STUMP » Articles » State Bankruptcy and Bailout Reactions: No Bailout, Yes Bankruptcy Group » 11 May 2020, 22:01

Well, a few of them are “maybe bailout”, so you could look upon this as a fancier version of Yes bailouts with strings attached, but the concept is that with bankruptcy, at least there would be a definite process with an end, so one need not try long-term strings that won’t stay attached. But some of these are anti-bailout, pro-bankruptcy.

A reminder as to the state of play:

• COVID lockdowns have made a huge hit to state tax revenues
• Local Illinois politicians [all Democrats] put in a bailout request, including pension payments, amounting to over $10 billion
• Mitch McConnell said “No bailouts… have you considered state bankruptcy?”
• There have bee a variety of reactions: news coverage of various politician reactions, No Pension Bailout, No State Bankruptcy Contingent [my preference], Bail Them Out With Strings Attached Contingent , and more.

I haven’t done much with the “WHY DO YOU WANT US TO DIEEEE!” contingent yet, but they’ll get their time.

I hope that gets everybody up to speed. Various things are flying about, and while this is likely the top Congressional priority right now, we’ve already seen them slow walk stimulus/bailout bills earlier this year, so I probably have more time to play with this.

Oh, and a bunch of Western states sent a letter to ask for $1 trillion today. Pensions were not mentioned [they’re smarter than Illinois.]

Joshua Scharf from the Independence Institute

I’ve not heard of these guys, but here’s the author bio on the piece:

Joshua Sharf is a Senior Fellow for Fiscal Policy at the Independence Institute, a free-market think tank based in Denver, Colorado. He currently serves as a State House Republican appointee on the Pension Review Subcommittee for the Colorado legislature.

I’m not sure the difference between that and Cato, Reason, etc., but whatever. I’m pretty independent and pro-free-market myself.

BANKRUPTCY FOR STATES? IT’S A BETTER IDEA THAN YOU THINK

Rather than simply writing a check to state spendthrifts, we should be looking at the idea voiced by Senate Majority Leader Mitch McConnell to allow states to seek protection under federal bankruptcy laws.

This is hardly the first time in recent memory that America has faced the looming specter of state defaults. After the financial crisis, California prepared to pay bills with IOUs, as did Illinois in 2015. In 2011, former Florida Governor Jeb Bush penned a piecesupporting the return of state bankruptcy protections. And in 2016, President Barack Obama actually authorized a form of bankruptcy protection and reorganization for Puerto Rico.

State bankruptcy wouldn’t be unique in American history, either. In the 1830s, states borrowed heavily against expected property tax revenue to finance road, railroad and canal construction. The Panic of 1837 swept away much of that tax revenue, and many states ended up defaulting on those debts.

I’m sorry, but that’s not bankruptcy the legal process, but the reality that the states did not have the cash to pay for their obligations and so… they defaulted. That has always been a possibility for states, not requiring any new legislation.

Most of those debts were rescheduled and repaid, as in bankruptcy, but both the depression and the defaults cast a long shadow over the country’s memory—as deep and long as the Great Depression. Accordingly, states tightened up their fiscal management, placing limits on debt issuance and requiring balanced budgets.

Pity it didn’t stick.

Also, note: “as in bankruptcy”. States were sovereigns… and could negotiate terms with creditors directly without court supervision, which is what legal bankruptcy involves. States can still do this.

By contrast, states have let these unfunded pensions build up over decades. Funded at over 100% in 2001, the New York City Employees’ Retirement System fund fell to only 64% funded by 2010. Despite strong market returns, the fund had only recovered only to 72% funded by 2018. The State Retirement System’ of Illinois’ fund has languished at less than 40% funding since 2010.

New Jersey is a case study in the dangers of a bailout. Governor Phil Murphy has been among those in the greatest fiscal anguish. But he has actively opposed measures to help fix a pension system ever more mired in debt, even as those pensions threaten the state’s ability to build and repair infrastructure.

It’s hard to see the creation of long-term unfunded pension obligations as anything other than a dodge to get around those fiscal stringencies. No debt is issued, and only the current year’s payment needs to be covered by the current year’s revenues, but the taxpayers are still on the hook for potentially massive long-term obligations.

So here’s a trick – just like other obligations, such as bond payments, when a state runs out of money… those long-term obligations simply won’t get paid.

Again, this does not require any new federal legislation or opening up bankruptcy protection to states.

Contrary to pension apologists, bankruptcy wouldn’t necessarily mean the end of defined benefit pensions. Current pensioners would and should collect what was promised to them. While terminating those plans in favor of defined contribution plans might be desirable, it might also be possible to require that new defined benefits be fully funded from day one.

While I agree bankruptcy does not mean that DB pensions would or even should be obliterated, the part I highlighted is simply not true.

For Illinois, Kentucky, and New Jersey, it is very much a question as to whether those states can actually cover the liabilities for those already retired.

I know the pension funds don’t cover that liability for those states, because that information is in their own reports. Now, it may be a case of shunting all tax revenues to those pensions, but that is not a viable solution. In a February 2020 post, I went down possible outcomes: as with Detroit’s bankruptcy, pensions for current retirees can be cut; as with Prichard, Alabama, pensions for current retirees might not be paid at all for over a year.

It is not clear to me that Scharf even knows what he’s talking about. It’s as if he’s missed a decade of public pension turmoil. I searched my own posts, and don’t see his name pop up. I searched the Actuarial Outpost pension section [where I’ve been archiving pension stories since 2008], and he doesn’t come up at all. So I don’t know. What I see above is that he may know about the old history of state insolvency; he may not have a clue as to what’s going on with public pensions.

Most important, we can bring the market enforcement of fiscal discipline to state finances. By making the risk explicit, rather than allowing for hidden, soft defaults, it would help to bring borrowing costs in line with actual risks. After the 1840s, U.S. states faced as much as a full percentage point borrowing premium compared to Canadian provinces. That’s how it should be.

I’m not sure why highly-rated states need to pay for Illinois’s profligacy via higher interest rates on their bonds.

Fiscally irresponsible states won’t go without a fight. New York Governor Andrew Cuomo claims his state is entitled to compensation because it sends more to the federal government than it gets back. Such special pleading ignores the decades’ worth of state and local tax deductability that subsidized his state and other high-tax states, enabling their profligacy. Rather than chasing their tax base out of the state with additional tax hikes, perhaps they should have spent the last three years getting their house in order.

Last three years? The heck? Why not the last decade, as it’s been a long bull run since 2010. Until just a few months ago.

The two other non-bankruptcy options often floated, either bailing out the states or doing nothing at all, are worse. So far, none of the governors asking for help has offered a plan to make sure they won’t be back soon, clamoring for even more. Bailing out the states would continue to enable corrupt behavior, while forcing people who never had a hand in making those deals to make good on them. The risk of moral hazard is real.

I totally agree with this.

Doing nothing at least has the benefit of forcing a reckoning, but it could be a very messy, drawn-out reckoning that fails to address the destructive underlying behavior that landed those states in this mess in the first place.

Allowing profligate states to declare bankruptcy would force more honest accounting of liabilities, align borrowing costs to risk, and close loopholes that states have been using to avoid fiscal discipline. It’s the best of the painful choices that some states have left themselves.

I want to be fair to Scharf here [other than not realizing that current pensions would have to be cut to even get close to sustainable for some states].

It may be that he had a word count limit imposed on him. It does seem that certain bits of his argument were missing, and he was forced to cut those paragraphs. I totally understand that – this is why I prefer to write here, where I have no limits.

The thing is, part of the reason that bankruptcy as an option is being fought is that many players know just all the stuff that can get cut in bankruptcy. Pensions can get cut, and have been cut. Don’t assume only bondholders would get hit in a state bankruptcy.

The politicians of New York, New Jersey, Illinois, and Kentucky are not acting like pensions for current folks wouldn’t get cut.

Marc Levine, former chairman of the Illinois State Board of Investment

On state bankruptcy: “I think it’s the biggest gift they could ever get.”

Well, he’s right there.

He does mention the 1970 Illinois state constitution.

He doesn’t mention amending that constitution. It’s not the federal government’s business to fix the state’s screwed-up governance.

UPDATE: Yuval Levin

I added this bit on May 12, as I found a piece I had overlooked.

How Congress Can Help the States

I will skip over the bits about loans and grants. It seems to me the federal government already doled out grants, and I may talk about the money already being loaned by the Federal Reserve another time.

Finally, for states whose long-standing fiscal negligence is now becoming untenable because of the suddenly weaker economy, Congress should offer some options for help strictly conditioned on essential reforms. Bankruptcy, which is not available to state governments under current law, should be made an option, as the University of Pennsylvania’s David Skeel has argued. Or as AEI’s Andrew Biggs has suggested, in return for federal financial support, Congress could require states either to accept the stricter accounting rules that federal law imposes on private pensions or to freeze existing pension programs and shift employees to defined-contribution plans. Such options would limit the exposure of federal taxpayers while still helping states and encouraging them to behave more responsibly. This sort of conditional assistance could be offered to states but not forced upon them, maintaining their sovereignty.

As I will note below, all of this is really moot.

Very few states that are actually in this trouble will take advantage of such a system.

Lawyers are standing by

This isn’t about pro- or con-

This is about lawyers gearing up for that sweet, sweet bankruptcy action:

It’s no secret that major law firm bankruptcy practices are ramping up for a historic rise in Chapter 11 filings, workouts and other restructuring work as industries are battered by the COVID-19 pandemic.

Controversial comments by the Senate majority leader last month raised the possibility that restructuring lawyers could also gain a new clientele: state governments.

States can’t file for bankruptcy under the current bankruptcy code. But after Kentucky Sen. Mitch McConnell said that some struggling states may have to consider a Chapter 9 filing instead of counting on a federal bailout—remarks that were rebuked as overtly partisan by lawmakers on both sides of the aisle—restructuring attorneys have nevertheless been gaming potential scenarios.
….
Even with the framework in Puerto Rico as a guide, much would have to change in the U.S. bankruptcy code before states could even attempt to seek such relief, as they are sovereign under the Constitution and cannot fully submit themselves to federal oversight.

Larry Larose, a partner in Sheppard Mullin’s finance and bankruptcy practice group who focuses on municipal restructurings, pointed out that although Puerto Rico eventually found a path forward, the territory had to clear enormous hurdles—and there would be even more roadblocks for states.
…..
Peter Friedman, O’Melveny’s bankruptcy litigation group leader, agreed that move to allow states to declare bankruptcy would likely be fought in court.

“Another barrier people don’t usually talk about, is that states can’t file for bankruptcy because if they do, in effect they are taking steps to violate the Contracts Clause, a provision of the Constitution that bars states from taking action to impair contracts,” he said. “It’s a complicated question that’s ultimately addressed through extensive litigation, and it’s not surprising to see the issue reviewed by the Supreme Court in a number of historical cases involving states and bankruptcy.”
…..
At Sheppard Mullins, Larose said that even if state bankruptcies never fully come to fruition, he expects to see increased municipal restructuring work at the local, city and agency level.

“Bankruptcy for states is probably not a silver bullet, but there could be bankruptcy-lite for some states,” he said. “There’s a federal statute that says states could commit part of themselves to federal jurisdictions and reorganize parts of themselves in federal court. These may be baby steps as opposed to putting a whole state through the process, but given what we’ve seen in the last two months, and anticipating what’s coming, something needs to be done.”

What is cute about these items is they say “something needs to be done”…. but they don’t get too specific as to who needs to be doing it.

Because it won’t be every state, or every municipality, that needs bankruptcy protection. It’s a very specific set of municipalities (New York City, Chicago), and a very specific set of states (Illinois, New Jersey, Kentucky, and maybe Connecticut).

Will it be constitutional?

Okay, I’m getting away from finding pro-bankruptcy folks [yes, I know some exist, but I’m having difficulty finding pieces – I’m more likely to find the “no bailout, no bankruptcy”, “bailout with strings attached”, and “GIMME GIMME GIMME” takes than anything else.]

Here is just making the claim that state bankruptcy can be made to work, even under the U.S. Constitution.

State Bankruptcies May Be Legal If System Structured Correctly

Allowing states to declare bankruptcy could be constitutional if Congress avoids infringing on state sovereignty and relies on court oversight rather than an outside board.

Color me skeptical about the difference between a federal court and an oversight board when it comes to dealing with state sovereignty.

It wouldn’t be difficult to create a bankruptcy system for “a sovereign state essentially consenting to the jurisdiction of a specialized federal court,” said John J. Rapisardi, chair of O’Melveny & Myers’ global restructuring practice.

There is some debate whether Congress could simply expand existing bankruptcy code provisions that allow municipal bankruptcies, practitioners and scholars told Bloomberg Law.

Doing so could run afoul of states’ sovereign rights, as well as Constitutional protections for contract rights, they said.

Any new state bankruptcy provision would almost certainly generate legal challenges, but lawmakers themselves are a more immediate obstacle. Members of Congress aren’t likely to show much enthusiasm for Senate Majority Leader Mitch McConnell’s (R-Ky.) suggestion Wednesday that states file bankruptcy as an alternative to federal bailouts.

Before I get farther into this, let’s make a very obvious claim: the states that are essentially insolvent mainly have a Democratic-controlled legislature and governor, and most have no intention of using a federal bankruptcy process for anything.

Reality check: some pension bankrupts have to be forced into dealing with it

The states with any-party-controlled legislature and governorship that wanted to tackle pension reform have already done so. Rhode Island is a very Democratic polity, and they managed to at least cut COLAs for their state pensions. Yes, there were legal challenges. Those failed.

So we’re left with: Illinois, New Jersey, Kentucky, and Connecticut.

I’ve had a lot to say about Kentucky. There have been various reforms attempted there, and they’ve all failed. The current Democratic governor doesn’t want to admit that they can’t possibly afford the pensions.

Illinois and New Jersey absolutely do not want to reform with regards to pensions or their spendthrift ways. You are going to have to wait for the pension funds to run out and then have benefit payments be unsupportable and the bond market totally thwart them before they will admit they’ve got to cut the pensions. Allowing for state bankruptcy won’t do a damn thing for them. [In my own mind, it’s been a race between Illinois and New Jersey for the first one to hit rock bottom.]

I don’t know about Connecticut politics too much, though I had been working there [before forced to stay home in New York] and have been following their public finance woes. The current Democratic governor definitely has no interest in cutting anything. But then, he may not have much of a choice.

This is my point: the federal government could theoretically make state bankruptcy process a thing. It doesn’t mean any of the worst profligates would take advantage of the process.

Voluntary bankruptcy for profligate states is meaningless

So let me go back to the Bloomberg Law piece:

Currently about half the states authorize some kind of municipal bankruptcy filing, said David Skeel, a University of Pennsylvania law professor who has written about the state bankruptcy question.

But states are different because their rights, sovereignty, and immunity are protected under the 10th and 11th amendments to the U.S. Constitution, Skeel said.

Those protections mean that states—unlike individuals or businesses—can’t be put into bankruptcy involuntarily by creditors, he said.

And that makes a state bankruptcy process meaningless for the states I named above. They don’t want to do it this way, because it means far more than defaulting on bondholders [which they can get away with…… once.]

If there is a court-supervised process, as with Detroit’s massive municipal bankruptcy, that means all creditors will have to see cuts.

Including pensioners.

A voluntary state bankruptcy law could work if the law were structured properly, Skeel said. Such a law could look like current Chapter 9 or PROMESA, the 2016 law passed to allow Puerto Rico and other territories to restructure their debts, but without a federal oversight board, he said.

A law for state bankruptcies would likely be held constitutional as long as it mirrored existing federal law that permits municipalities to declare bankruptcy, according to Vincent Buccola, of the University of Pennsylvania.

Oh really.

Municipalities derive any power from their states. States can withdraw power. Municipalities have no sovereignty.

Others questioned whether those existing frameworks could be applied to states.

Extending Chapter 9 to cover states wouldn’t work, said Bruce Markell, a Northwestern University law professor and former U.S. bankruptcy judge. Neither could reliance on the Puerto Rico Oversight, Management, and Economic Stability Act, he said.

In typical municipal bankruptcies, the state creates a board to oversee the restructuring, Markell said. It also can exercise influence by threatening to cut off funding. Neither is an option given state sovereignty, he said.

Yup, that’s my point.

“How can you have independent review of government financial decisions?” Markell asked. “It’s all political—where do you raise taxes or force concessions by creditor blocks, consisting primarily of bond holders, pension plans, and labor contracts?”

The whole point of the concept of state bankruptcy is to try to shield responsible parties — the political powers — from having to make a decision and stand by it.

For a sovereign power, there is no shrinking and whimpering “But the judge made me do it”.

A sovereign power can default, it can negotiate, and it can do all sorts of things…. except pretend that some other minor functionary makes it do something else. A sovereign power cannot avoid taking responsibility for its actions, and to go from the abstract to the particular, the executive and legislative aspects of that sovereign power cannot pretend they aren’t the final say in what it does with respect to its finances.

Public finance does not have the same time frame as private industry

There is more at the Bloomberg Law piece, but the whole point of the “state bankruptcy” is so that the political actors don’t have to take responsibility for balancing competing interests with regards to public finance.

At some point, the money was always going to run out. Even if the federal government shovels in the equivalent of one year’s worth of pension contributions, it will barely stave off the reckoning the worst-funded public pensions will have to deal with. Eventually.

As I said in earlier posts, there are still several years to go in some of these funds. Yes, I’m skeptical funds like Chicago’s MEABF will last long, even with supposed fixes in place, but the state funds of Illinois, New Jersey, and Connecticut will likely last long enough that COVID-19 will be far in the past by the time they are really going to have to face the truth.

There’s a lot of ruin to be had in public finance. The smash may be complete once it comes, but it’s a long time coming.