The document outlines the challenges of state financial insolvency, emphasizing its impact on various stakeholders including bondholders and retirees. It identifies the causes of insolvency as a mix of structural imbalances, poor policy decisions, and unfunded retiree obligations, highlighting the political nature of these issues rather than merely fiscal ones. Additionally, it discusses the complexities of potential federal intervention, the prerequisites for state bankruptcy, and the implications for both state and federal fiscal responsibilities.

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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