The metastasizing state-bankruptcy meme

By Felix Salmon
January 21, 2011

Talk of introducing legislation allowing states to declare bankruptcy began in earnest in November. A speech by Newt Gingrich was followed up by a big Weekly Standard piece on the subject by David Skeel, and soon the meme filtered into the blogosphere. Unlike most political chatter, this kind of talk isn’t cheap at all: it’s very expensive. As the subject has refused to go away—which means, as House Republicans have continued to work on drafting some kind of bill—the municipal debt market has plunged.

Now, with a massive front-page story in the NYT, the stakes have got even higher. Mary Williams Walsh is well aware of what she’s doing: she talks explicitly about “the fear of destabilizing the municipal bond market with the words ‘state bankruptcy’”; while at the same time splashing those very words across the most influential public real estate in the world. She frets that the mere introduction of a state bankruptcy bill could lead to some kind of market penalty, even if it never passed—but the fact is that her own article, in and of itself, is almost certain to drive up borrowing costs and uncertainty.

Walsh’s piece comes on the heels of an important report from the Center on Budget and Policy Priorities, which makes a compelling case that state bankruptcy is neither necessary nor desirable:

It would be unwise to encourage states to abrogate their responsibilities by enacting a bankruptcy statute. States have adequate tools and means to meet their obligations. The potential for bankruptcy would just increase the political difficulty of using these other tools to balance their budgets, delaying the enactment of appropriate solutions. In addition, it could push up the cost of borrowing for all states, undermining efforts to invest in infrastructure.

But the message isn’t sinking in. James Pethokoukis is a reliable guide to what the GOP is thinking:

The NYT article raises the specter that states would be shut out of credit markets if allowed to declare bankruptcy, or if one should actually take that step if federal law is changed. That seems unlikely, although some may have to pay higher interest rates. Municipalities and even countries repudiate debt and yet continue to borrow. And even investor apprehension would be balanced by states getting their finances in order, which should appeal to potential lenders.

This is completely bonkers. If states are allowed to file for bankruptcy, then Illinois, for one, would be shut out of credit markets. And if Illinois or any other state were to actually go ahead and file, then many other states, including New York, would be shut out of credit markets. That’s not “unlikely,” it’s certain.

As for Jim’s idea that “municipalities and even countries repudiate debt and yet continue to borrow,” he’s just plain wrong about that. A country which repudiates debt has no access to private credit markets: the only borrowing ever available to such a state is from official-sector institutions. I defy Jim to name a single municipality or country which has repudiated its debt and yet continued to borrow money in the private markets.

That said, it’s pretty unthinkable, even if a state were to declare bankruptcy, that it would go so far as to repudiate its debts. Indeed, bankruptcy is a formal recognition that a borrower is sinking under the weight of far too many legitimate debts; it seeks to restructure some of those debts to make them manageable, rather than repudiating them outright.

On the other hand, Jim’s utterly wrong that somehow bankruptcy is costless to the states, and that the downside of forcing a haircut on lenders would be fully counteracted by the upside of putting the states on a solid fiscal footing. Lenders really don’t much care about fiscal sustainability: all they care about is that they get their money back, as contracted, in full and on time.

It’s worth remembering here that most municipal bondholders are individuals, rather than sophisticated institutional investors. If your aunt Sally put her savings into state bonds, she is not going to be happy if she can’t get her money back, and she is certainly not going to be mollified by talk of lower deficits in future. The deficits are what allowed her to buy the bonds in the first place; she doesn’t particularly want them to go away. But there’s no way she’ll stand for a haircut. And, of course, she votes.

The fact is that states are not going to declare bankruptcy, and they’re not even going to be allowed to declare bankruptcy. So the worst thing that can happen, for the municipal bond market, is that people continue to talk about municipal bankruptcy for the next couple of years. Let’s take the option off the table, once and for all, rather than taking it seriously and thereby only making it harder for states to borrow the money they need.

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Comments
18 comments so far

Of course all this loose talk isn’t about repudiating debt, but breaking contracts with unions. And of course Newt Gingrich being Newt Gingrich, will take a legitimate policy goal (reducing states pension obligations-I don’t agree that we should do it maybe, but I at least recognize that reasonable minds will disagree) and try to accomplish it in the most irresponsible and explosive way possible. It’s comical because now he’ll get Wall Street and public sector unions on the same side of a political fight.

But this gets talked about seriously because you have a significant faction of elite opinion in this country that thinks that what’s holding us back is the New Deal. Whatevs.

Posted by mushr00m | Report as abusive

It is pretty clear that this is about the desire never to have to raise taxes to cover spending and to be able to break public unions. Also, since munis are typically tax exempt and carry lower interest rates, they are typically not held by financial institutions except in mututal funds they run and therefore they don’t really care if they lose value.

On these three topics:

Taxes: The GOP mantra has been that taxes should never be raised. Unfortunately, both Democratic and Republican states and municipalities have been spending like drunken sailors over the past couple of decades and have pushed promises into the future to allow that spending. Those promises are beginning to come home to roost. Some of the promises are required under state law to be met, such as pensions. They have the option of doing law and constitutional changes internally at the state. The individual states should be addressing this issue internally instead of making it a national bankruptcy bill.

On the union issue: I think many of the public unions are taking the UAW head in sand approach to addressing the viability of public spending. They are in danger of ending up in the same position as the UAW over the last couple of years. However, once again, that is a state-by-state issue. It is time for the politicans and union leaders to become adults.

On who holds munis: The banks don’t really care much about this issue since they don’t hold them. As a result, they are probably not lobbying hard either way. They care much more about changing states property laws to make it easier to do foreclosures with their securitzation mess. As a result, the typical retired muni investor would take this GOP philosophical hobby horse on the chin and nobody but those investors will give a damn as long as the political philosophical points are made.

We have moved into an “Alice in Wonderland” environment where the real world need not intrude on politicial philosophies.

Posted by ErnieD | Report as abusive

Is there a play here to take advantage of a fear induced drop in the value of municipal bonds. Could Goldman make enough money doing this to justify their interest ? How would you go about shorting municipal bonds ?

This whole campaign makes me want to buy muni’s because this disinformation campaign will make them under-priced

Posted by msobel | Report as abusive

Or the Federal government could press a button like they did with GM and Chrysler.

Felix, when will you admit that a lot of this misinformation can be laid at the feet of the Peter Peterson Foundation?

Posted by petertemplar | Report as abusive

Felix, you make a number of very definite statements there without any attempt to back them up (in your defense, that’s what others are doing, too). You’re not being very convincing, either. I think the best we can say is that no one is quite sure what will happen, and it’s probably good that this conversation is occuring, even if there is an immediate cost.

I seem to remember not too long ago that GM insisted that it could not declare bankruptcy, as it was a self-fulfilling prophecy and no one would buy a car from a bankrupt auto company. And besides, even if it did survive, credit would become prohibitively expensive. Yet it managed to get done, with some important Federal intervention.

Now, I understand that GM is not Illinois, but can we not conceive of one or more scenarios that would enable a state to restructure debts and perhaps mend their fiscal ways? I think we probably can.

Posted by Curmudgeon | Report as abusive

“Lenders really don’t much care about fiscal sustainability: all they care about is that they get their money back, as contracted, in full and on time.”

Pure gold Felix… poetry.

Now explain to this investor how California is going to do that.

Their top income tax rate is 10%
They charge state and local sales taxes of up to 10%
They charge the highest gas tax in the nation almost 50 cents a gallon.

These taxes do not bring in nearly enough rev to cover the cost of the goverment they have created.

I know you hate making any comment that could remotely be construed as investment advice but broadly do you think the current ytm of roughly 4.5% on a 10 year California State GO bond adaquatly compensates an investor for both interest rate risk and credit risk?

At current yields I think you’re better off looking at the weak Euro-states than Cali.

Posted by y2kurtus | Report as abusive

Ah, Newt:

1. “The Tenth Amendment doesn’t say send power from Washington to Austin. The Tenth Amendment says ‘The States and the people thereof’ and so the trick is to get the power through Austin back home.”

From http://www.uscourts.gov/FederalCourts/Ba nkruptcy/BankruptcyBasics/Chapter9.aspx

“The first municipal bankruptcy legislation was enacted in 1934 during the Great Depression … Although Congress took care to draft the legislation so as not to interfere with the sovereign powers of the states guaranteed by the Tenth Amendment to the Constitution, the Supreme Court held the 1934 Act unconstitutional as an improper interference with the sovereignty of the states.”

2. “States like California and New York and Illinois that think they’re going to come to Washington for money can be told, you know, you need to sit down with all your government employee unions and look at their health plans and their pension plans and frankly if they don’t want to change, our recommendation is you go into bankruptcy court and let the bankruptcy judge change it, and I would make the federal bankruptcy law prohibit tax increases as part of the solution, so no bankruptcy judge could impose a tax increase on the people of the states.”

Ah … a two tier system:

1) Bankruptcy judges making decisions on behalf of states such as “California and New York and Illinois.” Gee, whom do they usually vote for?

2) For Texas, state sovereignty, even though Texas is “$27 billion short of what we need to write a budget that funds what the state is doing now.” http://www.cppp.org/research.php?aid=102 8

Fair and balanced.

Posted by Hinchman | Report as abusive

The ability of States to actually repudiate their bond obligations is almost impossible. GELPCKE V. CITY OF DUBUQUE sums up the Supreme Courts position on the topic:

“The sound and true rule is that if the contract, when made, was valid by the laws of the state as then expounded by all departments of the government, and administered in its courts of justice, its validity and obligation cannot be impaired by any subsequent action of legislation, or decision of its courts altering the construction of the law.. We shall never immolate truth, justice, and the law because a state tribunal has erected the altar and decreed the sacrifice.”

Posted by sless | Report as abusive

Gee, state governments might be unable to borrow money from the private sector. Tch, Tch, how terrible. Granny can’t cash in her bonds. Nor bankers here and abroad. That is, indeed, bad for state governments and those who lend to them. And those who depend on them. In other words, it is bad for those who deserve to suffer.

Posted by wootendw | Report as abusive

Isn’t there a more cynical explanation for this legislation?

It is highly likely that there are any number of hedge funds and possibly investment banks who believe that the next “big short” is in munis. One of the few ways to short munis is to buy credit default swaps on the big, heavily traded issuers, which tend to be the large states, most of which are facing fiscal troubles. And these are no longer just the ususal suspects of Ca, Il and NJ. You can now add Az, Fl, Mi, NY, Pa and Tx just for starters.

So what better way to send the value of those CDS’s through the roof than to abolish the prohibition on state bankruptcies. If you could follow the money from those who stand to benefit from this trade to members of Congress behind this legislation, you might just find another example of the wicked folly of the Citizens United decision.

Posted by mgjovik | Report as abusive

Businesses go bankrupt when they no longer have the money to make the payments on their debts. Political entities go bankrupt when they no longer have the public will to make the payments on their debts.

The problems in MA are likely pretty typical. Formal debt around $80B, with a public pension that is underfunded by $20B. Seems pretty manageable for a state with a $400B GDP, no?

It isn’t that easy, though. First, the state revenues are only $30B, so the debt is more than 3x the annual money available to pay it. Second, the $20B pension shortfall assumes an 8.25% annual return on the $50B pension fund. Anybody seriously think they can achieve that target?!? (Nor can this be “inflated away”, since pensions are tied to wages and partially indexed to inflation.) Their actual pension obligation could run to the hundreds of billions when all is said and done.

This isn’t “breaking contracts with unions”, however. The pension system may have been originally negotiated with unions, but it is an obligation to the INDIVIDUAL. Teachers hired in the last fifteen years pay 11% of their salary into the pension fund, in theory enough to pay for their full pension (albeit with optimistic return assumptions). After decades of collecting their contributions (and using them to pay benefits to retirees) you’re going to turn around and tell them their pension is worthless?!? Bernie Madoff went to jail for precisely that fraud.

I was at one point a teacher in Massachusetts, forced to contribute to the retirement system. Under state law this is NOT optional (I asked when I was hired), likely because it exempts the state from paying into Social Security. When I left the public schools after a decade, I withdrew my contributions from the system (along with 2% annual interest that they so graciously were willing to pay me for the use of my money), which is a big part of why I’m financially sound today.

But my ex-colleagues are still contributing their 11%, still hoping that they will receive SOMETHING when they retire. They won’t get Social Security, even if they’ve paid their 40 quarters (state law prohibits that). They won’t get anything like their full pensions if the state is allowed to declare bankruptcy. I sure hope they have something else to live on!

The pension system is evil in so many ways, but if states are allowed to steal pension funds and then declare bankruptcy, it becomes a pure fraud, perpetrated by the taxpayers against the public school teachers and employees.

Posted by TFF | Report as abusive

Fear not TFF teacher’s wont be getting the shaft as a result of state bancrupcy.

In 5 years time this problem will be mostly behind us and the public retirement ages will be pegged at the same age as Social Security using exactly the same discounting forumla for early retirement. You want to retire at 62 you get 66% of your full penison.

The problem now is that some municipalities truely do have old General Motors style pensions retire with FULL INCOMRE REPLACEMENT at 60. That is a staggeringly expensive benifit considering the life expentancy of a 60 year old is something like 26 years. (And probably a bit higher if you consider that the 60 year olds in question are well educated citizens with good health care!)

Posted by y2kurtus | Report as abusive

y2kurtus, that is EXACTLY what I mean. Taxpayers love to make promises when it saves them money (or pushes the bill down the road). When it actually comes time to PAY that bill, they suddenly get cold feet and look for ways to renege.

A MA teacher born in 1971, hired in 1996 at the age of 25, contributes 11% of their salary annually to the pension fund. In return they can retire at the age of 60 (after 35 years of service) to an 80% pension. If you assume an 8% annual return, the employee contributions fund roughly 80% of the value of their pension. The state obligation is minimal.

Your “solution” slashes the value of that pension (which they paid for 80% out of their own pocket) by a third. The state promised to fund 20% of the pension. Instead, they’ll contribute NOTHING — instead confiscating a portion of the employee contributions to pay off past debts.

Sounds like “getting the shaft” to me… Especially since you don’t offer them any positive alternative. They can quit their job (in which case they get back just 2% annual interest on their contributions, leaving the remainder in the fund) or they can accept that they’ll get back less than they put in.

Any HONEST pension reform would take one of two alternative paths:
(1) It would wholly honor existing obligations and terms, applying only to new hires.

-or-

(2) It would offer current employees the right to withdraw their pension contributions from the system along with the 8% rate of return implied by the pension assumptions.

The former could easily cost MA alone hundreds of billions, especially if future investment returns fail to keep up with the 8.25% target rate.

The latter would result in roughly a $20B obligation (if everybody were to cash out of the system) but would protect the state from additional losses down the road.

Hopefully the MA Supreme Court will strike down any attempts to otherwise renege on the implied debts.

Posted by TFF | Report as abusive

TFF, I’ll agree with you that pension accounting is dishonest on it’s face.

In the private sector where accounting rules and funding requirments are actually tougher, nearly all companies have converted to defined contribution rather than defined benifit plans. The risks of underperforming investments has been entirely shifted to workers.

In the U.S. the law requires payment in full of the benifits that have been acrued by workers. The problem with pension math is that the teacher you used in your example has not actually invested all that much… in the ballpark of 60k assuming 4000 annually. Even if you add the compunding at 8% (a fantastic return over the last 15 years) that only gets you to 100k.

Now 100k is a lot of money… for a 40 year old to have saved up for retirement… but it’s still not anywhere what the pension will be worth.

If you are willing to assume that the average teacher retires today at 60years old with a final salary of $60,000 what will it cost to replace 80% of that income?

Well to buy an immediate annuity paying $4000/month costs $692,401 according to http://www.immediateannuities.com

So there’s the problem… the teacher you used in the example has worked 42% of there carreer and has amassed about about 1/7th of what they need to retire.

I’ll also point out that the pension scheme you noted in Mass is actually pretty reasonable compared with many. Many allow 100% income replacement rather than 80%. Many allow for inflation ajustment… that one imminently fair and seemingly small change increases the cost of a pension by nearly 1/3rd.

Posted by y2kurtus | Report as abusive

y2kurtus, I recently ran the numbers. If you assume:
(1) An 11% contribution rate by the teacher. (Fact.)
(2) A pattern of salary escalation over the first 10 years, followed by flat earnings for the rest of the career. (Varies, but roughly accurate.)
(3) Annual town or state contributions of 3%.
(4) Real investment returns of 5% annually.

Then the pension is wholly paid for. A teacher might start at $40k and work up to $60k, contributing an average of $8k per year over the first fifteen years (double what you describe). Moreover, at a 5% real rate of return the money doubles every 14.5 years, so those initial contributions compound substantially before retirement. Finally, your annuity payout assumes industry standards that are based on a *3%* rate of return. If you assume an 8% rate of return on the payout, you get a much higher income stream.

As always, the devil is in the details. In this case, the key detail is the assumed rate of return. Massachusetts assumes investment returns of 8.25% on their portfolio. If they can achieve that, they’ll be fine. But I fear that is a political fiction in this investment environment.

Posted by TFF | Report as abusive

Don’t know how I got $8k annual contributions. Shouldn’t post before coffee…

A quick-and-dirty analysis:
35 years of 11% contributions based on $60k/yr salary, compounded at a 5% real return, comes to:
=FV(0.05/12,35*12,5000*0.11) = $625k

25 years of 80% payout, compounded at a 8% nominal return, requires funding of: =PV(0.08/12,20*12,4000) = $518k.

The major errors in the above:
(1) Teaching salaries escalate rapidly over the first ten years of employment (typically adding $20k between the bottom and top of the scale), so those valuable EARLY years contribute less to the pension fund.

(2) A portion of the pension is indexed for inflation, significantly increasing the cost.

Still, both of those simplifying assumptions pale in significance next to the assumed 8% annual returns, 5% real returns (calculating real return as nominal return less wage escalation). If you knock the assumed real return down to 3% (partly to take salary escalation into account) then the employee contributions fund only 80% of the pension.

Still cheaper for the schools than paying Social Security would be. As long as the school/state contribution to the pension is less than 6.2% annually (36% of the value of the pension), it saves the taxpayers money. This is why they prefer “pension reform” to abandoning the pension system entirely.

The pension system works out quite nicely for a teacher who starts in their mid 20s and never does anything else. It is a good deal for the taxpayers, who don’t have to contribute to Social Security. It is a very bad deal for anybody who teaches for a decade and then leaves (contributions are returned, NOT investment growth) or for anybody who spends a decade in private industry (contributing to Social Security) before entering teaching.

The ultimate effect of this is to suppress career mobility in teaching. The longer you’ve taught, the greater the cost to leave (even if your heart is no longer in it). Nor is it a recommended “second career” for anybody coming from business, since they are still required to contribute the same 11% to the system but at sharply less favorable terms. (Among other things, their paid-for Social Security benefits will get “clawed back”.)

It continues to puzzle me how people can complain about public school teachers and teaching, yet work SO hard to make the job unattractive to people with professional qualifications and experience.

Posted by TFF | Report as abusive

It appears that Newt likes to break some contracts.

Posted by NewExaminer | Report as abusive

1-What about future medical costs/coverage?
2-It seems politicians aren’t to be trusted with taxpayers money. To make a deal assuming 8% annual returns is fantasy. Just a way for politicians to buy votes. Bills are coming due, as they always do. Nothing
against teachers, we need more police, get rid of redundant administrative state beaurocratic positions once and for all.

Posted by dgknj | Report as abusive
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