Bankruptcy's Bank Shot

What connects government default, short selling and union bashing?
by | April 2011

Good pool sharks know that it’s often easier to score on a bank shot than by a direct assault. Aiming at one ball sometimes makes it easier to sink several others.

That seems to be what’s happening in the frenetic debate over state and local government budgets. In looking at the tough budget situation, Heritage Foundation Senior Research Fellow David John raised the possibility of loosening federal bankruptcy laws to avoid having state and local financial problems drain the federal budget. “A federal bailout would have no more long-term effect than taking away a shopaholic’s old credit cards while new ones are already in the mail,” he wrote. Better to create a bankruptcy option to prevent more of the behavior that helped create the current situation.

On the CBS newsmagazine 60 Minutes, financial analyst Meredith Whitney suggested that the prospect of government defaults was very real. “You could see 50 sizable defaults, 50 to 100 sizable defaults,” she said. Losses could run into the hundreds of billions of dollars. In the aftermath, the market could falter, with investors yanking as much as $4 billion out of the muni bond market in just one week. Investment returns could fall and the borrowing costs for state and local governments could rise quickly.

But no one on the ground ever really thought bankruptcy protection was a real option. Even in Harrisburg, Pa., where a municipal incinerator project gone bad has made it one of the most beleaguered governments in the country, the state has stepped in to forestall a default on bonds. Everyone knows that junk bond status would devastate the finances of any state or local government. None can survive for long without being able to borrow for short-term cash flow needs and long-term capital projects. No one was seriously proposing municipal bankruptcy for Harrisburg, so the Center on Budget and Policy Priorities called the resulting turmoil “unnecessary alarm.”

The bankruptcy option, however, had the effect of a well played bank shot, with balls caroming from the first target. Yes, the proposal to loosen bankruptcy laws was DOA, but it also hardened opposition in Congress for more bailout money. Meanwhile, some analysts whispered that some people might be making money on the turmoil. Short selling on municipal bonds -- making bets that the prices would fall -- quintupled at the end of 2010, according to a Bloomberg report, and the projections of massive bankruptcies talked down the market. Meanwhile, state and local borrowing costs rose as nervous investors were less willing to loan money to governments portrayed as distressed.

There was still one carom left in this shot: how to stem the red ink. In states like New Jersey, Ohio and Wisconsin, governors took tough stands against public employee unions. A Pew Research Center poll helped suggest why. The only option that citizens view as a remotely palatable budget-cutting strategy is to decrease the government employees’ pension benefits, although votes for and against it were equal. All other spending reductions, from reducing state spending for colleges and universities to cutting support for K-12 education, stirred up strong opposition, ranging from 2-1 to 4-1 against, according to Pew’s poll results.

In Wisconsin, Gov. Scott Walker has tried to force state workers to pay more for their pensions and health-care benefits, a move that would effectively cut their pay by 7 percent. That proposal created angry protests in Madison and shut down several school districts for days, as teachers left work to demonstrate against the plan. For the new Republican governor, it was the culmination of his party’s long struggle with public employee unions, which for decades had bankrolled millions of dollars in campaigns against Republican candidates. In fact, this battle was an origin for the massive issue ad explosion that has since swept the country. For Republicans itching to even political scores, these bank shots provided an unmatched opportunity to dismantle the power that public employee unions had long established.

It’s hard to think of any intergovernmental issue in recent memory with such complex and interrelated pieces. It would be easy to paint this as a conspiracy from the right to incite a crisis and advance a union-busting agenda. The reality is far more complex. The last months have been the product of a collision among churning state and local fiscal problems, the end of the stimulus program, reporters searching for the next crisis, the Tea Party movement’s call for cutting government and some well timed specters of bankrupt governments.

Whatever the roots, however, this pool shot has ricocheted in wild ways. It killed prospects, no matter how dim or unwise, of expanded bankruptcy protection for state and local governments. It seriously wounded prospects of another round of federal stimulus funds, put a harsh spotlight on state and local budgets, and fueled the budget-cutting fervor of a new breed of governors. In the process, public employee unions, which now represent more than half of the nation’s union members, are under attack as never before. If they weren’t the initial target, they are now. All in all, that’s a pretty remarkable shot.

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