Budget Blues: What Would State Bankruptcies Accomplish?Published: February 16, 2011 in Knowledge@Wharton
Follow the news in just about any state in the country and you're likely to find accounts of budget woes. California, Illinois, New Jersey -- the list goes on, with some estimates suggesting that states altogether face a $125 billion budget gap over the next year, and much more later.
The slow economy of the past few years is a factor, causing tax revenues to shrink. But many states have budgetary problems too deep to be resolved by a routine uptick in tax receipts, including debts from past borrowing coupled with pension obligations to state employees, past and present. In fact, the Pew Center on the States has estimated that states have $1 trillion in unfunded pension obligations.
When individuals and corporations find liabilities overwhelming their assets, they can declare bankruptcy, discharging past debts, eliminating most continuing financial obligations and starting fresh. Even municipalities can declare bankruptcy, and sometimes do. But federal law denies states this remedy.
Maybe that should change, suggests David Skeel, a University of Pennsylvania law professor who says the federal bankruptcy code could be modified to include states. "It would take very little more than adopting a set of laws ... preferably, a new chapter in the bankruptcy code that would look a lot like city bankruptcies," notes Skeel, referring to the Chapter 9 code that allows municipalities to declare bankruptcy.
"What bankruptcy would do is provide an easier way to negotiate [and] reduce the debt," says Wharton finance professor Franklin Allen. "I think it probably would be a good idea to have a bankruptcy system for the states, but whether it would make debt cheaper or more expensive is an interesting question. I don't think we know the answer to that question."
"The positive aspect of the suggested reform is that this is the classic way out of an unsustainable debt position," adds Wharton finance professor Richard J. Herring. "In some cities and states, the off-balance sheet commitments are so large that unless they can be renegotiated there appears to be no way out.... Taxes can be raised to some extent, but beyond some point it becomes self defeating. Anything or anyone productive will simply move [out of the state]."
Like a municipal bankruptcy, a state bankruptcy would be very different from the procedure used by corporations, Skeel says. While creditors can force a company into bankruptcy and even push it into liquidation, such a rule for states would be unconstitutional, so a state bankruptcy could only be voluntary. The bankruptcy court -- preferably a panel of judges rather than just one, Skeel suggests -- would not have the authority to force the state to raise taxes, cut expenditures or sell assets, as that power would also violate the constitution.
What, then, would a state bankruptcy filing accomplish? According to Skeel, it would put the state in a strong position to wring concessions from two major creditors: bondholders and present and former employees. He outlined his proposal in an article last November in The Weekly Standard. "Ideally, bondholders would vote to approve a restructuring," Skeel wrote. "But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be 'crammed down' over their objections under certain circumstances."
Investors in municipal bonds might, for instance, be prodded to accept less than 100 cents on the dollar when the bonds matured. Maturity dates could be postponed, or interest payments suspended for a time. A bankruptcy law would also "give debtor states even more power to rewrite union contracts," Skeel wrote. "It is possible that a state could even renegotiate existing pension benefits in bankruptcy, although this is much less clear and less likely than the power to renegotiate an ongoing contract." In other words, it might be possible for a state not only to cut pay and benefits for current and future workers, but, conceivably, to reduce pension benefits that had already been earned by current and past employees, including those who are already retired.
Skeel's proposal has become part of the ongoing debate about how to resolve state budget problems. A congressional committee included bankruptcy among the remedies discussed at a hearing in early February, but has not so far recommended pursuing the option. Public employees' unions have opposed the idea for obvious reasons, and even the National Governors Association has argued against it, saying that merely discussing it could push up states' borrowing costs by causing municipal bond investors to demand higher interest rates. Many experts in the municipal bond markets don't like the idea, either, as they feel it could undermine prices of bonds issued in past years, as investors worry about receiving less than they are owed. Even without a state right to declare bankruptcy, concerns that states may default on debts have contributed to falling municipal bond prices and an investor exodus from mutual funds holding municipal bonds.
Bond Market Issues
Although states like California and Illinois have well publicized and severe budget problems, they still don't equate to those that have plagued some European countries. The Wall Street Journal reported, for example, that Illinois's debt, including bonds and unfunded pension obligations, is about 13% of the state's gross domestic product, while Greece's government debt equals about 144% of GDP.
In the U.S., defaults on municipal bonds issued by states, cities and counties have been and continue to be rare, even though many cities and counties do have a bankruptcy right. From 1970 through 2009, the default rate on AAA-rated bonds was zero, according to Moody's Investor Service, while the rates for AA and A bonds were just 0.03%, and for BBB bonds a mere 0.16%. Corporate bond default rates were much higher, ranging from 0.5% for AAA bonds to 4.85% for BBB bonds.
While bankruptcy may sound like a simple solution to state budget problems, it could leave a string of victims, from individual and institutional bondholders to pensioners who worked for years for modest government salaries to earn retirement benefits that appeared to come with ironclad guarantees. Owners of municipal bonds "would not necessarily get 100 cents on the dollar," Skeel says. But the treatment of bondholders would largely depend on the provisions written into individual bond issues. Bonds backed by the state's full taxing authority, for instance, would probably be safer than those backed by an income stream from a narrower source, such as bridge tolls.
Some experts argue that providing for state bankruptcy would undermine the municipal bond market, with greater risk of depressing prices of existing bonds and driving up the interest rates investors demand for new bonds. "If municipal bonds cannot be floated easily, then it will be more expensive for taxpayers to pay for the budget shortfalls that we keep hearing about," according to Olivia S. Mitchell, professor of insurance and risk management at Wharton. Adds Herring: "When you change the rules of the game, investors will inevitably have to factor in the possibility of default and the loss given default. This will affect the price of new issues. Indeed, it may discourage many new issues. And, of course, there would be capital losses on outstanding securities."
Although investors would surely be unhappy, they did willingly shoulder the risk of default, notes Thomas Donaldson, professor of legal studies and business ethics at Wharton. "What's clear to me is that this issue is very similar to the one now hotly debated in Europe: Can individual states -- Portugal, Ireland, Greece and Spain -- give a haircut to their debt holders? Many critics have argued that those who bought bonds -- hedge funds, banks, etc. -- have to assume some risk that the issuer will default. After all, sovereign debt ratings are one of the factors in pricing government bonds." Municipal bonds, too, receive risk ratings that affect prices.
A bankruptcy right would have some affect on state's bonds, experts say, but it would not necessarily destroy the market. Cities, counties and towns have long been able to borrow cheaply by issuing municipal bonds, even though they have had the right to declare bankruptcy. And Skeel argues that bond investors might actually prefer an organized, court-supervised restructuring process that would give them a say, rather than the uncertainty that would surround any bond default under the current system.
Voters and State Employees
States would have another reason to leave default as a last-ditch option: Many of a state's bondholders are state residents, or voters. That's because investors can typically get state tax exemptions for interest earned on municipal bonds issued by their home states. Municipal bonds are widely held by individuals as opposed to institutions.
While state bankruptcy could be costly for employees and pensioners, the results could vary in different states depending on how the employees' rights were enshrined. In many cases, it might be comparatively easy to cancel contract provisions on pay and benefits for current and future workers. But in many states it would be very hard, if not impossible, for a state to renege on benefits that had already been earned, such as pay and health benefits for retirees. Pension benefits earned before the bankruptcy filing would thus be protected, but employees would stop earning new benefits, or would earn them on a less generous scale.
"In many states, there's little that can be done to restructure an existing pension," Skeel says. Indeed, Mitchell adds, in many states the employees' rights are written into the constitution. Not only does that protect benefits that have already been earned, but in some cases the constitution defines the future benefit-accrual rate for all current employees. "As soon as you are hired, the promise of that benefit formula -- the buildup of benefits in the future -- is guaranteed," she says. "That's one reason why it's so difficult to get out of the public-pension problem that we are in.... If the state did declare bankruptcy, the question is: What would happen to those constitutional guarantees? I just don't know."
Even if it were possible to reduce benefits earned before the bankruptcy, officials would probably be reluctant to take that approach, Skeel notes. Employees and pensioners would be heard by the bankruptcy court and could argue for a tax increase instead; a history of broken promises could undermine hiring; and employees and pensioners could organize a powerful voting block.
As a practical matter, Mitchell says, it's generally easier for a governmental body to achieve benefit modifications around the edges -- for example, getting employees to pay bigger medical deductibles rather than trying to reduce the monthly pension payout. "As a matter of realpolitik, the most a state would be able to do is possibly to change its pension promises to future employees," Skeel states.
"One big advantage to a bankruptcy law [is that] it would make it much easier to renegotiate those contracts," Allen adds. "In many states these are much too generous, and they are going to have to be renegotiated in some way."
But would a bankruptcy safety net encourage state officials to make unrealistic promises like trimming taxes, or to continue with the poor management practices that caused their problems? That's possible, according to Waheed Hussain, professor of legal studies and business ethics at Wharton. In the corporate world, a certain amount of risk taking is encouraged, and the bankruptcy option does help support that goal by providing a way out, he says. "But I'm not sure we really want to do that for the states, because you don't want to let a government say, 'Well, we can take these obligations on now, and when things get too tough we can hit the reset button.'"
Government plays a different role in society than in business, he adds, arguing that a bankruptcy option could undermine a desirable public perception that government commitments are more dependable than those of profit-oriented companies. Hussain also suggests that bankruptcy could let state taxpayers off the hook, forcing employees and bondholders to shoulder the lion's share of a problem created by the office holders the taxpayers elected. A bankruptcy option would not necessarily correct the bad management that created the problem.
Wharton finance professor Richard Marston notes that those management practices are ingrained in a number of states' government cultures. Many agreed to overly generous union contracts, used lax accounting that underestimated pension liabilities and failed to squirrel away surpluses in the boom years to get through the bust years, he says.
Still, a bankruptcy option could help resolve the problems that have resulted, according to Marston. He envisions a procedure similar to the one used for General Motors, where the federal government provided temporary financing and helped oversee a restructuring that involved compromises from all parties. After watching GM's experience, which wiped out shareholders and cut workers' pay and benefits, parties at Ford negotiated solutions without resorting to bankruptcy, he notes. "The model [is that] when a state will need a rescue, the U.S. provides some bankruptcy financing ... and the unions give up something. The state might then be able to deal with the unions without actually going through a bankruptcy. But all this requires a bankruptcy procedure."
Skeel suggests that concern about reputations would prevent states from using a bankruptcy option as a free pass to bad behavior. "There's a cost to being a governor who puts his or her state into bankruptcy," he says, noting that corporate executives struggle to avoid taking this path. "One of the things creditors might do is put pressure on you to do things like raise taxes, which is one of the things a governor doesn't want to do." Although a court could not force a tax hike, it could turn down a reorganization plan that does not include one, prolonging the crisis for the governor and legislature.
"Filing for bankruptcy is never a great career move," Skeel notes. It's hard to imagine [a governor thinking], 'I'll just throw caution to the wind because I have this wonderful alternative in case things don't work out.'"
State bankruptcy would not be a painless solution to a budget crisis. Taxpayers could end up paying more, employees and bondholders would get less than expected, and legislators and chief executives would emerge with tarnished reputations to face angry voters. "The real benefit of bankruptcy is that everything is on the table," Skeel says. "It seems to me that everybody needs to sacrifice."