting process. Who is minding the store there? Is there a centralized State approach to program cost estimation, or is that left up to the vagaries of each State department?

    • My impression from Layne is that no one has been minding the store, although he is trying to get a handle on things. There is no centralized state approach to estimating program costs. Each department draws up its own forecasts. In some departments, the numbers and variability aren’t big enough to matter much. Medicaid is an obvious exception. K-12 inputs under the Standards of Quality is another. So are transportation mega-projects.

  4. So if we’re truly worried about the impact of Climate Change on hurricanes and flooding, where is the plan to start taxing landowners in areas most susceptible to flooding for measures to minimize the damage from flooding? And, better yet, how about changing laws to discourage (hell, prohibit) new building in floodplains?

    • This is an excellent point and one that I think has been overlooked. We could start by stopping some of the ongoing subsidization such as with flood insurance and the widening of beaches by the Corps of Engineers.

  5. So if we’re truly worried about the impact of Climate Change on hurricanes and flooding, where is the plan to jump start nuclear?

    Answer: all the serious people are working on that. Bill Gates, for example.

    The rest are spending $5 billion on ash, and paving over the state with steel and glass panels and windmills.

  6. Virginia did not gain its reputation for being one of the best managed states in the country by being “cavalier” in its forecasts or for operating with “no one minding the store”. From 2000-2016, the leadership of John Bennett and Ric Brown, with Ric being the constant in those years, kept the state’s finances in good condition. They had to maneuver through some rough financial times.

    The statement, “There is no centralized state approach to estimating program costs. Each department draws up its own forecasts,” gives the impression that spending is willy-nilly. That is incorrect. Each department is limited to its appropriation in the budget. It submits requests for additional appropriations for new or existing programs to the Department of Planning and Budget. DPB reviews the requests and makes recommendations to the Governor. The Governor submits his recommended budget to the General Assembly, which conducts its own analysis of the requested program costs. After the budget is enacted, each agency must live within that budget. DPB can make administrative adjustments by shifting money around, but cannot, with few exceptions, increase the overall general fund appropriation. If program costs in an agency exceed its original estimate, the agency must make adjustments in other areas to make up the difference.

    The revenue forecast is overseen by the Dept. of Taxation. It uses consultants and models from the private sector, most recently IHS Market. Various scenarios are reviewed by the Governor’s Advisory Council on Revenue Estimates. This group consists of leading businessmen appointed by the Governor, as well as members of the legislative money committees. Based on the input from that group, the Governor uses a forecast of revenues for the introduced budget.

    All governments and businesses have to estimate their future revenues. Those estimates are based on past history and an analysis of future events. Layne’s statement of the state being screwed if the econometric model is wrong would apply to any government or business. Virginia’s revenue forecasting in the past has been remarkably accurate. There have been times in which revenue has fallen short of the forecast, but one has to keep in mind that, when dealing with billions of dollars, a difference of a few tenths of a percent can mean tens of millions.

    Medicaid is the biggest driver of budget appropriations. The Department of Medical Assistance Services is responsible for preparing the cost estimates for that program. There were some problems in preparing the 2018 budget. From what I can understand, there were two main factors. One, the state had converted to using a managed care approach and there was little history upon which to base a forecast. Two, a lot of the people involved in the upper management of the agency were new. And as always, medical costs generally are going up. The result was that the forecast was too rosy and costs were higher than had been anticipated.

    As Secretary of Transportation, Layne inherited a mess from the McDonnell administration and did a good job of guiding the state into getting a handle on the costs and management of large transportation projects and setting priorities. As Secretary of Finance, his portfolio is much bigger and subject to many more factors over which the state has little control. His background and nature cause him to worry about the possible risks out there. It is good to have someone pointing out potential future risks to politicians who usually are not looking beyond the next election cycle. But, I think some of the comments here reflect too dire a view. The state has begun to emerge from the recession and to move away from too much dependence on federal spending. The General Assembly has shown some restraint and begun to build up reserves. Yes, a national recession or a major natural disaster could result in significant financial trouble, but that is true of any state and of the national government, as well, but Virginia is probably in better shape to weather such events than most states are.

    • “As Secretary of Transportation, Layne inherited a mess from the McDonnell administration and did a good job of guiding the state into getting a handle on the costs and management of large transportation projects and setting priorities.”

      I greatly appreciate Dick’s comment. When I first started blogging here on Bacon’s Rebellion, I looked into for the first time a number of related subjects. UVA and how it was being run. I also looked into Dulles Airport, the Dulles Toll Road, the Silver Line, Arlington’s Million Dollar Bus-stop, how they were being run and financed. I looked into Fairfax County, its development processes and their results over the years, and how they had been run and financed and continued. Finally, I looked into the McDonnell Administration, its conduct of transportation policy throughout out the state, and also later McAuliffe as to marketing and other related PR matters.

      I had paid no attention to these matters for nearly two decades, since the early 1990s. And of course, I was picking up on the leads of many of Jim’s fine articles. Sad to say, I was absolutely appalled at what had gone on in Northern Virginia most particularly over the years since the late 1990s, but also during the McDonnell Administration then in progress, and also what was going on at UVA during then present times.

      All these matters and institutions and processes in my view were riddled with corruption, profoundly, intimately and abusively so, from top to bottom. I simply could not believe what I was reading and learning. Much of what I found has been laid out here in Bacon’s Rebellion. Some is yet untold. But in many ways my focus was narrowly confined, so much was left outside its scope.

      I remember clearly when Lane and then Moret showed up on the scene. In my limited view, the difference in their areas of responsibility has been enormous, and all to the positive benefit of Virginia, relative to what they inherited. I suspect they both daily swim against tides born of the habits and culture of others and entire systems. This is normal. Such is life. Good ethics and proven competence are always sorely tested in this world of ours. Hence, recognition and respect are due to those who swim against those tides, and make a positive difference doing so. Too often we forget or fail to see merit.

      • You’re right, Reed, institution after institution is falling short of expectations or failing us outright.

        A semantic quibble. I would not use the word “corruption,” which implies bribery, payoffs, or other kinds of self-dealing and law-breaking. Rather, I call it “institutional sclerosis” — increasing rigidity and failure to adapt. However, insofar as our institutions are failing us due to “regulatory capture” by stakeholders or ideologues, I use of the word “corruption” is not entirely unjustified.

        • Jim, I agree with your wider definition of corruption. That is how I most often intend its meaning when I use the word. But that does not mean that corruption so defined, but preventable, does not do enormous harm. And, equally important, such broadly defined corruption almost always, unless countered by individuals in a well run system, slides into “bribery, payoffs, or other kinds of self-dealing and law-breaking”, all of which is hard to find and correct, and very hard to be sure about. That is why so many names should be left out of so many stories of sure corruption where so much went wrong but its very hard to know how with precision as to human beings working on the scene and involved with it.

    • Layne doesn’t expect Virginia’s budget makers to have a perfect track record in making budget forecasts. Nobody has a perfect track record, not in the private sector any more than in the public sector. Nor did he criticize the specific methods that the Commonwealth uses to make its forecasts, which Dick describes above.

      Layne’s concern is that no one did anything when it became obvious that the Medicaid forecast was off track. The difference between the public sector and the private sector is that in a private company, managers would be held accountable. If their forecasts went off the rails, they would be expected to know about it early in the game, and they would be expected to do something about it. He describes the attitude of the people running Medicaid as, “Well, we missed the forecast. Oh, well.”

      Compared to other state governments, Virginia may have some of the best forecasting and budget controls in the country. But that doesn’t mean the Commonwealth can’t do better — especially when it’s implementing massive new programs like Medicaid’s shift to managed care. As Dick says, there was little history upon which to build a forecast. That’s all themore reason to track to forecast and make adjustments as early in the budgetary year as possible.

  7. Thanks Dick! That’s been my impression. No one is perfect at forecasts even the “good” ones and the “best” ones are in investment and they are not always covered in glory either!

    The ironic thing about MedicAid was that there were quite a few people who wer eligible who did not apply because they did not know they were covered under Original MedicAid but when the state expanded, they thought they MIGHT be covered an applied – and found out they would have been already covered.

    Unfortunately for the State, they had grossly underestimated the number who wer already elgible but had not applied. So the big bubble for Medicaid was not the expansion but the original.

    Finally, for those who think they like Mr. Layne (and I do), be advised that Mr. Layne is the Father of the HOT lanes and SmartScale!

    And ironic that McAliffe and Northam, oft labeled by Conservatives as leftist tax&spend liberals have in their employ – Mr. Layne for Transportation and Finance – and forecasting!

  8. Government is “people”. There are all kinds of “people” Business is also run by “people”.

    And there are good, bad and ugly.

    Private sector business is riddled with corruption and incompetence because they are run by folks who are not the best and/or make mistakes in addition to the folks who are good and competent. For every Bill Gates or Warren Buffet, there are some scam artists like Elon Musk and a few other notable dung bots.

    The idea that we expect Govt to have none of those faults and/or that we must “hold them accountable” by ferreting out all the bad and heaping blaming and recrimination on them…….. I dunno.

    I’m NOT in favor of corruption and incompetence and I do not excuse it but I go back to the idea that people run business and government and we have a range of good, bad and ugly to which we do have a responsibility to keep them honest.

    But I have to say – the tenor and tone sometimes is just plain nasty and accusatory and I think, off target and counterproductive at times.

    I favor looking at both sides of an issue and as Dick points out – try to be informed and knowledgeable in the criticism.

    Virginia has had its issues with forecasting – before Layne and as Layne admits – it’s not pure science and flubs are common. It’s an inherently risky thing.

    And a bit ironic that someone like Layne has to essentially read the riot act to our good buddies in the General Assembly to get their attention on things like the rainy day fund and our Bond Rating.

    • The big difference between incompetence in the private sector (except for monopolies) and the public sector is that the costs of incompetence in the private sector generally falls on the shareowners and employees, whereas the costs of incompetence in the public sector generally falls on taxpayers.

      When American car manufacturers continued to produce crappy cars, I stopped buying cars from the Big Three. I’ve bought cars from Japanese and Korean manufacturers, including some that were built in the United States. Same basic type of worker but with much better management. Which companies have been expanding and which contracting? And who eats the costs of contraction in the market?

      When Fairfax County or the Commonwealth of Virginia screw up, the costs are paid by taxpayers in the form of higher taxes or cuts to other programs.

      No one can forecast costs, demand, etc., with perfection. But the Commonwealth did a crappy job forecasting the costs associated with the expansion of Medicaid. And “Yes,” those costs include the stimulation of demand from people who were eligible for the program before expansion because of advertising, etc. If this were a private program, the board of directors would hold the CEO and the CEO would hold its planners responsible for a failure to produce more accurate projections. In business, one needs to know the impact of a change in policies as it affects everything material.

      We constantly allow people in the public sector to make poor projections of costs and demand without punishment. This problem extends from national defense to social programs to education to health care. Wouldn’t it be refreshing to see the MSM track Congress’s projections of program costs and publish them irrespective of program or political party?

      How about the massive cost overruns for the Silver Line, the construction of which enabled already wealthy landowners in Tysons and elsewhere in the corridor to make zillions more to due to rezoning? How about the big increases to tolls above projections and politician’s promises? This has been a huge transfer of wealth from ordinary middle class drivers of the DTR to the benefit of construction companies and landowners/developers. Where are the progressives worried about economic fairness? Heck, I’m sure that at least some of the DTR drivers paying the high tolls are not in the country legally!!!

      • Northern Virginia from the mid 1990s, say with the takeover of the airport Board, to say 2010 with arrival of new management at Dulles Airport was Wolfe’s Bonfire of the Vanities writ large.

      • I get frustrated with the constant disparaging of government agencies and employees while holding up the private sector as the paragons of competence and accountability. Two areas illustrate my frustration:
        1. Military procurement contracts–The Pentagon does not build the planes, ships, etc; it contracts with the private sector. For some items, such as ships, one company has a monopoly. The constant overruns in military contracts are due, not to government, but to delays, errors, faulty designs, shoddy workmanship, and bad estimates of the private contractors. There is very little holding these contractors accountable; the government just pays more. Even President Trump has complained about the excessive costs being charged by some contractors.
        2. CEO golden parachutes–I have lost count of the CEOs who were replaced because of their companies’ performance failures, who, instead of being shown the door and having their salaries eliminated, got lucrative separation payments.

        • I’d place military (and some other government) contractors in my monopoly category where taxpayers often eat the costs of inefficiency. I tend to agree with Dick on golden parachutes. I don’t mind when successful CEOs make boatloads of money but when they screw up or just fail to produce good results over a fair period of time, they should go empty-handed. I guess some level of compensation is due to CEOs when they leave after a takeover (merger or acquisition).

          • Reed Fawell 3rd

            This military (and some other government) contractors problem where taxpayers often eat the costs of inefficiency and cost gauging is growing by leaps and bounds. A huge problem since the beginning of warfare, it long has been one of the reasons why people and their leaders go to war one against the other. But now we have a hydra-headed monster on our hands. Weapons systems today are so complex and lethal in so many ways, without the need even to fire of a single explosive, that the problem today has grown exponentially. How do you keep your best people in the service, when they can jump over to the contractor side and make far more money, without any of the inconvenience, risk, price, and/or personal sacrifice that us inherent in serving your country in its military?

            Military service today, when it is done right by the individual serving, is among the very noblest of all modern jobs and professions, bar none.

          • Reed Fawell 3rd

            Correction to above:

            How do you keep your best people in the service, when they can jump over to the contractor side of the business and make far more money, without the inconvenience, risk, price, and/or personal sacrifice that is inherent in serving your country in the military?

            Military service today, done right by the individual serving, is among the very noblest of all modern jobs and professions, bar none.

  9. Plus, much of N. Va. problems arose from corrupted state and quasi gov. agencies in cahoots with powerful private corporate interests organized into “task forces” built and run over decades to grab control of or fleece public monies for their own private advantage.

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