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The State Bankruptcy Threat

Wealth Cycles
Jan 25, 2011

Crushed with debt, labor contracts, and a floundering business model, General Motors underwent one of the largest bankruptcies in U.S. history—reorganizing $27 billion in debt and shaking up its stock—replacing original investors with the U.S. Treasury and the old bondholders, who were forced to trade bad debt, with equity ownership. It was a huge and messy process, gobbling up many billions of U.S. taxpayer resources, but, in the end, GM survived.

Now, financially unfit states are looking at the GM bankruptcy as a model to get out from under crushing debt loads and enormous pension promises. But as of right now, states are forbidden from filing bankruptcy—which puts contracts up on the chopping block and allows bankruptcy judges to reorganize debt and wipe out bondholders.

According to the New York Times, lawmakers are studying the ramifications of state bankruptcy—and how it could affect the $2.9 trillion market, which includes state bonds and “muni” bonds (any government or local debt below the state level).

The State Bankruptcy Threat sifmamarketsizechart

Unlike cities, the states are barred from seeking protection in federal bankruptcy court. Any effort to change that status would have to clear high constitutional hurdles because the states are considered sovereign.But proponents say some states are so burdened that the only feasible way out may be bankruptcy, giving Illinois, for example, the opportunity to do what General Motors did with the federal government’s aid.

Beyond their short-term budget gaps, some states have deep structural problems, like insolvent pension funds, that are diverting money from essential public services like education and health care. Some members of Congress fear that it is just a matter of time before a state seeks a bailout, say bankruptcy lawyers who have been consulted by Congressional aides.

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General Obligation (or G.O.) bonds are considered amongst the safest type of bonds because they are backed by the ability of a state or municipality to levy taxes. If the borrower cannot pay the interest and principal outstanding on their debt, a General Obligation bond stipulates that they must levy or raise taxes in order to make up for whatever shortfall exists. Many states’ debts are legally protected by their constitutions as well.

So is bankruptcy a good way to undo boneheaded agreements made by states? Nicole Gelinas of the New York Post thinks not:

Take New York, with its $78.4 billion in outstanding bond debt and estimated $81 billion in unfunded obligations for state-employee pensions and retiree health care. The idea seems to be that the Empire State would go “bankrupt,” figure that it can afford only, say, 80 percent of this number — and get a judge to lop off 20 percent.Ha. The complications of the municipal-bond markets make this plan hopelessly naive.

For starters, states like New York run up “their” debt indirectly. They issue bonds through tens of thousands of separate legal entities. New York “state” doesn’t owe all of that $78.4 billion in debt — it owes only $3.5 billion in “general-obligation” debt.

Who owes the rest? The MTA, the Dormitory Authority, the Triborough Bridge & Tunnel Authority and so on. Legally, each is not a government but a “public-benefit corporation.” Each has its own board, its own rules and its own contractual agreements with creditors, from bondholders to unions. Each of those agreements offers creditors different protections.

So what really would happen? Would thousands of legal entities be declared bankrupt when the state declares bankruptcy? At that point, would investors begin looking for the next wobbly chair, i.e. the United States?

The murky legalities of this are complex because of state-sovereignty and the complex interaction between Federal and State law. The one certain thing is that there is no magic pill to pull states through this massive upcoming crisis that has been decades in the making.

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