Through the din of protests over state budget cuts in Wisconsin, Ohio and elsewhere across the nation, one word is now being bandied about with greater frequency: bankruptcy. Some Republicans, including Newt Gingrich, Jeb Bush and others, are not just floating the idea but going so far as to recommend it. “A bankruptcy option for the states would look very similar to Chapter 9 municipal bankruptcy, with some necessary modifications,” Gingrich, the former GOP House Speaker, and Bush, the former Florida governor, wrote in a recent op-ed.
Why? Try this on for size: All told, states now face a cumulative $125 billion operating deficit for fiscal year 2012, according to the Center on Budget and Policy Priorities. (The shortfalls for 2009 and 2010 and most of the shortfalls for 2011 — totaling over $430 billion combined — have already been closed through a combination of spending cuts, withdrawals from reserves, revenue increases, and use of federal stimulus dollars.) In addition, unfunded public pension liabilities may be as high as $574 billion, according to a new report by Joshua Rauh, finance professor at Northwestern. This fiscal promise is above and beyond the roughly $3 trillion (or $27,000 per household) in unfunded liability of all state‐sponsored pension plans in the U.S., so many cities are carrying substantial off‐balance‐sheet debt. . “These [liabilities] are the largest loophole in balanced budget pledges,” said Rauh in recent testimony before a House subcommittee.
Currently, U.S. states—considered sovereign by the constitution—are barred from filing for bankruptcy. Gingrich and Bush want Congress to amend the constitution to allow states to file, since Congress is reluctant to provide bailouts to the states. Filing bankruptcy, they claim, would avoid default and be a better alternative than a bailout.
Newly elected GOP state governors including Wisconsin’s Scott Walker, Ohio’s John Kasich, and New Jersey’s Chris Christie, of course, have been targeting changes in collective bargaining and worker contributions for health-care coverage and pensions as part of their efforts to close budget gaps. Even some Democratic governors, including Andrew Cuomo in New York and Jerry Brown in California, plan to trim many of the robust benefits that were pushed by unions and granted almost routinely to public workers during better economic times.
Though state tax revenues are projected to grow 6.6 percent in fiscal year 2011 and 7.2 percent in fiscal year 2012, governors face rising social service costs and the end of federal stimulus funds; that means continued budget deficits in fiscal year 2012, said economist Dan White, with Moody’s Analytics. “Local government defaults and bankruptcies have become an increasing risk to both state and local government fiscal outlooks,” said White. “While the municipal market is not in immediate danger of a wave of local government defaults, cities and counties in general are at a higher risk of default or bankruptcy than the extremely low historical average.”
Time to “Swallow the Pill”?
For many years, says John Steele, business historian and author of American Empire of Wealth, states “gave away the candy store. Now, [private workers] have woken up and said, ‘Hey, I can’t retire at 55 with a 90 percent pension, so why should a clerk at the Department of Motor Vehicles be able to do that?” Political support now exists for “states to get really tough and say, ‘We can go into bankruptcy or we can negotiate.’"
Leslie Linfield, executive director of the Institute for Financial Literacy, says that there has been “talk” of amending the Chapter 9 bankruptcy rules to allow for states to file—and that this talk hasn’t occurred during previous economic downturns. “This is a new discussion, and it’s about pension obligations as a time bomb sitting out there that states have to deal with,” she said. “Big states like New York and California have relatively well funded pensions when compared to Massachusetts, Connecticut and Hawaii—whose unfunded pension obligations are huge, especially when compared to their debt. Massachusetts alone has almost $22 billion in unfunded pension liability.”
Linfield adds, “You have three options, whether you’re an individual or a government. You can increase income, decrease expenses, or a combo of both. Pensions will have to be dealt with it. It won’t necessarily be pleasant. But manufacturing and corporate America has gone through with it. So, swallow the pill.”
If states can’t find a long term solution, there’s legitimate concern that taxpayers might ultimately be on the hook for bailing out the most profligate among them, said Patrick Gleason with Americans for Tax Reform. “Addressing the need for reforms to the public pension system will lessen the talk of whether state bankruptcy code is needed,” he said.
The Muni Market: A Ripple of Concerns
Just the mere talk of bankruptcy, of course, can disrupt the municipal bond market. States take on a great deal of debt from these bonds to finance investments in infrastructure, hospitals and schools. Not long ago Meredith Whitney, a banking analyst who famously predicted the collapse of several big banks in 2007, drew criticism for her ominous comments on this topic. “You could see 50 sizable defaults, 50 to 100 sizable defaults, more,” she said on 60 Minutes in December. “This will amount to hundreds of billions of dollars’ worth of defaults.”
Those comments helped drive the usually sleepy municipal bond market into frenzy, with investors pulling out a record $3.9 billion for the week ending January 19, 2011, according to Lipper U.S. Fund Flows, which tracks mutual funds. That was the tenth consecutive week investors withdrew from the municipal bond market. Outflows have continued since January 19th as the bond market has seen 14 consecutive weeks in the red. In the week ending February 16, investors withdrew $1.069 billion.
“It’s always been impossible for states to default because they had to run balanced budgets,” said Robert Shapiro, former Undersecretary of Commerce. If a state did declare bankruptcy, the bonds would plummet in value, interest rates would go up and no one would want to buy them, Shapiro added.
“Unless bankruptcy provisions enabled [states] to modify their labor contracts and pension obligations, it would serve no useful purpose,” said Kevin Cunningham of Ballard Spahr, a Philadelphia based law firm. “Bankruptcy can be reasonably good, so long as the legislation is targeted at those obligations that are most burdening states.”
Municipal bonds are issued by states or cities to finance special projects such as highway or sewer construction projects. The interest on the bonds is exempt from federal income tax and often state tax. Individual investors hold about two-thirds of the roughly $2.8 trillion of U.S. municipal bonds outstanding, either directly or indirectly through mutual funds and other investments, according to the SEC.
Either way, some say that even though default wasn’t much of a concern in previous economic downturns, a state bankruptcy option is unlikely. “I can’t imagine a state government as being so irresponsible to default,” says the historian John Steele. And the nation's governors and legislators adamantly oppose calls for bankruptcy protection for states. In a recent letter to the congressional leadership , the chairs of the National Governors Association wrote, “Bankruptcy proposals suggest that a bankruptcy court is better able to overcome political differences, restore fiscal stability and manage the finances of a state. These assertions are false and threaten the fabric of state and local finance.”
