What Happens When a State Goes Bankrupt?
Member David Guaspari writes in, asking:
It seems clear that the political classes of New York and California will continue to misgovern their states into ruin, confident that the states are too big to fail and will be bailed out by the rest of the country.
Leaving aside prudential questions, what would it mean legally for a state to go bankrupt (or whatever would be the appropriate term)?
Does there already exist a mechanism--like the bankruptcy courts for individuals and corporations--for dealing with it?
If not, what might a salutory federal law look like--some shot across the bow making it likely that bail-outs will not be forthcoming? Presumably (unfortunately) the only liability destructive officeholders face is that of being voted out of office.
Here are three questions, each of which deserves an extensive answer, which I don’t think that I can supply with sufficient fullness. But here are some hints along the way.
To David's first question: the meaning of bankruptcy is clear. The debtor is insolvent in one or two senses.
First, its liabilities exceed its assets. Second, even if its assets exceed its liabilities, they are not liquid enough to permit payment of the debts as they accrue. California is insolvent in this second sense. It is probably insolvent in the first sense as well. Places like Illinois and New York are close to the line in both senses. At the crisis point there are only stopgap measures, like the payment of scrip, which most banks will refuse to accept as it is in reality only a form of unsecured credit that goes to the back of the queue in any bankruptcy proceedings.
Given insolvency, bankruptcy does three things. First, it marshals the assets for distribution; second, it sets the priorities for various classes of creditors; third, it offers a discharge for the bankrupt party for most of these obligations.
In general secured creditors come first and unsecured creditors get what is left over. That pattern did not hold in the GM and Chrysler bankruptcies because federal intervention from the executive branch rigged the transactions so that the union pension claims were able to push aside the secured creditors'.
That issue looms large here because the most important feature of any state bankruptcy would be to discharge the pension obligations. It is doubtful that the obligations would be completely eliminated, but they could be extensively trimmed to bring them in line with private pension funds, which is both a financial and a moral necessity. Once that is done, the rest of the process should not be nearly as complicated.
To David's second question: there is no obvious mechanism for state bankruptcies, even if there are some procedures, I believe, for municipal bankruptcies. This is a ticklish issue because states are sovereigns and it is a frightening prospect to think that when mired in bankruptcy, they could not discharge their essential functions because they could not pay their pension obligations, among others. So the battle over the form of bankruptcy will be acute, and I have no idea how this would play out--except badly.
To David's third question: I don’t think that full-fledged bankruptcy is a realistic prospect as of now. I think that the much more sensible approach is to side-step the bankruptcy proceedings and find ways to attack the union pension obligations directly, given their enormous size. It is odd that these days the only sacred contracts are those which the state enters into with unions for the benefit of their members.
The key question is whether it will be possible to persuade the courts that these pension agreements were the result of political self-dealing, which means that they should be set aside unless it could be shown that the state received fair value for the services rendered when it made those deals. I think that case is bold but winnable, yet only when the situation becomes truly desperate. Funding that litigation will take some bankrolling, but the corporate law analogies on self-dealing make it pretty clear that the state legislatures violated all their duties of loyalty to the public at large when they entered into deals from which union pension funds got all the upside and everyone else got the downside. Not nice. Undoing it is the work of the next generation.
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Re: What Happens When a State Goes Bankrupt?
Richard is far more of an expert than I on matters commercial. Let me just add a few points. My limited understanding is that states cannot declare bankruptcy in the way that cities can (Orange County declared bankruptcy in the last decade); there is no provision for it in the federal bankruptcy laws (or so I've been told).
But I suppose a state could default on its bonds. Or it could default on its pension obligations. That would be similar to bankruptcy. If California or New York refused to pay, they would probably be unable to borrow money for a long time on the financial markets, and they would have to offer rates far above normal state bond rates. They would also destroy any confidence in the state governments--if Sacramento or Albany were willing to default on their bonds, where would they stop in destroying business value to balance their budgets?
Re: What Happens When a State Goes Bankrupt?
It may be the case that investors in California and New York bonds assume that the federal government will bail out the states before any default. Washington sends money to the states as part of the stimulus. This only puts off the date of reckoning and deceives citizens about the true nature of state finances. The new Congress could promote honesty in state finances, and prod Sacramento and Albany into getting their fiscal houses in order, by passing legislation stopping the transfer of money to the states and making clear that state bonds will not be back stopped by the Treasury.
Jul '10
Re: What Happens When a State Goes Bankrupt?
Wouldn't your final paragraph also stand as an indictment of public service unions, in general? If the case can be made that such self-dealing was prevalent a state's dealings with public unions, wouldn't it considered illegal, or at least improper, to enter into future negotiations without some new framework to make sure that such self-dealing doesn't occur again?
And if so, what form could such a framework take? A plebiscite on future union contracts, where the population votes on the contract either as a union member, or a taxpayer, but not both? Increased oversight by the Labor Relations Board (not much of a relief there, I'm afraid).
Or maybe, (cue harp music) outlawing public unions entirely?
Re: What Happens When a State Goes Bankrupt?
John is of course correct that the view in California and New York today is that a federal guarantee from other states will be the Deus ex Machina that saves them from their own profligacy. The rest of the nation should take stern steps to make sure that it never happens. Put otherwise if the nation were the Titanic, and each state were one of its water tight compartments, you would want to make sure that a break in one department did not lead to a rupture in all the others.
One sensible step to prevent the cross subsidies that led to the current excesses in California is to eliminate the deduction of state income taxes from the federal income, which right now creates huge distortions between tax heavy California and income tax free Texas.
Jul '10
Re: What Happens When a State Goes Bankrupt?
@Richard Epstein: "So the battle over the form of bankruptcy will be acute, and I have no idea how this would play out--except badly."
A California bankruptcy would inevitably be one of the most chaotic, acrimonious and shameful spectacles ever witnessed on the political stage. What frightens me most about it is that there is no trustworthy arbiter - I certainly don't trust the courts with something of this magnitude.
The only solace I take is my belief that, above all else, the interests of bondholders will have to be protected. If California were to be enabled to abrogate those rights, no state would be able to float bonds at any reasonable rate of interest in the future.
If I am right about that, then pensions take center stage - after, of course, the state's politicians do the standard wailing about having to cut back on police, firefighters and teachers.
Oct '10
Re: What Happens When a State Goes Bankrupt?
Richard,
What recourse does a union have if a state decides to unilaterally trim pension benefits for members who are already retired?
I'm curious if a labor agreement that establishes a standard that says, "If you work X years, we will pay all of your health benefits and Y percent of your salary for the rest of your life." is something that a state can't change without some sort of bankruptcy proceeding.
Jul '10
Re: What Happens When a State Goes Bankrupt?
What's insidious about California's predicament is that even if they were to cut "police, firefighters and teachers", it would do no good; those folks would still have pensions due them, eventually. And even if they quit belly-aching and actually cut non-essential personnel, the same point would apply.
To avoid bankruptcy, they either have to curtail future PSU pension benefits, or they have to grow their economy in a scale that matches the blue-sky dreams that were prevalent when these PSU contracts were negotiated.
They just elected Jerry Brown governor. I am deeply pessimistic.
Sep '10
Re: What Happens When a State Goes Bankrupt?
Conservative dreaming about saying Drop Dead to CA may be nothing less than a form of pocket pool. NYC in the '70s may be a more likely model. See the article Infamous ‘Drop Dead’ Was Never Said by Ford.
Please note in the article that someone said that the tough conditions 'saved NYC from itself'. Also please note that there is some sentiment that Ford's original tough response to NYC played a role in his loss of the election.
In the context of CA - and several other states by extension - several things can be taken:
1. IMHO, because they cannot save themselves from themselves, it's a given that CA politicians have no choice but to eventually go to the feds. In this sense, the CA election results make perfect sense. From CA's point of view, CA will be better off having Boxer and Brown on CA's side of the negotiating.
2. A'la Ford's election loss, there is political danger to the Repubs if too heavy a hand is taken to CA and the others. Republican leaders should keep this in mind, and be gaming it even now. The Democrats are surely doing so.
Edited on Nov 8, 2010 at 9:50amNov '10
Re: What Happens When a State Goes Bankrupt?
"The key question is whether it will be possible to persuade the courts that these pension agreements were the result of political self-dealing, which means that they should be set aside unless it could be shown that the state received fair value for the services rendered when it made those deals."
Most of these deals involved applying pension formulas (i.e. 3% at 50) to earnings prior to the date the deals were made. These are essentially gifts to the unions. Therefore, to Prof. Epstein's point re state receiving fair value, I think not, at least for the retroactive part. The state had already received service from these employees on less-generous pension terms per previous contracts, to which the employees and their unions agreed voluntarily.
http://community.pacificlegal.org/Page.aspx?pid=1324
May '10
Re: What Happens When a State Goes Bankrupt?
As Professor Epstein noted with respect to GM and Chrysler, the political values weigh heavily on the "rule of law." The political values of propping up the "non-going concern " fka California will far outweigh the good of either the California taxpayer, Federal taxpayer or bond market investors. Given the current courts view of individual rights versus the greater public good (Kelo v. New London), the outcome will likely be a federal bailout.
Did Orange County's bankruptcy actually reduce the pension liability? How much?
Sep '10
Re: What Happens When a State Goes Bankrupt?
An additional challenge is sometimes written into the state constitution.
In Illinois, any pension benefit reductions are subject to interpretation of Article XIII, Section 5 of the Illinois Constitution: Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired. (source: http://www.chicagofed.org/digital_assets/others/events/2010/charting_illinois_fiscal_future/weiss.pdf).
I believe other states may have the same issue, but there are different interpretations on if / how it applies to state pension benefits (see: http://articles.chicagotribune.com/2010-03-27/news/ct-edit-pensions0328-20100327_1_pension-plans-house-speaker-michael-madigan-illinois)
Jun '10
Re: What Happens When a State Goes Bankrupt?
At least here in CA, the state constitution can be amended by initiative with a simple majority vote. If the state voters passed a Proposition to slash pensions, and wrote it into our state constitution, wouldn't that trump everything except the federal constitution?
Nov '10
Re: What Happens When a State Goes Bankrupt?
What if a Republican congress refused to fund a bailout of California or New York? How does that play out?
Could California and New York be placed into "receivership" to extract some sort of federal guarantee that a Republican congress would fund? Could this hypothetical "receivership" be prevented from being co-opted by the executive branch?
Oct '10
Re: What Happens When a State Goes Bankrupt?
How much political capital would Republicans lose by making CA bailout money contingent on "austerity measures", similar to what the IMF did with Greece?
The political calculation becomes interesting; Republicans can't be expecting to win NY and CA in 2012, so the political fallout hinges on whether voters in other states would respect a Republican HoR for playing tough with CA, or condemn the House for "sending firemen and nurses to the soup kitchen."
Nov '10
Re: What Happens When a State Goes Bankrupt?
J. D. Fitzpatrick: How much political capital would Republicans lose by making CA bailout money contingent on "austerity measures", similar to what the IMF did with Greece?
The political calculation becomes interesting; Republicans can't be expecting to win NY and CA in 2012, so the political fallout hinges on whether voters in other states would respect a Republican HoR for playing tough with CA, or condemn the House for "sending firemen and nurses to the soup kitchen." · Nov 9 at 8:38pm
I like this on the face. Europe is pushing Greece to collect additional taxes as well as cutting spending. In California and New York, I expect, that collection of additional taxes would not go down well as we already are the highest taxed in the country. Greece has a very high tax rate but people simply do not pay them. That's a tad more difficult in California. To quote an erstwhile president: "Read my lips - no new taxes."