Time To Plan For State Bankruptcies

The City Council in San Bernardino, Calif., voted last night to take that city into bankruptcy proceedings, becoming the latest – but surely not the last – government body to use the law to get back on its feet.

San Bernardino, which has a $45 million budget gap and is struggling to pay city workers, joins two other California cities, Mammoth Lakes and Stockton, that are currently in bankruptcy court. They have plenty of company; last year, individuals filed 1.35 million personal bankruptcies.

Stockton, with around 300,000 residents, is the largest U.S. city, by population, to file for bankruptcy; San Bernardino has around 200,000 citizens, while Mammoth Lakes is much smaller. Stockton’s filing also reported the biggest debt load on record for a U.S. city entering bankruptcy, a distinction that previously belonged to Vallejo, Calif. When it filed in 2008, Vallejo owed its creditors $50 million. Stockton is $700 million in the hole.

Still, that is small change compared to the largest municipal bankruptcy so far, which involved a county – Alabama’s Jefferson County – rather than a city, and which included $4.23 billion in debts.

Stockton’s creditors include retirees, city workers and bondholders. In a particularly controversial move, as part of its bankruptcy plan, Stockton wants to eliminate city-funded medical benefits for retirees next July.

Although Stockton’s is the biggest city bankruptcy so far, it is not unique. Since 1937, when Congress changed the bankruptcy code to allow municipalities to file, 640 government entities have done so. Stockton is the seventh to seek protection so far this year.

The reasons for Stockton’s filing are nearly as familiar to those outside the city as they are to its residents. The city banked heavily on the real estate boom. Counting on more prosperity than it actually had reason to expect, it offered overly generous benefits to public workers and embarked on a number of expensive civic projects. Now the city has a budget deficit of $26 million and, according to the California Public Employees’ Retirement System, a pension plan with an unfunded gap of $147 million.

Even before San Bernardino and Mammoth Lakes sought bankruptcy protection, the Stockton filing had many wondering if this is the beginning of a wave of similar municipal bankruptcies. I expect that it is. As I have written before, for many years now municipalities have made promises they can’t keep, primarily to public employees. Instead of offering competitive salaries to attract high-quality workers, municipalities pushed costs into the future by offering attractive pension and retiree health coverage packages. But they have not actually set aside the money to fulfill those promises. Many municipalities will eventually have to come to terms with the fact that they cannot meet all of their commitments. Bankruptcy will offer them an organized, though likely still painful, way of deciding which promises to honor.

What concerns me even more than a potential rise in municipal bankruptcies, however, is another possibility that many still consider unthinkable: a state default. The reason this is so worrisome is precisely the fact that no one has yet been willing to think about it. There are no legal means in place to allow a state to go through bankruptcy.

Several states have the same underlying problem as struggling municipalities do – an excess of promises they can’t afford to keep – and many of them have likewise chosen to postpone dealing with the problem. Earlier this year, I wrote about New York’s particularly delusional practice of allowing public employers to make their required payments to the state pension system by borrowing from the system itself.

Not all states are in dire financial condition, of course. Since Standard & Poor’s downgrade of the U.S. government’s credit rating, the agency now rates 13 states higher than the federal government. However, California, the lowest-rated state, has a rating of A-, putting it between an A, defined as “strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances,” and a BBB, defined as “adequate capacity to meet financial commitments, but more subject to adverse economic conditions.” The next-worst-rated state is Illinois, at A+. Both states have had recurrent problems paying their bills on time. I would not want to be a long-term bond investor, or a public employee counting on post-retirement benefits, in either one.

Ultimately, there is not too much difference between the 1.35 million individuals who filed for bankruptcy last year, the 13 municipalities that did the same, and the states that might need to do so in the future. In each case, financial problems stem from over-commitment and chronic budget imbalances. The approximately one in four Americans who have more credit card debt than emergency savings could likely find a lot to talk about with their local and state treasurers. But while we know what to do when an individual or a municipality is unable to pay its debts, if and when a state must default, we will be in uncharted territory.

As municipal bankruptcies become bigger and more common, it’s time to start thinking about the once-unthinkable. A state bankruptcy would not be easy for bondholders or residents. But it would be far better than a state default with no bankruptcy procedures available. A forward-looking Congress ought to get busy thinking about the unthinkable and consequently updating the bankruptcy law so it will be available if – or, more likely, when – one or more states need to invoke it.

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