First GM, now states? Pros and cons of bankruptcy

Big companies like 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 policymakers 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 was already 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 payments 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," says 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, notes Dean Maki, chief U.S. economist at Barclays Capital. With states, the danger is greater.

"There's only 50 of them, so if you allow one to file, people will say, 'Why does that state get to escape their debt and not others?'" Maki says. "Are you encouraging poor behavior?"

Bankruptcy talk may already be taking a toll on public finances. Matt Fabian of Municipal Market Advisors says 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, says 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.

"There's increasing recognition that something has to give," says Robert Ward, head of government finance research at the institute. "Are state taxes going to go up dramatically? Not in most places. Are services going to be slashed? Not in most. There are really only a few escape valves."

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," says 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 says. House Judiciary Committee Chair Lamar Smith, R-Texas, says 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 have 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. Bankruptcy opponents note that pension gaps always shrink as the economy improves and assumptions get brighter — though a strong economy would not entirely close the gap.

"Overall, pensions are not a significant reason for state financial problems," says Charles Loveless of the American Federation of State, County and Municipal Employees, who argues that states don't need a bankruptcy option.

Any legislation would face high hurdles. It's not clear the Constitution even allows a federal court to reorder a state's finances. Forcing investors to accept less money than a state promised when it sold bonds would be like forcing them to accept less money from bonds sold by Mexico.

House Majority Leader Eric Cantor, R-Va., contends that states don't need bankruptcy because they have other ways to handle ballooning debts, including spending cuts, tax hikes and negotiations with unions.

He might have mentioned another: default. States can simply stop paying what they owe, though they most certainly would face higher interest rates the next time they sold bonds, assuming they'd be able to sell any. The fallout is difficult to judge because so few states have defaulted. The last time was when Arkansas stopped paying its creditors during the Great Depression. Only 54 of 60,000 municipal bonds that Moody's Investors Service rated from 1970 through 2009 have not been paid off on time.

The lack of defaults explains why U.S. governments of all sizes have managed to pay relatively low interest rates on their bonds, though rates have begun rising. Illinois bonds maturing in 2028 yield 6.1 percent. That's up from 5 percent in early November.

State bankruptcy is orderly and allows a final resolution of claims so states can borrow again. But it's easy to exaggerate the benefits and understate the costs.

James Spiotto, an attorney with Chapman and Cutler LLP in Chicago, says states would have to cede some control to the courts. Federal judges would determine economic priorities for millions of residents. And Lawrence Larose of Winston & Strawn, who represents owners of bonds sold by bankrupt Vallejo, Calif., notes that the payoff is uncertain.

Scrambling to pay its bills, with most revenue going to pay city workers, Vallejo felt it had no choice but to enter bankruptcy court. That was 2 1/2 years ago. The city has won some concessions from unions but is still fighting in court over what it can and can't legitimately cut.

"It's a very blunt scalpel," Larose says of bankruptcy. "It won't be a quick fix in any case."


Wagner reported from Washington. Associated Press Writers Alan Fram and Christopher S. Rugaber in Washington contributed to this report.