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Bankrupt Reasoning: The Facts of State Bankruptcy

On February 9, the House Committee on Oversight and Government heard testimony about whether states, like corporations and some municipalities, should be allowed to declare bankruptcy. A proposal from University of Pennsylvania Professor David Skeel has been making the rounds and gained traction recently with endorsements from several prominent conservatives.

The allure of bankruptcy is not too surprising when you consider states' short- and long-run fiscal challenges. Total state revenues—including taxes as well as investments—plummeted 30 percent in 2009. Although taxes have been picking up, they remain significantly below pre-recession levels.

Meanwhile, demands for services have held steady or escalated. Federal stimulus funds helped prop up states temporarily, but they—along with temporary tax increases and other short-term fixes like borrowing, fund shifts, and deferrals—will soon be off the table.

Thus, governors are proposing deep budget cuts. Given the size of projected shortfalls, the axe will fall where states spend most of their money: education and health care. These also happen to be areas popular with voters. At a macro level, forecasters worry about potentially chilling effects of state and local layoffs on the economy.

The long term holds more bad news: States are on the hook for large pension promises. Although stretched out over several years, unfunded liabilities have been estimated at $1 trillion and potentially approaching $4 trillion depending on modeling assumptions.

Federal policymakers would like to help, but they face their own fiscal challenges. Hence the appeal of amending bankruptcy laws instead of sending more money. Currently, states cannot declare bankruptcy. Municipalities can but only in some states and even then often only with state approval.

There may be demand for a new state bankruptcy code. One ex-state budget official has said he pined for the idea at the height of the financial crisis. However, others have called the proposal ludicrous and accused backers of helping to send muni bond yields on a wild ride.

It's worth taking a step back here. Professor Skeel's original proposal is more nuanced than often portrayed. As he observes, the real question about a state bankruptcy law is whether its benefits outweigh the costs.

Focusing on benefits, a potential stumbling block is sovereignty. Indeed, these concerns bogged down early efforts to establish a U.S. municipal bankruptcy code. In the end, the Supreme Court ruled that the law was permissible because it was voluntary and limited. Judges could not force municipalities into bankruptcy, nor could they direct the way out (tax hikes, spending cuts, etc.).

State bankruptcy procedures could follow this lead, but at what cost? As Profesor Skeel notes, corporate bankruptcy judges wield the ultimate threat of liquidation: "Because creditors are likely to be worse off if the company is simply liquidated, they tend to be more flexible, and more willing to renegotiate what they are owed."

Where municipal bankruptcies are allowed, judges lack this essential leverage. Witness Vallejo, CA, which entered bankruptcy in May 2008 and has yet to emerge due to hold-out problems, or creditors refusing to sign on to a deal. It's difficult to see how states, whose sovereignty is even more deeply ingrained in the U.S. Constitution, would avoid this difficulty.

A related issue is what economists refer to as agency problems. Given that proceedings would be voluntary, why would governors resistant to mass layoffs or reopening collective bargaining agreements rush into bankruptcy? And if they did, how would judges disentangle overlapping promises to teachers, cops, and firefighters from state and local pensions? The ensuing mess could make home mortgage modifications look like a picnic.

So what is to be done? This discussion raises the larger question of commitment. We all want to do what's right in the long term, but temptation lurks behind every corner. Hence perennial debates about a federal balanced budget amendment and new fangled inventions like alarm clocks that donate money while you snooze or gym memberships that dock you for missed workouts.

As these examples imply, one solution to commitment problems is outsourcing. Many municipalities—including New York, Philadelphia, Washington, DC in the past and now Harrisburg, PA and Nassau County, NY—have looked to outside control boards to help them sort out their finances.

The private sector could also play a role. Last year, New York's Lieutenant Governor Richard Ravitch proposed "transition bonds" to help the state get out of its multi-billion dollar budget hole. The bonds would come with strict covenants attached. If an independent board failed to certify the state was moving toward structural balance, bonds would go into automatic default. Attorney James Spiotto has proposed a similar Public Pension Funding Authority.

Tougher disclosure requirements could also help. A proposal from Representatives Nunes, Ryan, and Issa would require states to disclose pension obligations as a condition of keeping their tax-exempt bonding authority. There is also talk of repealing the so-called Tower Amendment, or regulating municipal bond issuers just like their corporate counterparts.

In any event, the House is to be commended for turning their attention to states and localities, which after all provide the bulk of public goods and services in this country. Let's hope that all of this attention brings light and not just heat.