Bankruptcy Court for States?

Recently, there’s been talk about changing the law to allow states to file for bankruptcy.  Under current law, cities and towns are able to file for bankruptcy, but states can’t.

There have been three recent times when this issue was mentioned:

1. Newt Gingrich delivered a speech in November in which he said, “I also hope the House Republicans are going to move a bill in the first month or so of their tenure to create a venue for state bankruptcy.”

2. A Penn Law School professor wrote an article arguing that a law could be passed allowing for state bankruptcy.

3. A New York Times article last week said that Republican legislators were considering a law to allow states to file for bankruptcy.

Here’s a non-exhaustive list of the key issues:

1. Some states have huge deficits.  California’s deficit is approximately $25 billion.  Illinois has a $15 billion deficit.  Texas has a two-year deficit of approximately $26 billion.

2. States have structural budget problems (unfunded pension liabilities) and this may mean diverting money from essential public services.

3. One major reason why states aren’t allowed to file bankruptcy is that states are sovereign.  Therefore, it is not possible to have a bankruptcy judge imposing terms upon them.  As a result, any new law will preclude any person or entity from forcing a state into bankruptcy.  In bankruptcy, a judge will be precluded from forcing a state to change their tax policy or their spending.

4. If there is no bankruptcy, states will eventually seek a bailout.  With an upcoming election, it may be very appealing to bailout California, Illinois and New York.  Obviously, a bailout will transfer wealth from all US taxpayers to a particular state.

5. The threat of bankruptcy could give states leverage with unions.

6. Bankruptcy could mean altering contractual obligations to retirees and general obligation bondholders.  Both could end up as unsecured creditors.  Bankruptcy would be a wealth transfer from bondholders and state employees to taxpayers.

7. If Congress actually even talks about a bill like this, it could become very difficult for states to raise money.

8. The default / bankruptcy premium could become significant in the muni market.  There have already been $25 billion of outflows from muni funds in the past two months.  (You could argue that this already exists based on credit default swap prices.)

9. Politicians (governors) may appreciate the ability to shift the blame for austerity measures to a bankruptcy judge.

Let me be clear…while I work for the state of Texas, I do NOT have a pension – so I’m not writing about myself.  I have a 403 plan (just like a 401(k)).

Again, there’s no easy solution to this. There’s been some research that argues that public employees are overpaid.  Regardless of whether the research is right or not, we offered these jobs and made these promises.  I think that the vitriol directed at state employees is wrong.  Personally, I don’t want to work in a prison, I don’t want to work the night shift as a Police Officer.  Actually, I don’t even want to work in a public high school or grade school.  I wouldn’t trade with any of these people and I don’t think most of you would want to trade either.  It’s way too easy to speak badly about these employees and it’s just not right.  Most importantly, it’s not going to solve the problem.