This presentation looks at the issues involved in determining whether a state might become unable to pay its bills and what might happen if it does. It explores the history of state insolvency and the merits of adding a new chapter to the federal bankruptcy laws to accommodate such a situation.

1. Joe Kennedy
Kennedy Research, LLC
January 11, 2013

2.  Financial insolvency is likely to affect all of a state’s
counterparties:
◦ Bondholders
◦ Retirees
◦ Current workers
◦ Beneficiaries of state services
 Businesses interact with states in many ways:
◦ As taxpayers (taxes are likely to go up)
◦ As suppliers (spending cuts will hurt investment and
consumption)
◦ As participants in the general economy (economic
uncertainty may slow the economy and lead to a loss in
competitiveness)
 State insolvency is likely to have worse consequences if there
is no plan to deal with it.
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3.  There are two explanations:
◦ Structural imbalances that exacerbate cyclical
downturns.
◦ Bad policy combined with a growing time bomb in
the form of retiree obligations.
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4.  This is a political problem, not a fiscal one.
 Federalism has put states in a very difficult
fiscal position:
◦ Social spending (education, Medicare,
Unemployment Insurance) is constant or procyclical.
◦ States are relying more on procyclical income and
sales taxes rather than property taxes.
◦ This means that state budgets worsen in townturns.
◦ Balanced budget requirements require states to
cuts spending and increase taxes in the midst of
recessions, making their problems worse.
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5.  Does not explain why states generally fail to
save in good times.
 Does not really explain why some states do
better than others or why in good times some
pass legislation that worsens their position in
downturns.
 State borrowing limits are self-imposed.
States presumably keep them because they
benefit from lower interest rates.
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6.  Long-term state fiscal problems are largely
due to unwise policies in some states,
particularly a lax attitude toward economic
growth and the existence of large retirement
obligations.
 While near-term fiscal problems are
exacerbated by recessions, states eventually
recover from them.
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7.  Under Hamilton the federal government assumed
much of the state debt caused by the
Revolutionary War. Since then the federal
government has not explicitly bailed out any
state.
 In the 1840s many states had trouble paying off
railroad and other debt.
 After the Civil War, many Southern states had
trouble with debt obligations.
 After the Great Depression a number of states
had fiscal problems and Arkansas defaulted.
◦ Popular opposition from solvent states killed an effort to
get federal aid.
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8.  National averages are not helpful.
 The answer depends on several things:
◦ What is the discount rate for both funded and
unfunded liabilities?
◦ Will states bail out subdivisions?
◦ Will the economy grow?
◦ Are employee benefits, especially health care, long-
term commitments or do they expire with the latest
collective bargaining agreement?
◦ Can the political process enact meaningful changes?
◦ Are liabilities measured as a percent of GDP or of
revenues?
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9.  All levels of government are interrelated.
Fiscal problems at one level are likely to
affect other levels.
◦ After the latest recession the federal government
pumped lots of money into the states, this
temporary funding has ended.
◦ States may feel pressure to help distressed
municipalities.
◦ Similarly, state consolidation may lead to a decline
in revenues going to cities, worsening their balance
sheets.
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10.  Benefits of Having a Pre-defined Process.
◦ Allows states to exit from hopeless situations.
◦ Hopefully, reduces overall expense and uncertainty.
◦ Can get priced into future contracts.
 Costs of Having a Pre-defined Process.
◦ May lead to moral hazard and make states more
prone to borrow.
 Right now markets seem to price this risk accurately.
 State borrowing restrictions remain in place.
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11.  Sovereign defaults in the 1980s.
 A national decline in housing prices.
 The bankruptcy of Fannie Mae and Freddie
Mac.
 Another Great Depression.
 Downgrading of U.S. debt.
 Breakup of the Euro.
It pays to be prepared!
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12.  Moratorium on collection efforts.
 A clear set of priorities among creditors
(including retirees).
 Creditor coordination to eliminate hold-outs.
 Ability to deal with executory contracts.
 Final discharge of debts to eliminate debt
overhang.
 Access to bridge financing.
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13.  States must allow it.
 Has seldom been used.
 Municipalities must initiate the process,
debtors cannot.
 Municipality must be insolvent (unclear
exactly what this means).
◦ Courts may reject a filing if the municipality has
room to raise taxes or cut spending.
 Municipality develops the workout plan.
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14.  States are sovereign entities under the
Constitution and cannot be sued in federal
court (Article 11).
 But the Contract Clause prevents states from
eliminating these debts entirely since they
remain binding contracts.
 Only the federal government can void
existing contracts under the bankruptcy
clause.
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15.  States have generally been free to stop paying
debt and creditors have few good options for
enforcing their claims:
◦ States cannot be dissolved and seldom have
significant assets that can be seized and sold.
◦ Democratic principles are likely to inhibit judges
from ordering tax increases or specific spending
cuts and from ordering state officials to do so.
◦ In past instances of state insolvency, state officials
have often resigned rather than carry out orders to
pay creditors.
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16.  Involves a balancing between the Contracts
Clause and the state’s inherent police duties
to protect public welfare.
 Criteria:
◦ Was the event foreseeable?
◦ Is there judicial review of the modification?
◦ Are the debtors worse off than with no
modification?
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17.  State must initiate it, voluntarily waiving its
sovereign immunity (some question whether
it can do this).
 State will develop the workout plan in
consultation with creditors.
 Court will lack the authority to increase taxes,
cut spending, or sell assets but will have the
authority to discharge debt.
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18.  Last debated in 2010. The debate was
initiated by articles advocating a federal
bankruptcy option and Meredith Whitney’s
prediction of multiple state and local
bankruptcies.
 Sources of opposition
◦ Unions (saw it as a threat to collective bargaining).
◦ Financial industry (argued that the bond market
would over react and show much greater volatility).
◦ States (were fearful of having to pay higher rates)
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19.  Advantages
◦ It may be that only the federal government can provide
sufficient bridge financing.
◦ To the extent that policy changes are an explicit part of
any restructuring, the federal government rather than
the courts may be in the best position to negotiate and
enforce them.
 Disadvantages
◦ May compromise the states’ ability to borrow as
sovereign debtors.
◦ If widespread, it will likely to lead to a further
centralization of power.
◦ Requires political support from health states.
◦ Congressional attention is likely only when there is an
actual emergency.
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20.  Drawing attention to state finances may
increase the pressure to deal with them in a
timely way.
 Anticipation of a federal bailout gives
opponents time to react.
 If there is a bailout, advance warning is likely
to result in better policy conditions (as
opposed to TARP) and lower cost shifting.
 Surprise often results in hurried and bad
legislation.
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