Path Is Sought for States to Escape Debt Burdens

http://www.nytimes.com/2011/01/21/business/economy/21bankruptcy.html?_r=2&adxnnl=1&src=busln&adxnnlx=1295578848-ffShtOpjiAQjlJbdl956sA

Path Is Sought for States to Escape Debt Burdens
By MARY WILLIAMS WALSH
Published: January 20, 2011

Policy makers are working behind the scenes to come up with a way to  
let states declare bankruptcy and get out from under crushing debts,  
including the pensions they have promised to retired public workers.

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.

Bankruptcy could permit a state to alter its contractual promises to  
retirees, which are often protected by state constitutions, and it  
could provide an alternative to a no-strings bailout. Along with  
retirees, however, investors in a state’s bonds could suffer, possibly  
ending up at the back of the line as unsecured creditors.

“All of a sudden, there’s a whole new risk factor,” said Paul S. Maco,  
a partner at the firm Vinson & Elkins who was head of the Securities  
and Exchange Commission’s Office of Municipal Securities during the  
Clinton administration.

For now, the fear of destabilizing the municipal bondmarket with the  
words “state bankruptcy” has proponents in Congress going about their  
work on tiptoe. No draft bill is in circulation yet, and no member of  
Congress has come forward as a sponsor, although Senator John Cornyn,  
a Texas Republican, asked the Federal Reserve chairman,Ben S.  
Bernanke, about the possiblity in a hearing this month.

House Republicans, and Senators from both parties, have taken an  
interest in the issue, with nudging from bankruptcy lawyers and a  
former House speaker, Newt Gingrich, who could be a Republican  
presidential candidate. It would be difficult to get a bill through  
Congress, not only because of the constitutional questions and the  
complexities of bankruptcy law, but also because of fears that even  
talk of such a law could make the states’ problems worse.

Lawmakers might decide to stop short of a full-blown bankruptcy  
proposal and establish instead some sort of oversight panel for  
distressed states, akin to the Municipal Assistance Corporation, which  
helped New York City during its fiscal crisis of 1975.

Still, discussions about something as far-reaching as bankruptcy could  
give governors and others more leverage in bargaining with unionized  
public workers.

“They are readying a massive assault on us,” said Charles M. Loveless,  
legislative director of the American Federation of State, County and  
Municipal Employees. “We’re taking this very seriously.”

Mr. Loveless said he was meeting with potential allies on Capitol  
Hill, making the point that certain states might indeed have financial  
problems, but public employees and their benefits were not the cause.  
The Center on Budget and Policy Priorities released a reporton  
Thursday warning against a tendency to confuse the states’ immediate  
budget gaps with their long-term structural deficits.

“States have adequate tools and means to meet their obligations,” the  
report stated.

No state is known to want to declare bankruptcy, and some question the  
wisdom of offering them the ability to do so now, given the jitters in  
the normally staid municipal bond market.

Slightly more than $25 billion has flowed out of mutual funds that  
invest in muni bonds in the last two months, according to the  
Investment Company Institute. Many analysts say they consider a bond  
default by any state extremely unlikely, but they also say that when  
politicians take an interest in the bond market, surprises are apt to  
follow.

Mr. Maco said the mere introduction of a state bankruptcy bill could  
lead to “some kind of market penalty,” even if it never passed. That  
“penalty” might be higher borrowing costs for a state and downward  
pressure on the value of its bonds. Individual bondholders would not  
realize any losses unless they sold.

But institutional investors in municipal bonds, like insurance  
companies, are required to keep certain levels of capital. And they  
might retreat from additional investments. A deeply troubled state  
could eventually be priced out of the capital markets.

“The precipitating event at G.M. was they were out of cash and had no  
ability to raise the capital they needed,” said Harry J. Wilson, the  
lone Republican on President Obama’s special auto task force, which  
led G.M. and Chrysler through an unusual restructuring in bankruptcy,  
financed by the federal government.

Mr. Wilson, who ran an unsuccessful campaign for New York State  
comptroller last year, has said he believes that New York and some  
other states need some type of a financial restructuring.

He noted that G.M. was salvaged only through an administration-led  
effort that Congress initially resisted, with legislators voting  
against financial assistance to G.M. in late 2008.

“Now Congress is much more conservative,” he said. “A state shows up  
and wants cash, Congress says no, and it will probably be at the last  
minute and it’s a real problem. That’s what I’m concerned about.”

Discussion of a new bankruptcy option for the states appears to have  
taken off in November, after Mr. Gingrich gave a speech about the  
country’s big challenges, including government debt and an  
uncompetitive labor market.

“We just have to be honest and clear about this, and I also hope the  
House Republicans are going to move a bill in the first month or so of  
their tenure to create a venue for state bankruptcy,” he said.

A few weeks later, David A. Skeel, a law professor at the University  
of Pennsylvania, published an article,“Give States a Way to Go  
Bankrupt,”in The Weekly Standard. It said thorny constitutional  
questions were “easily addressed” by making sure states could not be  
forced into bankruptcy or that federal judges could usurp states’  
lawmaking powers.
“I have never had anything I’ve written get as much attention as that  
piece,” said Mr. Skeel, who said he had since been contacted by  
Republicans and Democrats whom he declined to name.

Mr. Skeel said it was possible to envision how bankruptcy for states  
might work by looking at the existing law for local governments.  
Called Chapter 9, it gives distressed municipalities a period of debt- 
collection relief, which they can use to restructure their obligations  
with the help of a bankruptcy judge.

Unfunded pensions become unsecured debts in municipal bankruptcy and  
may be reduced. And the law makes it easier for a bankrupt city to  
tear up its labor contracts than for a bankrupt company, said James E.  
Spiotto, head of the bankruptcy practice at Chapman & Cutler in Chicago.

The biggest surprise may await the holders of a state’s general  
obligation bonds. Though widely considered the strongest credit of any  
government, they can be treated as unsecured credits, subject to  
reduction, under Chapter 9.

Mr. Spiotto said he thought bankruptcy court was not a good avenue for  
troubled states, and he has designed an alternative called the Public  
Pension Funding Authority. It would have mandatory jurisdiction over  
states that failed to provide sufficient funding to their workers’  
pensions or that were diverting money from essential public services.

“I’ve talked to some people from Congress, and I’m going to talk to  
some more,” he said. “This effort to talk about Chapter 9, I’m worried  
about it. I don’t want the states to have to pay higher borrowing  
costs because of a panic that they might go bankrupt. I don’t think  
it’s the right thing at all. But it’s the beginning of a dialog.”
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