The great ‘Chapter 8′ debate: Should states be allowed to declare bankruptcy?
Continued from:
Part 2: Pennsylvania capital considers bankruptcy as California city seeks to emerge
Part 1: Cash-starved cities increasingly look to dangerous, rarely used Chapter 9
By Mike Hinshaw
In the preceding two installments, we looked at a rarely used provision of the U.S. bankruptcy code known as Chapter 9, which is unlike the two most commonly used types of personal (or “consumer”) bankruptcy protection, Chapters 7 and 13. The latter are designed to allow individuals the chance at a fresh start while minimizing damage to society.
Chapter 9 can be risky for the cities that use it, including city workers, various kinds of investors and municipal bond holders.
Professor fuels debate with proposal for ‘Chapter 8′
Despite those risks, assorted pundits and industry professionals have recently been discussing one law professor’s contention that creating a new provision in the bankruptcy code–suggested as Chapter 8–would allow states to declare bankruptcy and thereby avert another financial crisis.
Published in The Weekly Standard in November, law professor David Skeel says: “Anyone who proposed even a decade ago that a state should be permitted to file for bankruptcy would have been dismissed as crazy. But times have changed. As Arnold Schwarzenegger’s plea for $7 billion of federal assistance for California earlier this year made clear, the states are the next frontier in ‘too big to fail.’ In the topsy-turvy world we now inhabit, letting states file for bankruptcy to shed some of their obligations could save American taxpayers a great deal of money.”
States facing interest on federal loans
And make no mistake–despite any yarns coming off various gubernatorial spinning wheels, simply servicing the interest on federal loans is a big problem for many states.
As reported in a Jan. 15 piece in The New York Times:
As if states did not have enough on their plates getting their shaky finances in order, a new bill is coming due — from the federal government, which will charge them $1.3 billion in interest this fall on the billions they have borrowed from Washington to pay unemployment benefits during the downturn.
The interest cost, which has been looming in plain sight without attracting much attention, represents only a sliver of the huge deficits most states will have to grapple with this year. But it comes as states are already cutting services, laying off employees and raising taxes. And it heralds a larger reckoning that many states will have to face before long: what to do about the $41 billion they have borrowed from the federal government to help them pay benefits to millions of unemployed people, a debt that federal officials say could rise to $80 billion.
Certainly, most states are in trouble. In a Dec. 30 follow-up to her earlier series at CNBC called “States of Pain,” Nicole Lapin writes, “We’ve all seen the deficit numbers. Twenty-five billion for California. Fifteen billion for Illinois. Ten billion dollars for New Jersey.
“Meredith Whitney says we will all feel the states’ pain in the spring when federal stimulus money dries up.”
Have warnings been ingnored?
To be sure, some states were warned. A Jan. 16 article from the Austin bureau of the Houston Chronicle is headlined “Strayhorn finds vindication, but no joy, in shortfall,” pointing out in the subhed that the perennially re-elected Gov. “Perry rejected ex-comptroller’s budget warning in 2006″:
Comptroller Carole Keeton Strayhorn did not win friends five years ago when she warned Gov. Rick Perry and state lawmakers they were writing the “largest hot check in Texas history” during a tax overhaul that resulted in lower property taxes and a revised business tax.
Strayhorn told them their plan would fall about $23 billion short over a five-year period.
Now, five years later, state leaders are staring at an estimated budget shortfall of nearly $27 billion over the next two years.
According to this Fort Worth Star-Telegram editorial and this piece in D magazine, the vagaries of the state budget process don’t allow us to pinpoint the precise number: the deficit may be about $15 billion, or it may really be closer to $15 billion–depending on what actually gets counted. That’s because, says D, “the Comptroller only estimates revenue. She cannot estimate what the Legislature will spend. (And she is probably a little gunshy on the revenue, since she overestimated by $4.2 billion for the current budget; her $15 billion shortfall may only be $13 billion.)
“The problem on the expense side is growth. One example, as cited by Senator Carona, is the increase in schoolchildren. Texas grew at roughly 2 percent a year during the last decade. Using the same rate of growth, we will have added some added some 2,300,000 new Texans by 2013. That’s more people requiring state services like the DMV, etc. Cut state agencies by 7 percent, as the governor has done, and you’ve effectively cut by 14 percent because not only are you serving few people but you’re also not serving all the new people either. In other words, Texas is far from keeping up with its growth.”
‘Almost every state’ in trouble
Rest assured: the same type of debate is going on in state legislatures from sea to shining sea. Despite the back-and-forth over actual figures, the bottom line is summarized in a Jan. 16 editorial in The New York Times: “Almost every state is in deep fiscal trouble this year, but only a few others have admitted that cutting spending will not be enough.”
In a Dec. 7 opinion blog for Reuters, Felix Salmon addresses the possible backlash of creating a Chapter 8 for state bankruptcies, in direct opposition to Professor Skeel:
Skeel doesn’t mention the single biggest problem with this idea. If it were implemented, or if it even looked like it might get implemented, prices of municipal bonds would plunge, and most states would find it pretty much impossible to borrow money. As such, facing a massive and immediate liquidity crisis, they would be in more need of a federal bailout than before the bankruptcy legislation was seriously mooted.
The fact is that there’s only one reason to invent a Chapter 8 bankruptcy provision for states—and that’s to come up with an efficient and legal way to impose losses on bondholders and other creditors. (Chapter 9, which applies to cities and other municipal entities, doesn’t apply to states.) The creditors, fully aware of this, would immediately cease lending, certainly to the rockier states like California, Illinois, and New York. That’s not what we want. As a result, unless or until those states can bring their budgets into a primary surplus, introducing such a provision would certainly do more harm than good. And if those states can bring their budgets into a primary surplus, then we don’t need the bankruptcy provision, since they’ll be easily capable of rolling over their debts.
However, even Salmon concedes the Skeel’s idea does “make a certain brutal sense.”
Regardless of the merits of Chapters 7 and 13 for consumers, and Chapter 11 for business reorgs–and beyond what the average American thinks–Chapter 8 may well be one of those ideas whose time has come.
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