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New “Zombie Index” helps illuminate risks facing taxpayers

October 9, 2018

In the last week we have had a healthy reminder that stock and bond prices can go down as well as up. Granted, a few days does not make a trend. But it always makes sense to consider darker possible scenarios, particularly for many state and local governments whose financial position has deteriorated since 2009 despite a huge apparent recovery in financial markets.

What would happen in the event of a large, sustained downturn in financial markets, perhaps arising with sustained higher long-term interest rates? Which of the United States are potentially at higher risk than others? With Halloween coming up, we’ve decided to revise and update the “Zombie Index” we include in our State Data Lab database.

This index is inspired by the work of Edward Kane, Professor of finance at Boston College. Kane wrote books warning about the developing crisis in the deposit insurance system in the late 1980s.  Kane coined the term "zombie bank," referring to banks and thrifts that were effectively insolvent but allowed to remain open via untruthful accounting and regulatory forbearance.  

Kane called them "zombies" because they were really dead but allowed to walk among the living, and false accounting delayed loss recognition.  Zombies had incentives to take large risks to try, in Kane's words, to "gamble for resurrection" – especially considering moral hazard generated by expectations that taxpayers would get the downside of the gambles. These incentives, in Kane's view, amplified the cost of the savings and loan crisis for taxpayers.

Similar incentives may still exist today, for “too-big-to-fail banks” as well as troubled state and local governments facing huge shortfalls in their pension plans – shortfalls long left outside government balance sheets.

Our Zombie Index is based on five elements related to what Kane viewed as the factors in Zombie-ness. The first is Truth in Accounting's "Taxpayer Burden" (weighted at 25%), the second is the timeliness (or lack thereof) in filing the annual Comprehensive Annual Financial Report (weighted at 25%), the third is the trend in timeliness (weighted at 10%), the fourth is Truth in Accounting's "Transparency Score" (weighted at 25%) and the fifth is the average ratio of accrual expenses to accrual revenue in the last 10 years (a measure of whether governments really 'walk the talk' on balanced budget requirements, weighted at 15%).

States with higher "Zombie Index" scores may be more likely to be taking higher risks in their investments and other areas.  The Zombie Index Ranking is from 1-50, with one indicating the highest Zombie Index ranking, and 50 indicating the lowest ranking.

We report the Zombie Index rankings for 2009 to 2014, and for 2017 onward. Beginning in 2015, state and local governments began including previously off-balance-sheet retirement benefit debt on their balance sheet, changing the nature of the "hidden debt" component previously included in our Zombie Index rankings. We substituted the Transparency Score for that component beginning in 2017, and added the trend in timeliness and the rolling 10-year average ratio of accrual expenses to accrual revenue in 2017 as well.

The biggest ‘Zombies?’ New Jersey, Massachusetts, New Mexico, Connecticut, and Illinois. Taxpayers and citizens in those states could benefit from more oversight of risk exposure in investments backing retirement funds. They might also benefit from some form of ‘prompt corrective action’ advocated by Kane and others for supervisors of failing banks – sooner than later.

Some related possible remedies could include Paul Rose's recent recommendations for considering fundamental changes in the fiduciary responsibilities for public pension fund managers, and Ed Kane's ideas about fiduciary duties for managers of “too-big-to-fail banks.”


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