First GM, now states? Pros and cons of bankruptcy

NEW YORK - Big companies such as General Motors file for bankruptcy. Some cities do, too. And, last year, 1.5 million Americans did it.

But U.S. states aren't allowed. Now, a few policy makers and pundits are debating whether it's time to give states a court-sanctioned way to shed their debts.

The idea galls critics. "Baloney" is what California Treasurer Bill Lockyer calls it, saying his state, which is already weighing painful tax hikes and spending cuts, doesn't need the option.


It seems clear that some states can't afford their long-term promises to pay for pensions and retiree health care. Those swelling costs could force states to raise taxes and slash services like public transportation.

But is bankruptcy the right solution?

In Bankruptcy Court, a judge could force lenders and public workers to accept less than they are owed. Debt could drop overnight. Existing union contracts could be replaced with cheaper ones. In theory, states could regain their financial health.

But the risks are high. A state could be tied up in court for years as various sides squabble over a deal that might bring only scant relief in the end. Even discussing the idea could spook investors and rattle states' fragile finances. States need investors to buy their bonds, and demand already was dropping before talk of a bankruptcy option spread.

Fearing that towns and cities may default, investors in November and December pulled a record $21 billion from funds that invest in municipal bonds - twice as much as they did at the depths of the 2008 credit crisis, the Investment Company Institute says. Those still buying are demanding higher interest rates to compensate for the risk.

Standard & Poor's, which determines how credit-worthy states are and assigns ratings, said last week that a bankruptcy law would cause it to review the way it judges states. Downgrades would force states to pay higher interest rates.

If investors started selling the bonds, that would force interest rates higher, too, adding to the cost of financing the bonds.

"The higher the interest rate a state has to pay, the more potholes that can't be filled," said Marilyn Cohen of Envision Capital, a company that invests in bonds. "There's a whole chain reaction."

Some also question whether allowing states to go bankrupt would be wise economic policy in the long run. When a company or family cuts its debt through bankruptcy, it risks encouraging others to do the same, said Dean Maki, chief U.S. economist at Barclays Capital. With states, the danger is greater.

Bankruptcy talk already may be taking a toll on public finances. Matt Fabian of Municipal Market Advisors said states, cities and towns are avoiding issuing new debt, partly because they fear a bankruptcy option.

States' combined deficits for next fiscal year are a projected $125 billion, said Iris Lav of the liberal Center on Budget and Policy Priorities. And they haven't put enough money away to cover pensions due in coming decades. Estimates for the collective pension shortfall range from $500 billion to $3 trillion.

State tax revenues are starting to recover as the economy improves and as states raise taxes. Revenue rose 6.9 percent in the October-December quarter, based on early data from 41 states, according to a report from the Nelson A. Rockefeller Institute released Tuesday. That would be the fastest increase in more than four years.

Still, most states face brutal budget squeezes. Tax revenue remains just below pre-recession levels, the report says.

Two possible targets are bond investors and public workers.

Backers such as former House Speaker Newt Gingrich say states need the threat of a court-approved bankruptcy option to wrest concessions from bondholders and unions.

Unions would "face a much more dire outcome in Bankruptcy Court than they would if they renegotiated," said Patrick Gleason of the Americans for Tax Reform, a conservative group pushing for such a law.

Also propelling the idea is fear that states may eventually approach Washington for a taxpayer bailout like the one for Wall Street. Sen. Mark Kirk, R-Ill., thinks a bankruptcy option would keep states from seeking federal aid, a spokeswoman said. House Judiciary Committee Chairman Lamar Smith, R-Texas, said his panel will hold a hearing on the issue later this month. Unlike the case with cities and towns, there is no law allowing states to seek bankruptcy protection in federal courts.

A few states have moved to fix their finances. Lawmakers in Illinois, for instance, voted to raise personal income tax 66 percent, along with spending cuts. The state still faces a $15 billion deficit.

Some opponents argue that most states have the resources to pay their debts. They say bankruptcy backers are scaring people by lumping pension shortfalls, which can be plugged over many years, with annual deficits, which demand an immediate fix to keep state budgets balanced.

Unlike the federal government, every state except Vermont has a legal requirement to balance its budget, according to the National Conference of State Legislatures. So, when tax collections fall or spending spikes, states must find the money elsewhere. That's why so many cut basic services during the recession.

By contrast, state pension gaps are spread over many years. They shrink or grow depending on assumptions about economic growth and investment returns.

by Bernard Condon and Daniel Wagner Associated Press Feb. 2, 2011 12:00 AM





First GM, now states? Pros and cons of bankruptcy