WASHINGTON — Senate Majority Leader Mitch McConnell’s suggestion last week that he’d rather let states go bankrupt than see Congress rescue their coronavirus-decimated budgets raises the question: What would a state bankruptcy look like?
It would first require Congress to amend the federal bankruptcy code, which has never allowed state governments to declare bankruptcy. Municipalities — broadly defined as a town, city, county or other subdivision of a state, like a school district or independent authority — have been allowed to declare bankruptcy since 1937, but for states the only option would be defaulting on their debts.
It’s unlikely McConnell will be able to persuade the rest of Congress to go along with amending the bankruptcy code. His comments were met with swift and harsh backlash.
“You want to send an international message that the economy is in turmoil? Do that,” said New York Democratic Gov. Andrew Cuomo at a news conference Friday. “Allow states to declare bankruptcy legally because you passed the bill. It’ll be the first time in our nation’s history that that happened. I dare you to do that.”
On Thursday, fellow Republican Rep. Peter T. King of New York likened McConnell to Marie Antoinette.
In casual conversation, “bankrupt” and “broke” may be interchangeable terms. But bankruptcy is a legal process in which a person, company or municipality reorganizes its debts. It happens when an entity is insolvent — when there isn’t enough money to pay everyone what they’re owed. Companies also have the added option of shutting down and selling assets to pay off as much of the debt as possible.
One reason for bankruptcy to be unavailable to states is that they have the ability to raise taxes, and thus get the money to pay their debts. State bankruptcy thus risks being used for political purposes. McConnell hinted at such a purpose when his office said the federal COVID-19 aid shouldn’t be used to “bail out state pensions.” Bankruptcy, if it were available, could be a way to avoid meeting a financial obligation to those pensions.
Even with COVID-19 wreaking havoc on state budgets, it’s unlikely that any would be insolvent under the meaning of the bankruptcy code, Breckinridge Capital Advisors’ co-head of research, Adam Stern, wrote recently. “No state is insolvent right now, probably not even Illinois. Illinois can certainly choose to default on its debt obligations, but it likely cannot establish that it is ‘insolvent’ for the purposes of bankruptcy law,” Stern wrote.
Pension costs are one of the biggest drags on states’ fiscal health, and Illinois has one of the worst-funded public pensions in the nation — just 38.4% funded as of 2017, according to a Pew Charitable Trusts report in 2019. McConnell’s home state of Kentucky, at 33.9 percent, had the lowest public pension funding ratio in the nation.
While bankruptcy is unavailable, forcing states to tighten their belts could still have a large impact on economic recovery. State and local government spending is also a large part of the national economy, making up a little over 10% of GDP last year — about on par with the manufacturing sector.
Stern notes that states can already legally abrogate bond or pension obligations when it’s “reasonable (an emergency exists, for example) and necessary (no other choice exists but to renege on the contract).” This would take the form of a state negotiating with specific creditors to reduce the debts while still paying them in the interim.
Reorganization under bankruptcy law takes many different shapes — federal bankruptcy judges have wide latitude to structure them. Loans due can get pushed back, making each payment smaller. Some debtors get forced to accept less — take a haircut — than they were originally owed.
In a theoretical state bankruptcy, leaders would essentially cede their power to negotiate independently with some of their creditors to the binding arbitration of an unelected federal judge, who might opt for politically untenable solutions, such as cutting pensions.
Bankruptcy is messy and chaotic, but defaulting could be worse.
There aren’t many examples of state default. The last state to stop paying its bondholders was Arkansas in 1933. Puerto Rico, a territory, recently defaulted on some of its debts, deepening an ongoing financial catastrophe on the island.
