Journal 4

Preventing Local Government Fiscal Crises: The North Carolina Approach

CHARLES K. COE

Some local governments face fiscal challenges due to mismanagement and declining economies. In particular, manufacturing states like Michigan and Ohio have been hard hit by the effects of international competition. To prevent fiscal distress from becoming a crisis, states exercise oversight over local government fiscal management. The three bond rating agencies consider the North Carolina oversight system a model. This paper discusses the North Carolina oversight system, including audit review, technical assistance, debt issuance, and power to take over the financial operations of distressed local units.

INTRODUCTION

In 2005 the three rating agenciesFStandard & Poor’s Corporation (S&P), Moody’s Investors Service (Moody’s), and Fitch IBCA (Fitch)Frated $144.6 billion in general obligation (GO) bonds and $264.5 billion in revenue debt.1 In assigning a rating, the

agencies assess a government’s ability to pay the principal and interest on debt by

evaluating its economic base, financial condition and practices, debt factors, governance

and planning. To rate local governments, the rating agencies also take into consideration

a state’s oversight of local governments’ financial management practices. Among the

states, the rating agencies single out the North Carolina system as exemplary. Because of

the state system, Fitch improves the credit rating of North Carolina bonds rated below

‘‘AA’’ by one step.2 North Carolina is the only state so recognized by Fitch. Though

Charles K. Coe is a professor of public administration in the Department of Public Administration, North

Carolina State University, P.O. Box 8102, Raleigh, NC 27695-8102. He can be reached at coe@

social.chass.ncsu.edu.

1. The Bond Market Association, Bond Markets.com; available from: http://www.bondmarkets.com/

story.asp?id=2296: accessed 2 February 2006.

2. Amy Laskey and Rebecca Hall, State of North Carolina Local Government Commission (New York:

Fitch’s Investors Service, 2004).

Charles K. Coe / Preventing Local Government Fiscal Crises 39

Moody’s3 S&P4 do not expressly improve ratings, they do acknowledge that the quality

of the NC system contributes to lower bond ratings. Consequently, though ranking

11th in population and 37th in per capita income, North Carolina has the most local

governments with the highest bond rating of any state.

The rating agencies assign a better rating to North Carolina’s municipal bonds for

two reasons.5 First, the state reviews and approves the issuance of all local government

debt.6 Though issuers may hire their own fiscal advisors, the state sells the securities.

Second, the state exercises exacting oversight over local government fiscal management.

To prevent fiscal stress from becoming a crisis, the state closely monitors fiscal perfor-

mance, assists troubled communities, and assumes fiscal control over local operations.

A tribute to the early identification and assistance program is that North Carolina has

taken over the operations of only three cities and one water-sewer district since its over-

sight system began in 1932, which is particularly noteworthy in light of the large number of

local units (100 counties, 527 special districts, and 459 cities, their small size (200 cities less

1,000 in population), and the strained tax bases of many. In each instance, the state took

swift, effective action, turning back financial control to the cities within a year.

The North Carolina system serves as a model to other states. This paper discusses the

history of the oversight system, its operations, and powers, concluding with a cost–

benefit analysis of the oversight system.

HISTORY OF THE LOCAL GOVERNMENT COMMISSION (LGC)

North Carolina suffered the second highest number of municipal bond defaults during the

Great Depression.7 By 1932, 62 of 100 North Carolina counties, 152 cities, and

about 200 special districts defaulted on the principal, interest, or both.8 Consequently, the

legislature created the LGC, a division of the State Treasurer’s Office, to impose financial

controls and assist troubled communities. A nine-member board directs LGC operations:

� The State Treasurer, State Auditor, Secretary of State, and Secretary of Revenue (ex officio).

� Three governor’s appointees. � One appointee of the President of the Senate. � One appointee of the Speaker of the House.

3. David Alter, David, Julie Berman, and Patricia McGuigan, ‘‘Administrative Factors in Rating Local

Debt: Case Studies in the Southeast Region,’’ Moody’s Municipal Issues 9, 7–9,12 (1992).

4. Richard Marino, Colleen Woodell, and LaVerne Thomas, North Carolina Local Government Com-

mission Contributes to Higher Ratings (New York: Standard & Poor’s, 2001).

5. Laskey and Hall, 2–3 and Marino et al., 1.

6. The LGC approves all debt. It sells all general obligation debt. Local governments privately place

enterprise bonds and certificates of participation (COPs) after LGC approval.

7. Laskey and Hall, 2.

8. David Lawrence, Financing Capital Projects in North Carolina, 2nd ed. (Chapel Hill, NC: Institute of

Government, the University of North Carolina at Chapel Hill, 1994).

Public Budgeting & Finance / Fall 200740

The LGC oversees financial operations of cities, counties, school systems, charter

schools, hospital and airport authorities, and water and sewer districts. The oversight

system has two principal cornerstones: (1) control over debt issuance and (2) budgetary

and fiscal oversight powers.

DEBT ISSUANCE CONTROL

North Carolina is the only state legally responsible for the issuance of all local govern-

ment debt.9 The LGC directly issues or approves the sale of about 300 debt instruments

annually, including GO bonds and notes, enterprise and utility bonds, public hospital

bonds, and swap agreements. The LGC sells all GO bonds competitively. Local gov-

ernments privately place enterprise bonds and certificates of participation (COPs) with

an underwriter, after the LGC enters into a bond purchase agreement for an enterprise

bond and an acceptance contract for a COP.

In deciding whether a local government can sell a GO bond, the LGC evaluates the

adequacy of the bond amount, the bond’s effect on the property tax rate, and whether

the bond can be marketed at a reasonable interest rate. In deciding whether to issue a

revenue bond, the LGC requires a local unit to conduct a comprehensive feasibility

study, explaining the prospective bond’s effect on future revenues and expenses and

future service demand.

BUDGETARY AND FISCAL OVERSIGHT

To varying degrees, all states impose some measure of financial control on local units. States

commonly require local units to follow generally accepted accounting principles (GAAP)

and have an independent annual financial report conducted. In one survey 87% of the states

were found to require that local units submit their financial report to the state, and 42%

made their submission a condition of receiving state aid.10 States also may require that a

budget be adopted; limit the amount of GO debt that can be issued; regulate purchasing

and contracting practices; and specify the instruments in which local units can invest.

North Carolina regulates the audit process; extensively reviews financial reports;

assists troubled communities; and intervenes to assume financial control.

Auditing

As with debt issuance, North Carolina goes beyond most states with respect to auditing

requirements. Like most states, North Carolina requires an independent financial audit

in accordance with generally accepted auditing standards but further requires that local

units use the state’s standard audit contract; approves local governments’ auditor

9. Ibid.

10. Scott Mackey, State Programs to Assist Distressed Local Governments (Denver, Co: National Con-

ference of State Legislatures, 1993).

Charles K. Coe / Preventing Local Government Fiscal Crises 41

selection; approves the audit contract; and permits final payment to the auditor only

after approving the financial report.

Financial Report Review

To mitigate fiscal crises, researchers have developed models to enable states to predict fiscal

distress. Relatively few states, however, have adopted these tracking systems. Kloha et al.

found that 15 states have formally adopted indicators that define fiscal distress, but only

seven of these states use the indicators to predict fiscal distress.11 One of the seven, the

LGC extensively examines financial reports to detect errors, identify problems, and rec-

ommend corrective action. A staff of 13 CPAs subjects 1,086 financial reports to three

levels of review. First, an analyst scans the report for obvious financial problems and

enters the data into a data base. In the second-level review, the analyst looks for material

(important) deficiencies. When found, the LGC sends a letter (known as a white letter) to

the local governing board. Annually, the LGC issues about 700 white letters. Some letters

address minor problems that can be corrected in next year’s financial report. Others,

though, are more severe, requiring correction before the LGC will approve the financial

report and the independent auditor’s last payment. Common deficiencies include:

� Incomplete financial statements. � Inconsistencies between the financial statements and the notes to the financial

statements.

� Absence of a management letter. � Inconsistency between the type of audit performed and the information in the

general purpose financial statements.

� Improper categorization of financial statement items.

In the third-level review, the analyst examines for more serious financial problems.

When a problem is found, the LGC sends a letter (known as a unit letter) to which the

local governing board must state how it will correct the problem. The LGC issues about

200–250 unit letters annually addressing such problems as

� A qualified auditor’s opinion. � General fund balance below 8% of spending. � Property tax collections below 90% of current taxes collectible. � Material expenditure overages of budgeted amounts. � Significant internal control violations and material weaknesses reported in the

management letter.

� Deficit fund balances. � Previous year’s deficit(s) not being eliminated. � A low quick ratio in the enterprise fund(s).

11. Phillip Kloha, Carol Weissert, and Robert Kleine, ‘‘Someone to Watch Over Me: State Monitoring

of Local Fiscal Conditions,’’ The American Review of Public Administration 35, no. 3 (2005): 236–255.

Public Budgeting & Finance / Fall 200742

Along with the financial report, the LGC requires that the auditor issue a manage-

ment letter, detailing weaknesses in internal controls and financial systems. LGC analysts

compare the findings in the current year’s management letter with those expressed in the

prior year to ascertain if the local unit has corrected previously noted deficiencies.

LGC analysts review revenue bonds for compliance with the indenture rate covenant,

the additional bonds test, permitted investments, and reserve requirements. LGC staff

then compiles data in a format that allows statewide benchmarking of fiscal performance

among like-populated cities and counties.12

Assistance to Troubled Localities

Because only seven states predict distress, most states assist after a local jurisdiction finds

itself in financial distress. At which time, states take a range actions including on-site

technical assistance (eight states), loans (five states) and grants (four states); backing local

government debt with state funds (four states); and temporarily waiving state property tax

limits (four states).13 In contrast to this post hoc approach, the LGC proactively works

with local units to resolve identified problems. For some problems, staff simply calls

localities to see if they wish assistance. Most local units can correct their problems without

assistance; however, some need help from LGC staff. For serious problems, the LGC may

require that a local unit furnish monthly budget-to-actual statements. Finally, after

extensive state assistance, if a serious condition remains; the LGC formally warns the

governing body that it may have to takeover financial operations.

Intervention

State legislators are understandably cautious about intervening in local government

affairs.14 Nevertheless, seven states have statutory authority to create a financial control

board (FCB) to manage the operations of a distressed local unit.15 Four states require

the formation of a FCB as a condition of a troubled local government continuing to

receive state aid.16 Other states create oversight boards on an ad hoc basis by means of

special legislation. For instance, from 1990 to 1993 six states used this vehicle to create a

FCB notably in Bridgeport, CT (1988), Chelsea, MA (1991), and West Haven, CT

12. Cities and counties are compared by population size. Among the metrics are property tax collection

rates, revenues per capita, net debt per capita, fund balance, and the net working capital and quick ratio in

enterprise funds; available from: http://ncdst-web2treasurer.state.nc.us.lgc/units/unitlistjs.htm: accessed 3

March 2006.

13. Mackey, ‘‘State Programs.’’

14. David Berman, ‘‘Takeovers of Local Governments: An Overview and Evaluation of State Policies,’’

Publius 24, no. 3 (1995): 55–70.

15. For a discussion of state interventions, see Advisory Commission on Intergovernmental Relations,

Bankruptcies, Defaults, and Other Local Government Financial Emergencies (Washington, DC: Author,

1985).

16. Mackey, 6.

Charles K. Coe / Preventing Local Government Fiscal Crises 43

(1992).17 To restore credit worthiness, FCBs may have the power to restructure

debt, limit borrowing, and issue deficit-reducing bonds.18 To establish sound financial

management, FCBs have installed budgetary accounting systems and internal controls.19

A FCB may be authorized to raise taxes and/or cut services.20 For instance, the state-

appointed city manager in Hamtramck, MI fired employees, replaced department heads,

privatized services, reduced salary increases, froze hiring, and suspended the pay of the

City Council and Mayor.21

Because of its early detection and assistance programs, North Carolina has assumed

financial control on only four occasions since 1932. The four cases illustrate the effec-

tiveness with which the LGC uses its strong powers to get local jurisdictions back on

their fiscal feet. This power to take strong, effective, decisive action is among the chief

reasons that the three bond rating agencies favor North Carolina local government

bonds.22 Let us look at each case.

After over 40 correspondences and meetings, the LGC assumed control of the finances

of Princeville (population 1,701) in 1997.23 Before the takeover, the governing body had

failed to balance its general and water-sewer fund budgets despite repeated LGC

directions that it do so. Then, the LGC discovered payroll and pension fund shortfalls,

prompting its assumption of financial control. The LGC-appointed financial manager

eliminated the town manager and tax collector positions, increased revenues, and turned

a $250,000 deficit into a $250,000 surplus within 11 months after which the governing

body assumed control.

Due to sharp political differences, the governing body of Enfield (population 2,347)

refused to adopt its 1998 budget. Because they could not be paid without a budget, city

workers threatened to strike operations. The LGC stepped into the breech assuming

financial control in June 1997. The LGC-appointed financial manager prepared a budget

that did not change the service levels, tax or fee rates, or salary levels. The governing

body adopted this interim budget in July and took back financial control after adopting a

final budget in September.

In 2001 the LGC assumed financial control of East Spencer (population 1,800). The

town had refused to furnish the LGC with its FY 2000 and FY 2001 financial reports

despite repeated requests. To assess the situation, LGC staff examined financial records

on site, discovering a general fund deficit, an alarmingly low 80% property tax collection

17. Ibid., 11.

18. Henry Hren, Michael Morelli, and Lois Briggs, ‘‘Missed Opportunity: Urban Fiscal Crises and

Financial Control Boards,’’ Harvard Law Review 110 (1997): 733–750.

19. Ibid., 738.

20. Anthony Cahill and Joseph James, ‘‘Responding to Municipal Fiscal Distress: An Emerging Issue

for State Governments in the 1990s,’’ Public Administration Review 52, no.1 (1992): 88–94.

21. Elizabeth Carvlin, ‘‘The Art of Saving Cities,’’ The Bond Buyer, December 18 (2002).

22. Laskey and Hall and Marino et al.

23. The discussion of takeovers is based on interviews with Vance Hollomon, Deputy Treasurer, State

Treasurer’s Office, who served as the state-appointed financial manager in the four cases.

Public Budgeting & Finance / Fall 200744

rate, internal control deficiencies, and misappropriated state funds. Consequently, the

LGC assumed financial control in October 2001. The LGC-appointed financial manager

raised water and sewer rates by 23%, established sound financial management and

accounting controls, reduced staffing costs by contracting out services and using vol-

unteers, thereby eliminating the deficit and returning financial control.

Finally, the LGC assumed control of the South Brunswick Water and Sewer

Authority in 2003. Despite repeated LGC warnings, the authority had unwisely spent

impact and stormwater fees on general operations rather than on legally required debt

service payments and needed capital outlays. The state-appointed financial officer

promptly contracted out plant operations to Brunswick County, which subsequently

purchased the water and sewer system and retired outstanding bonds.

COSTS AND BENEFITS OF THE LGC

The LGC’s FY 2006 budget was $2,619,761, which includes the cost of personnel,

supplies, and equipment. The staffing was as follows:

Section Professional Staff Support Staff Total

Administration 2 2 4

Debt Management 10 4 14

Financial Management 13 2 15

Total 25 8 33

Local governments’ costs of complying with the LGC oversight program are nominal.

At no or minimal cost, they send their audited financial report to the LGC for review;

correct LGC-noted deficiencies, which are accounting and budgeting changes; and meet

with LGC for its review and approval and bonds.24

Benefits

The benefits the LGC oversight system have been lower debt costs, higher quality and lower

costing financial reports, sound accounting, safe investments, and fiscally conservative.

Lower Debt Costs

As stated earlier, Fitch Investors Service grants a one notch, half rating upgrade to local

units rated less than AA. A one-notch difference amounts to about nine basis points. As

of June 30, 2005 local governments had $7.5 billion in outstanding bonds and installment

24. A new program would also have start-up costs of purchasing equipment and possibly acquiring

space.

Charles K. Coe / Preventing Local Government Fiscal Crises 45

purchases rated less than AA. Assuming a nine basis point savings in the annual

debt service,25 local governments realized annual interest payment savings of

$6.75 million.26

Savings also occur regarding bond sale preparation. In other states, most local units

hire financial advisor to determine the feasibility of issuing debt, prepare a debt sale

calendar, advise on bond pricing, prepare for the meeting with bond rating agencies,

check the accuracy of bids, and decide whether to accept bids.27 In North Carolina,

though, all this work is done by the LGC presumably at a lower cost because it does not

pay income taxes or make a profit.

Interest costs may also be less because the LGC times bond sales to avoid saturating

the market. Rarely do local governments in other states voluntarily agree to avoid the

bunching of bond sales 28 In contrast, the LGC avoids bunching the bond sales of two or

more large issuers (e.g., Charlotte and Raleigh), sales in the same geographic area, and

sales by a large and small local unit.

Higher Quality/Lower Cost Financial Reports

North Carolina has high-quality auditing because the LGC provides to local jurisdic-

tions and independent auditors:

� An annually updated audit manual. � A sample request of audit proposals. � Single audit resources. � Illustrative financial statements. � U.S. General Accounting Office Yellow Book Standards.29

To ensure audit quality, the LGC permits localities to make final payment to their

independent auditor only after it has determined that the financial report meets stat-

utorily established reporting standards. Moreover, LGC staff trains auditors and finan-

cial managers on topics such as newly issued Governmental Accounting Standards

Board (GASB) standards, general statute changes, and financial management topics.

LGC staff train treasurers, Certified Public Accountants, finance officers, and budget

managers. Such training was especially valuable when local units had to convert to

25. The nine basis points are based on municipal yield curves for a 20-year general obligation bond as of

June 30, 2005. Data were provided by Thomson Financial, MMD Benchmark Yields 1–30 YR.

26. S&P and Moody’s do not specifically state how much they improve North Carolina ratings, so these

interest savings may be less.

27. A. Jack Vogt, Capital Budgeting and Finance: A Guide for Local Governments (Washington, DC:

The International City/County Management Association, 2004).

28. W. Bartley Hildreth and Gerald Miller, ‘‘Debt and Local Economy: Problems in Benchmarking

Local Debt Affordability,’’ Public Budgeting and Finance 22, no. 4(2002): 99–113.

29. To view these resources, access http://www.treasurer.state.nc/dsthome/StateAndLocalGov/Auditing:

accessed 3 March 2006.

Public Budgeting & Finance / Fall 200746

GASB 34. LGC staff provided training, technical assistance, a sample GASB 34 opin-

ions, and illustrative GASB 34 financial reports. To reduce audit costs, the LGC staff

compiles and distributes federal compliance supplements to auditors and localities,

which is done by auditing firms in other states thus adding to their audit fee.

To reduce localities’ cost of preparing financial data for audit review, the LGC freely

provides a software program that converts fund financial statements to the full accrual

statements as required by GASB Statement 34. In contrast, local units in other states had

to pay from $10,000 to $20,000 to private vendors for a similar conversion program.

Safe Investments

Annually, localities must submit a report of all cash investments to the LGC. LGC

analysts review the reports to ensure investments were legal, properly collateralized, and

were of appropriate maturity length.

Conservative Budgeting

The unreserved fund balance safeguards against the effects of unanticipated natural

disasters and economic downturns and ensures stable service levels. The GFOA recom-

mends that local governments maintain a fund balance between 5% and 15% of general

fund operating expenditures, or one to two months of general fund operating expen-

ditures.30 In North Carolina, the LGC normally will not issue bonds if jurisdictions have

less an 8% fund balance.31 The minimal 8% fund balance gives about one-month leeway

to avoid short-term borrowing until property taxes are received.

Beyond the minimum, the LGC recommends that local units maintain significantly

higher fund balances. The LGC recommends that the fund balance amount be the same

as the average for like-sized towns or counties. These averages, shown in Table 1, may at

first glance seem exorbitant. For instance, the average fund balance in the cities with

populations under 500 was 125%; but on closer reflection, this is $292,783 that all might

be needed after a devastating natural disaster or major plant closing.

Sound Accounting Controls

The LGC requires localities sound accounting policies and procedures regarding:

� The chart of accounts. � Fixed asset accounting. � Purchasing. � Payroll.

30. Stephen Gauthier, Governmental Accounting, Auditing, and Financial Reporting (Chicago: Govern-

ment Finance Officers Association, 2005).

31. The very rare exception occurs if bonds are needed to respond to threats to the health and safety of

citizens.

Charles K. Coe / Preventing Local Government Fiscal Crises 47

� Tax assessment, billing, and collection. � Ledgers and journals. � Grants and grant accounting. � Internal controls. � Insurance and risks. � Budgeting and capital planning.

CONCLUSION

According to the bond rating agencies, the North Carolina oversight system serves as a

model to other states. Whether other states can, or should, emulate North Carolina

would likely depend on three questions. First, what is each state’s need? North Carolina

clearly has a need for a strong oversight system in light of its large number of local units,

many of which have no professional management and are economically challenged.

Local governments in western North Carolina have been especially struck hard by the

sweeping exodus of textile jobs overseas, and many local governments in eastern North

Carolina face chronic economic circumstances.

Other states face similar challenges. The five lowest states with respect to personal

income per capita are Mississippi, Arkansas, New Mexico, Utah, and Montana.32 Some

TABLE 1

Average Fund Balances of North Carolina Counties and Cities June 30, 2004

Type of Unit Number of Units* Average Fund

Balance Percentage

Counties

100,000 or more population 23 16.9

50,000–99,999 27 22.7

25,000–49,999 24 26.2

Under 25,000 25 28.3

Total 99 18.6

Cities

50,000 or more 10 23.1

10,000–49,000 29 35.8

2,500–9,999 110 61.9

1,000–2,499 99 71.7

500–999 90 104.3

Under 500 110 124.8

Total 459 36.2

*Excludes 40 nonreporting local units and 70 cities whose fund balance totals not comparable due to having city-

owned electric funds.

32. U.S. Census Bureau, ‘‘Personal Income per Capita in Constant (2001) Dollars,’’ in Statistical

Abstract of the United States (Washington, DC: Author, 2004).

Public Budgeting & Finance / Fall 200748

states, like North Carolina, are economically challenged and have a plethora of local

units. For instance, Texas, ranked 32nd in per capital income, has 1,196 cities and 4,784

local units;33 Arkansas, ranked 49th, has 499 cities and 1,588 local units; Missouri,

ranked 29th, has 946 cities and 3,422 local units. Even more affluent states may face

problems due to their sheer number of local units. For instance, Pennsylvania, though

ranked 18th per capita income, has 1,017 cities and 5,031 local units; Illinois ranked 14th,

has 1,291 cities and 6,903 local units.

Other states, like North Carolina, are particularly hard-hit by the effects of global-

ization. In particular, manufacturing states like Michigan and Ohio have experienced

considerable job losses. Local units whose economy is dependent on the auto industry

now find themselves in an especially precarious economic position.

Assuming a need for state oversight, the second question is how likely would local

governments accept such oversight? The origin of the North Carolina oversight system,

the Great Depression, was anomalous. Cities and counties might well resist state actions.

Local units with home rule powers are particularly used to autonomy. Because Missouri

constitutionally granted home rule in 1875, 21 states have granted home rule authority to

their cities and counties.34

Such resistance occurred in Michigan. Concern over Michigan’s economic future

prompted the Citizens Research Council of Michigan to conduct a study, which con-

cluded that the state should adopt the North Carolina oversight system create a similar

system; but no action has been taken.35

Rather than resenting state oversight, North Carolina localities highly value it. Go-

vernors and state legislatures desiring more oversight should use the positive testimonials

of local government elected and appointed officials to allay local government concerns.

Assuming local resistance is overcome, the third question is what would be the costs

and benefits of adopting more oversight? Can North Carolina’s costs be extrapolated to

other states? Would other states likely receive bond interest savings as has been the case

in North Carolina? Each state must make its own assessment. To cut costs and reduce

local resistance, states might restrict themselves to financial oversight and not issue local

bonds.

Finally, more research is needed in the area of state oversight. Kloha et al. found that

only seven attempt to predict local government fiscal distress.36 These seven states should

be investigated. How do they predict distress; what assistance to they give to troubled

communities; and what intervention powers do they have?

33. Includes municipal governments, counties, town or township governments, subcounty general

purpose governments, school districts, and special district governments.

34. Jesse Richardson, Meghan Gough, and Robert Puentes, Is Home Rule the Answer: Clarifying the

Influence of Dillon’s Rule on Growth Management (Washington, DC: The Brookings Institution, 2003).

35. Citizens Research Council of Michigan, Avoiding Local Government Financial Crisis: The Role of

State Oversight (Livonia, MI: Author, 2000).

36. Kloha et al., 245.

Charles K. Coe / Preventing Local Government Fiscal Crises 49