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Proposal for State Bankruptcies Unlikely to Succeed

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By: Sean Mccarthy, Tom Schuette

The idea that U.S. states be allowed to go bankrupt – an idea that has been floated frequently over the past decade – seems likely to meet political and constitutional obstacles.

In a radio interview on 22 April, Senate Majority Leader Mitch McConnell said he would be in favor of states being allowed to declare bankruptcy as opposed to the federal government providing additional assistance. His comment came as legislators spar over future federal support for state and local governments.

Legislative hurdles, however, make the path toward granting states a path toward bankruptcy difficult. It would require that Congress overcome significant obstacles and follow a challenging path to amend the federal bankruptcy code. Additionally, states would need to alter their constitutions and pass legislation that gives governors authority to seek bankruptcy protection. This helps explain why an idea that has been floated frequently since the global financial crisis has never been seriously pursued.

In addition to the legislative obstacles, any path toward state bankruptcy would likely face legal challenges given that intervention by a federal court in states’ fiscal affairs might generate constitutional issues relating to the Tenth Amendment.

Finally, states would need to solve an insolvency test found within the municipal bankruptcy framework. It is doubtful that a federal bankruptcy judge would ever agree that a sovereign entity such as a state would pass this test, especially without first exhausting efforts to raise taxes and draw down cash reserves.

State revenues plummeting

The unprecedented economic slowdown caused by COVID-19 will blow a hole in many state budgets for fiscal 2020 and fiscal 2021, with forced shutdowns already taking a bite out of a variety of state revenue sources. New York State is warning of a 20% reduction in funding for local governments and schools, while California’s legislative analyst has suggested a $35 billion budget shortfall could materialize in the near future (an amount equal to more than 22% of the Governor’s initial fiscal 2020–2021 budget proposal).

Favorably, states enter the COVID-19 crisis with rainy day funds equal to $75 billion, or 7.7% of spending, more than 1.6 times greater than what states had entering the global financial crisis.In addition, as the last crisis showed, states have many options to balance budgets, including the ability to draw on reserves, sweep cash from additional funds, cut spending, raise taxes, and stretch payables. The lessons learned from the last crisis and the long economic expansion that followed have prepared states for the challenges ahead.

Moreover, while state revenue declines will be far larger than those experienced during the financial crisis, the federal response has provided a new set of tools, including the $500 billion Municipal Liquidity Facility and the CARES Act – which will disburse more than $15 billion just to California for expenditures related to COVID-19. Make no mistake, additional federal aid is needed to prevent states from enacting deeper austerity measures, but new policy tools are a welcome addition to their existing options.

States have protested against previous suggestions for a bankruptcy option, noting that it could lead to additional borrowing costs for municipalities and curb critical infrastructure financing. Reprising the idea of state bankruptcy reflects the current political sensitivity of providing federal aid to state governments – which some believe have mismanaged their budgets – as well as concerns that federal funding would be used to address unfunded pensions as opposed to maintaining services.

But as we’ve seen before, states are unlikely to welcome this proposal and instead find other means of addressing their budget gaps. 

Sean McCarthy is head of municipal credit research at PIMCO, and Tom Schuette is co-head of the investment research and strategy department at Gurtin Municipal Bond Management, a PIMCO company.

Originally Posted on April 24, 2020 – Proposal for State Bankruptcies Unlikely to Succeed

1 See https://www.pewtrusts.org/en/research-and-analysis/articles/2020/03/18/states-financial-reserves-hit-record-highs.

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