Congress Examines Municipal Defaults, State Bankruptcy

Witnesses disagree over whether state bankruptcy is a viable option, but Rep. Patrick McHenry says one thing is for sure: States aren't getting a bailout.
by | February 9, 2011

State and local government won’t get any sort of federal bailout, Rep. Patrick McHenry said at a hearing Wednesday examining whether Congress should consider creating a bankruptcy mechanism for state governments.

McHenry, chairing a House Oversight and Government Reform subcommittee, said that state and local governments are facing $125 billion in shortfalls this year, but Washington won’t be able to provide large-scale assistance if they find themselves in financial upheaval.

“The era of the bailout is over,” McHenry said in his prepared remarks. “More money from Washington would just delay the day of reckoning and only further complicate state fiscal situations. Besides, we don’t have any money to offer.”

State and local governments are faced with the growing burdens of unfunded pensions for their employees, increasing healthcare costs, depressed revenues and a bond market that has grown increasingly skittish. The hearing comes on the heels of an appearance by controversial banking analyst Meredith Whitney on “60 Minutes” in December in which she said there could be 50 to 100 municipal bond defaults. The prediction generated headlines warning of a municipal bond crisis, and groups that represent state and local government have aggressively responded to her estimate, which they say is vastly exagerrated.

Whitney, who has also been criticized by colleagues for the prediction, declined invitations to testify, The New York Times reported. “This isn’t about one analyst,” McHenry said in written testimony.

Witnesses, however, disagreed on whether a bankruptcy mechanism would be a logical solution for states to escape their fiscal difficulties. While municipalities can restructure their debts in bankruptcy court, states cannot. But some federal legislators have reportedly been quietly working on a workaround to permit it. If a state declared bankruptcy, it would theoretically be able to restructure its obligations to retired workers and bondholders.

Governors have publicly said they oppose any move by Congress to grant them the ability to seek bankruptcy protection, and they believe even the discussion of the subject is dangerous because it will make bond investors even more skittish, thus raising the cost of borrowing for states.

Witnesses who testified at the hearing disagreed on the subject of state bankruptcy.

Nicole Gelinas, a fellow at the conservative-leaning Manhattan Institute, testified that state bankruptcy isn’t viable because states might then be tempted to regularly threaten bankruptcy in order to get concessions from public employee unions during negotiations.

She also said that states issue bonds through hundreds of public authorities and special purpose vehicles set up as their own corporations. Because of that, it would be nearly impossible for a state to pool all the debt together and have a judge sort it out in a meaningful way.

Gelinas also said bankruptcy would be difficult for a state because, unlike a corporation, there are many different voices that all represent the state government. Having a governor and hundreds of state lawmakers simultaneously expressing their views of the bankruptcy process would be disruptive.

But David Skeel, a professor of corporate law at University of Pennsylvania, disagreed. He said a state in dire circumstances would only have two options if bankruptcy isn't permitted: default on its obligations or seek a federal bailout. Both are “deeply problematic,” said Skeel, who advocated for a last-resort bankruptcy mechanism.

He said bankruptcy could actually be advantageous because, in addition to allowing states to restructure debts and obligations, it would also be fair: Everyone who is owed money would be brought into the discussion.

Skeel also dismissed the notion that bankruptcy would violate state sovereignty, as some governors have argued, insisting it would be completely voluntary. And by creating thresholds that states would be required to meet as a prerequisite of declaring bankruptcy, they wouldn't be able to make the type of threats Gelinas predicted.

“Bankruptcy is not a perfect solution,” Skeel said. “It would be messy. It is an absolute last resort, but it's better than the other last resorts which is states simply defaulting on their obligations or a federal bailout."

Iris Lav, a senior advisor for the Center on Budget and Policy Priorities, downplayed the gravity of the situation facing states and localities. Predictions of a bubble in the municipal bond market are “are substantially exaggerated [and] are creating unnecessary alarm among policymakers and the public at large,” she said.

Lav added that states will be able to rectify their financial problems through budget cuts and tax increases, and there is no credible evidence that large-scale defaults are forthcoming.

Despite his advocacy for state bankruptcy provisions, Skeel also agreed that the prediction of 50 to 100 municipal defaults is high. He said some may occur, but exactly how many is unclear. But, he said, if even just a few states default on bonds, "we're in trouble."

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