Loss of bankruptcy card would weaken cities’ hands

August 2, 2011

By Reynolds Holding
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Taking away the bankruptcy card would weaken the hand of U.S. cities and counties. In high-stakes negotiations with unions and bondholders, the threat to file for protection from creditors in federal court gives local officials leverage. But states are blocking that option, fearing it spooks credit markets. For teetering local governments, that leaves as alternatives costly defaults or even bailouts.

Tiny Central Falls, Rhode Island, on Monday became the latest city to declare bankruptcy. And bigger failures loom. Jefferson County, Alabama — home to Birmingham — wobbles under $3.14 billion of sewer debt. Only a last-minute offer by creditors last week defused what would have been the largest municipal filing in American history. Officials have until Thursday to accept the proposal.

Only 24 states authorize bankruptcy for a city or county, and several of those are moving to block it. In June, Pennsylvania barred its capital, Harrisburg, and certain other towns from going bust for at least a year. In May, Michigan trumped cities’ bankruptcy options with a state scheme. California is on the verge of passing a similar measure.

State fears are understandable. Strapped cities have undermined the municipal bond market, and a major bankruptcy could have a domino effect that would threaten borrowing statewide. Voters also find few things more repugnant than shirking financial obligations, studies show. Woe to the politician who blesses such behavior.

But legal barriers are already high for declaring municipal bankruptcy. Unlike private debtors, for example, cities must prove they can’t pay their debts when due. That hurdle squelched Bridgeport, Connecticut’s bankruptcy in 1991 and provoked three years of wrangling over Vallejo’s in California. Only about 625 municipal filings have occurred since 1937.

More importantly, without the bankruptcy hammer, public unions might feel emboldened to reject benefits cuts. Bond debt would be nearly impossible to restructure. Certain towns could continue paying some of their obligations, but heavily indebted cities might default completely, devastating credit markets.

By eliminating the bankruptcy option, states set themselves up for bailouts. State and local debt already surpasses $2.4 trillion. Pouring more money into failing municipalities can be costlier — and politically riskier — than allowing them to regroup in an orderly way under court supervision. But it shouldn’t come to that. As in Jefferson County, the mere threat of going belly-up can make compromise look like the winning bet.

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