Could my state declare bankruptcy? It's not likely.

Commentary about business and finance.
Jan. 24 2011 6:49 PM

Bankrupt Reasoning

Why you don't need to worry about your state declaring bankruptcy.

California state capitol. Click image to expand.
The California State Capitol

You might not have noticed, but an investment panic swept through Wall Street last week. According to Bond Buyer, investors set a new record for weekly withdrawals from municipal mutual funds last week, taking out about $4 billion. Over the past 10 weeks, they have redeemed $29.3 billion, also a record, roiling the normally staid $2.8-trillion municipal debt market.

What's scaring investors off? One answer is that they are worried about the short-term gaps and long-term structural problems in state and local budgets. According to the Center on Budget and Policy Priorities, 44 states plus the District of Columbia are facing a combined $125 billion budget hole for fiscal year 2012. Illinois, worst off of all, needs to raise taxes and cut spending to the tune of $15 billion—about 45 percent of its budget. Many cities, towns, and counties are no better off. And many states are grappling with unfunded pension obligations and a host of other big, big budget problems.

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A more likely explanation, however, is that investors are reacting to a spate of panicked media reports about the effect of all that red ink—not just service cuts and tax hikes, but looming defaults and even state bankruptcies, something that has not happened since the Great Depression. Early worries centered on cities and towns, with famed Wall Street analyst Meredith Whitney predicting 50 or 100 "sizeable" defaults in the next year. Of late, concern has focused more on states—with the Weekly Standard calling for Washington to build a pathway to state bankruptcy and the New York Times running a story on the local pols taking up the idea.

Bond holders, understandably, don't want cities or states to default or declare bankruptcy. They just want to be paid back, thank you, with interest and on time. Fears they won't be repaid have caused them to pull their money from the market. But those worries seem unfounded. Yes, cities and states face tremendous budget problems. But there is no new evidence that they are looking to solve them by jilting their bond holders.

Yet the idea that states might need the option to declare bankruptcy is in vogue—and it is freaking out muni investors. The pro-bankruptcy argument goes something like this: At some point, states won't be able to make ends meet. They simply won't be able to raise taxes and cut services enough to pay back their bond holders and their pension and health care obligations. Some cash-strapped "beggar states" might in that case seek federal dollars—and Washington should refuse, for moral-hazard and budgetary reasons. Rather, the states should negotiate with pensioners and unions to reduce their billions in unfunded liabilities. If they cannot do that, they should have a bankruptcy judge do it for them.

Newt Gingrich, the former speaker of the House, called on Republicans to create a bankruptcy option for states to avoid federal bailouts in November. "[I] n the first month or so of their tenure," he said, House Republicans should move "to create a venue for state bankruptcy, so that states like California and New York and Illinois that think they're going to come to Washington for money can be told, you know, you need to sit down with all your government employee unions and look at their health plans and their pension plans, and frankly if they don't want to change, our recommendation is you go into bankruptcy court."

The proposal raises two questions. Is it possible? And is it necessary?

The answer to the first question is probably no: At the very least, it would prove so legally messy as to be unworkable. Nicole Gelinas of the Manhattan Institute explains using the example of New York. It owes very little debt directly, instead owing smaller amounts through tens of thousands of legal entities. "[E]ach is not a government but a 'public-benefit corporation,'" she writes. "Each has its own board, its own rules and its own contractual agreements with creditors, from bondholders to unions. Each of those agreements offers creditors different protections." So even if the state were to declare bankruptcy, it is not clear that each of those individual entities would or could—at least not without going through some painful court process.

More to the point, it probably won't ever be necessary for a state to declare bankruptcy—even Illinois or California. The total sums seem enormous and insurmountable on paper—states owe some $3 trillion in unfunded pension obligations, by some estimations. But on an annual basis, the sums seem much more manageable. According to the Center on Budget and Policy Priorities, bond payments remain comfortably within historical levels (4 percent or 5 percent of current state and local expenditures). And most states with serious budget problems have at least a decade to remedy pension and health-care-benefit shortfalls.

In short: States will have to make painful choices to make ends meet—they will need to cut services and raise taxes. But there's no reason for bond holders to believe they'll be the ones holding the short end of the stick. "States have adequate tools and means to meet their obligations," says the report from the Center on Budget and Policy Priorities. "The potential for bankruptcy would just increase the political difficulty of using these other tools to balance their budgets, delaying the enactment of appropriate solutions. In addition, it could push up the cost of borrowing for all states, undermining efforts to invest in infrastructure."

For those reasons—the specter of rising borrowing costs—states are now pushing back hard on the bankruptcy meme. On Monday, for instance, California's treasurer, Bill Lockyer, told reporters that bankruptcy is "a cynical proposal, intended to incite a panic in response to a phony crisis." He continued: "Killer bees, space aliens, and now it's the invasion of the bankrupt states." So the big worries about out-of-balance budgets remain. But the ones about bankruptcies need not—at least as long as politicians keep it out of the question.

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Annie Lowrey is a contributing editor for New York magazine. She can be reached at annie.lowrey@gmail.com.

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