State and local funds growing, but threatened

Despite current uncertainty driven by a series of executive orders in the opening days of the Trump Administration, many state and local governments are standing on firm financial ground thanks to reserve funds fattened by now dwindling pandemic relief money and robust tax collection.

State and local budget offices are reeling from conflicting signals coming out of Washington about the flow of federal funds that support Medicaid payments and infrastructure projects.  

“From what I hear, there was absolute panic,” said Marty Margolis, founder of the Public Funds Investment Institute, “and it was cross-partisan lines panic.”  

“A new administration always makes changes. Were they going to be this drastic? Nobody ever expected that.” 

The public finance world is still experiencing aftershocks reverberating from a series of executive orders, memos, judicial rulings, and clarifications that temporarily halted the flow of federal funds to state and local governments earlier this week.

But numbers from the Federal Reserve charting the growth of state and local government investment assets show an increase of nearly 14% in the 12 months ended Sept. 30, 2024. 

Per a report from Public Funds Investment Institute, “The growth rate is far higher than the overall pace of economic growth or the rate of growth in tax revenue in this period and seems to be a result of some mismatch between receipt and spending of federal funds but also an effort by public agencies to build reserves in the face of budget uncertainty.” 

The Fed’s numbers include money invested in local government investment pools.  

“The total assets are $4 trillion in round numbers,” said Margolis.

“My best guess of pool assets is $900 billion in round numbers. That suggests that that non-pooled assets are roughly three quarters of the investment assets of state and local governments.”  

LGIPs function as money market funds for government entities and are mostly free from any Securities and Exchange Commission regulations.  They typically don’t invest heavily in municipal bonds.  

According to the federal reserve’s figures, about 16% of the new assets were invested in commercial paper and corporate bonds with 12% going into federal agency obligations including the Government Sponsored Enterprises.

More than half of the increased assets were placed in Treasury securities which also showed the highest increase in value.  ”They are extremely safe and liquid,” said Margolis, “and they’re the most easily accessible.” 

“If you want to buy corporate bonds or commercial paper, you have to deal with the broker-dealer community.

“The broker-dealer community has changed over the years, and it has changed in a way that doesn’t provide a good service platform for most local governments. They’re too small and too episodic for getting involved in the markets.”  

Margolis pointed out that bank deposits are the other safe choice but aren’t getting much play either. “The banks have not been competitive in this space for the last several years. The bankers are not that interested.”  

In early January S&P Global Ratings reported the outlook for U.S. local government sector as stable with a chance of headwinds.  

Per S&P, “Bolstered by strong reserves due in part to federal stimulus during the pandemic, local governments are well placed to weather challenges.”  

 ”Slower forecast GDP growth in 2025 and fewer anticipated rate cuts from the Federal Reserve will create additional strains as LGs continue to accommodate rising operating costs from inflation and wage and salary growth.” 

“LGs are known for active management of fiscal challenges as well as their ability and willingness to adjust budgets to maintain operating balance.”