What if Your State Goes Bankrupt?

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Under existing law, a state cannot go bankrupt. That's not because the action is forbidden. Not the U.S. Constitution nor any other piece of paper says a state cannot. The bankruptcy code simply does not address the possibility.

Now lawyers, politicians and other ingenious folk are looking for a way around that problem -- a fact that should come as no surprise, given the perilous financial health of California, Illinois and other states encumbered with crushing debts.

The 50 states have spent collectively, in the past two years, half a trillion more dollars than they took in as taxes. Their pension funds, by some estimates, are underfunded by another trillion.

Like Titanic victims struggling in the water, they are desperately grabbing any orange crate that floats by, trying anything to stay afloat.

Arizona has sold off its state capitol. The investment group that now owns the Supreme Court building and the chambers of the house and senate is graciously leasing those buildings back to the people.

California, facing a $19 billion shortfall, must now spend more on pensions for its public employees than it spends on the University of California system. U.C., to avoid having to make deeper cuts than it has already made, hiked tuitions 32 percent in November 2008, igniting student protests. The Golden State's credit rating has sunk almost to junk status.

What a tonic, then, if these states could toss off their obligations, as one might a heavy coat. By declaring bankruptcy, states could start life anew and go skipping down the street.

Orange County, Calif., did it. Vallejo, Calif., did it. Harrisburg, Pa., is said to be thinking about doing it. They used Chapter 9 of the bankruptcy code, which applies to municipalities.

Law professor David Skeel of the University of Pennsylvania said he sees no reason why Chapter 9 could not be tweaked to apply to states. Doing so would be easy, he said: "You'd just have to change Chapter 9's definition of permitted entrants. Basically, you'd change the entrance requirements."

That change, of course, would require legislative action -- a process "always uncertain." An alternative would be to use Chapter 8, "which isn't currently taken," and use it to create something entirely fresh and new, exclusively for states, he said.

If and when states do grope their way to bankruptcy, the consequences would be most dramatic for state pensioners and for holders of state bonds.

Once a state had entered bankruptcy, Skeel, said there could be sales of assets -- something akin to a corporate liquidation sale. Creditors, including bond holders and unions, would be compelled to make concessions. With court approval, a state could rewrite its union contracts. Vallejo, Calif., has done just that.

It's possible, too (though legally less clear) that a state might re-negotiate its existing pension benefits -- a prospect that pensioners, understandably, find abhorrent.

Roger Marxen, retired member of the California State Employees Association, is president of CSEA Retirees, Inc., and as such speaks for 31,000 retired members.

Any attempt by California to use bankruptcy law to claw back pension benefits, he says, would be "legally and morally wrong. State retires have dedicated entire careers to state service. They have earned their pensions."

There could also be costly and unexpected consequences, he said.

"To take away the earned benefits of people in their golden years would force some to depend on social programs, which could ultimately cost California even more money," he said. Politicians, he said, "need to look beyond easy scapegoats."

Pensioners, though, wouldn't be the only ones hit hard.

Holders of the state's bonds would suffer, too, since under bankruptcy they would be treated as unsecured creditors. If you were such a holder, said Dick O'Brien, an executive vice president with brokerage Folger Nolan Fleming Douglas, "You'd be screwed. The only question is: to what degree?"

In Vallejo's case, he said, bond holders stand to get somewhere between five to 20 cents on the dollar. The mere fact that people are even discussing letting states go bankrupt he sees as one reason for the outflow of some $30 billion from municipal bond funds in the past 10 weeks. (The entire market, for perspective, is valued at between $2.8 and $2.9 trillion.)

If you're thinking about buying municipal or state bonds, he said, there are several things you can do to reduce your risk: Visit the website of the Financial Industry Regulatory Authority, FINRA, which has checklist of questions you should ask your broker before buying any bond.

Go, too, to the website of the Municipal Securities Rulemaking Board, MSRB, where you can find the safety rating assigned a bond.

O'Brien said the chance of a state declaring bankruptcy is remote. California, he says, isn't Greece.

"If you compare debt to GDP, Greece is at 133 percent; the U.S. is at 88 percent; and California is at 5 percent," he said. "Now, you tell me: Who has the problem?"

Practical considerations, he said, militate against a state's choosing bankruptcy.

"If a state declares bankruptcy, what is their ability going to be in future to get financing?" O'Brien said. "At the very least they're going to pay more. At the worst, they're not going to be able to float any new debt. Who will build the schools? Who will build the roads? No governor wants his state to go bankrupt. No unions want it."

Who does? Bankruptcy lawyers, he thinks, for the fees involved.

What if there were a way for a state to enjoy some of the benefits of bankruptcy, without having to enter it?

James Spiotto, head of the bankruptcy practice at Chapman & Cutler in Chicago, said he thinks he's found one.

Spiotto proposes creation of a Public Pension Funding Authority, a quasi-judicial body that would have the power to compel states and their unions to settle pension disputes. The power it would have he likens to a court-appointed special master's power to resolve a thorny and complex litigation.

It would be, he said, "a forum for the two sides to work out their problems" and to pay the cost of resolution either through an increase in taxes, say, or an increase in worker contributions.

America, he says, in past times of crisis has appointed "blue ribbon" panels to help resolve them. So, too, could the pension problem now be solved, without states' having to have resort to the more extreme remedy of bankruptcy.