John Mauldin: Don’t Be So Sure That States Can’t Go Bankrupt

BY JOHN MAULDIN

Our judicial system has a time-tested option for those who can’t pay their debts: bankruptcy. Individuals and businesses use it all the time.

The debtor submits itself to a court, which tries to reach the fairest possible settlement with creditors. It’s messy, but it usually works for the best.

Federal bankruptcy code permits cities, school districts, and other local governments to file bankruptcy.

Some have done so, and I expect many others will in the coming years. Cities like Detroit and others in California have used bankruptcy to renegotiate their pension plans and other debts.

States are a different matter.

Current law doesn’t let states go bankrupt… yet

If the law should change and a state actually tried to file for bankruptcy, creditors would immediately file constitutional objections under the contracts clause and the 10th Amendment.

Some legal scholars think those barriers can be overcome. The argument would go to the Supreme Court and probably take years to be resolved.

Passing such a controversial law for Congress could be quite difficult. There are good reasons to prevent state bankruptcies. The fact that they aren’t eligible for bankruptcy allows states to borrow money at lower interest rates.

Lenders assume states will always figure out some way to repay their debts. But will they?

Arkansas: a precedent for state default

In 1933, debt-plagued Arkansas unilaterally restructured and extended maturities on a series of highway and other bonds. Nowadays, we call that a default.

Bondholders sued, of course. The next year the state and its creditors reached a compromise refunding. Creditors exchanged their old bonds for new ones funded by a 6.5 cent per gallon gasoline tax.

In today’s dollars that would be about $1.16 per gallon, so this was a hefty tax on Arkansas drivers. I’m sure they complained. That deal fell apart, and after more twists and turns, the federal Reconstruction Finance Corporation (predecessor to the FDIC) bought the new bonds.

Back to the present

An April 2016 Moody's report sees almost zero chance that the federal government will bail out an indebted state government. I agree; the other state delegations in Congress would quash any such idea. You can debate whether the Arkansas episode was a “bailout” or just a refinancing, but it is one of the few precedents we have for a state default.

That leaves us in a very murky situation with regard to state and local pensions. We know many will have a hard time meeting their obligations.

Those at the state level can’t go bankrupt, nor can they expect federal help. Something will have to give in those states. Whatever the outcome is, it won’t be pretty.

And not every government below the state level can declare bankruptcy to discharge its pension obligations. Illinois and other states, including my own state of Texas, have passed laws that require cities to honor their commitments. They can change pension agreements going forward, but they are legally required to honor past agreements.

The states that are most likely to fail

This leaves an important question: which states and local governments will hit the wall first? Finding the answer is not as easy as you might think.

Evaluating a pension plan's future prospects requires all kinds of long-term assumptions: life expectancies, healthcare costs, interest rates, stock market returns, tax rates, and more. Tweak any of those numbers just a little bit now, and the difference over 30–50 years or more can be dramatic.

Near-term prospects are hard to judge for a different reason. States and localities all operate under different state constitutions, contract laws, labor laws, and other constraints. Two states might look the same, financially speaking, but have far different pension-system prospects for legal reasons.

Illinois, for instance, is in a jam because its state constitution doesn't permit it to reduce pension payments. Other states have more flexibility. States also give their pension managers different degrees of authority and liability. It’s a mess.

What states are most likely to raise taxes and/or cut government services?

I found one analysis that helps pinpoint the top risks. It considers not just pension shortfalls but other financial obligations as well. The Governing Institute (a group for state and local leaders) reviewed three separate studies from J.P. Morgan, PricewaterhouseCoopers, and the Mercatus Center of George Mason University.

JPM and PWC both point to the same four states: Connecticut, Illinois, Kentucky, and New Jersey. The Mercatus Center concurred on those four and added Massachusetts.

Make sure you’re not living in the next Detroit

This doesn’t mean everyone else is safe. You might live in a very sick city in an otherwise healthy state. You could also be in a sick city that is in a sick state, giving you double trouble if you own property there.

Oddly, you may be at risk if you stay, while your city and state are at risk if you leave. Property tax revenue depends on property values, and property values fall if too many people want to sell. If governments raise tax rates to compensate, then even more people will leave.

At some point, a death spiral sets in. Detroit went through this and is only now beginning to recover. People left the City of Detroit and moved to the suburbs. I think we’ll see many more Detroits. Make sure you don’t live in one.

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