Despite McConnell Comment, States Can’t Go Bankrupt, Only Default

April 29, 2020by Jim Saksa, CQ-Roll Call (TNS)
Senate Majority Leader Mitch McConnell (R-KY) speaks to reporters in the Hart Senate Office Building on Capitol Hill in Washington, D.C., on March 20, 2020. (Drew Angerer/Getty Images/tNS)

WASHINGTON — Senate Majority Leader Mitch McConnell’s suggestion last week that he’d rather let states go bankrupt than see Congress rescue their coronavirus-decimated budgets raises the question: What would a state bankruptcy look like?

It would first require Congress to amend the federal bankruptcy code, which has never allowed state governments to declare bankruptcy. Municipalities — broadly defined as a town, city, county or other subdivision of a state, like a school district or independent authority — have been allowed to declare bankruptcy since 1937, but for states the only option would be defaulting on their debts.

It’s unlikely McConnell will be able to persuade the rest of Congress to go along with amending the bankruptcy code. His comments were met with swift and harsh backlash.

“You want to send an international message that the economy is in turmoil? Do that,” said New York Democratic Gov. Andrew Cuomo at a news conference Friday. “Allow states to declare bankruptcy legally because you passed the bill. It’ll be the first time in our nation’s history that that happened. I dare you to do that.”

On Thursday, fellow Republican Rep. Peter T. King of New York likened McConnell to Marie Antoinette.

In casual conversation, ”bankrupt” and “broke” may be interchangeable terms. But bankruptcy is a legal process in which a person, company or municipality reorganizes its debts. It happens when an entity is insolvent — when there isn’t enough money to pay everyone what they’re owed. Companies also have the added option of shutting down and selling assets to pay off as much of the debt as possible.

One reason for bankruptcy to be unavailable to states is that they have the ability to raise taxes, and thus get the money to pay their debts. State bankruptcy thus risks being used for political purposes. McConnell hinted at such a purpose when his office said the federal COVID-19 aid shouldn’t be used to “bail out state pensions.” Bankruptcy, if it were available, could be a way to avoid meeting a financial obligation to those pensions.

Even with COVID-19 wreaking havoc on state budgets, it’s unlikely that any would be insolvent under the meaning of the bankruptcy code, Breckinridge Capital Advisors’ co-head of research, Adam Stern, wrote recently. “No state is insolvent right now, probably not even Illinois. Illinois can certainly choose to default on its debt obligations, but it likely cannot establish that it is ‘insolvent’ for the purposes of bankruptcy law,” Stern wrote.

Pension costs are one of the biggest drags on states’ fiscal health, and Illinois has one of the worst-funded public pensions in the nation — just 38.4% funded as of 2017, according to a Pew Charitable Trusts report in 2019. McConnell’s home state of Kentucky, at 33.9 percent, had the lowest public pension funding ratio in the nation.

While bankruptcy is unavailable, forcing states to tighten their belts could still have a large impact on economic recovery. State and local government spending is also a large part of the national economy, making up a little over 10% of GDP last year — about on par with the manufacturing sector.

Stern notes that states can already legally abrogate bond or pension obligations when it’s “reasonable (an emergency exists, for example) and necessary (no other choice exists but to renege on the contract).” This would take the form of a state negotiating with specific creditors to reduce the debts while still paying them in the interim.

Reorganization under bankruptcy law takes many different shapes — federal bankruptcy judges have wide latitude to structure them. Loans due can get pushed back, making each payment smaller. Some debtors get forced to accept less — take a haircut — than they were originally owed.

In a theoretical state bankruptcy, leaders would essentially cede their power to negotiate independently with some of their creditors to the binding arbitration of an unelected federal judge, who might opt for politically untenable solutions, such as cutting pensions.

Bankruptcy is messy and chaotic, but defaulting could be worse.

There aren’t many examples of state default. The last state to stop paying its bondholders was Arkansas in 1933. Puerto Rico, a territory, recently defaulted on some of its debts, deepening an ongoing financial catastrophe on the island.

The one clear takeaway: States that default would face significantly higher interest rates on subsequent bond issuances, if they could borrow at all. According to a 2016 paper from the Federal Reserve Bank of Cleveland, after its 1933 default Arkansas reached a deal quickly with its bondholders, but “the state’s reputation suffered for a long time and it was unable to return to credit markets without federal assistance.”

“Arkansas bonds remained ‘speculative grade’ until 1939, which prevented banks in the nation from investing in them. Even Arkansas’ own banks weren’t allowed to invest in the state’s bonds until 1937,” the Fed paper said. “Large financial centers remained closed to the state for a decade or more.”

Even when Arkansas’ bonds were better rated, they paid nearly half a% more to borrow that money than neighboring states. State spending was constrained for years, and the schools were only kept open thanks to federal grants, which made up 19% of the state’s total revenue in 1939.

Puerto Rico’s debt crisis began when the major credit rating agencies downgraded its bonds to noninvestment grade in 2014, following years of economic decline on the island. That downgrade effectively prevented Puerto Rico from selling new bonds to repay the maturing ones, forcing Gov. Alejandro Garcia Padilla to admit the debt might not be payable.

Garcia Padilla signed a law to allow utilities and public authorities owned by the territory to declare bankruptcy, but the U.S. Supreme Court ruled that the federal bankruptcy code preempted the Commonwealth’s statute. It wasn’t until 2016 that Congress passed a law to restructure Puerto Rico’s debt, but the territory’s financial woes continue.

President Donald Trump and some congressional Democrats have said that the next fiscal package should include infrastructure spending. But letting state budgets get crushed, and forcing states and localities to slash spending or rely on bonds to get through this massive downturn, could also undermine any attempt to rouse the economy by building bridges and roads.

Municipal bonds finance around two-thirds of all infrastructure across the nation. If localities take on debt for operating costs, they won’t be able to do so to finance capital expenditures. But even if they don’t do that, the banged-up budgets will mean uglier credit ratings, driving up the cost of borrowing.

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©2020 CQ-Roll Call, Inc., All Rights Reserved

Distributed by Tribune Content Agency, LLC.

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