Talk of bankruptcy and bailouts can be disorienting for bond investors. That’s why we think it’s important to clarify issues raised recently about having states struggling with high employee pension costs declare bankruptcy instead of being provided federal aid.
The COVID-19 pandemic has left states and local governments facing revenue shortfalls, and leaders will have to make some tough decisions. But in our view, whether states declare bankruptcy won’t be one of them. We believe that this option is off the table.
We believe there are several reasons for this, but here’s the most important one: bankruptcy is not available as US states are not subject to any section of the US bankruptcy code, and we believe changing that would require an act of Congress—and broad support from the states. (Puerto Rico is a commonwealth under the auspices of the Natural Resources Committee in Congress and is subject to different rules).
Neither seems likely to happen, in our view. In our opinion, the overwhelming majority of states are in a strong financial position. What’s more, any entity declaring bankruptcy is typically required to fail a solvency test. We doubt the states would, since they have the power to tax to increase revenues.
We also think a change in the bankruptcy law would drive up borrowing costs for all states and create near- and long-term budget pressure. We would expect that to potentially impact both higher-grade borrowers and states that may be more stressed.
Bankruptcy: No Silver Bullet
Long-term pension obligations are also part of this discussion, and we doubt bankruptcy would help states meet them. We can’t think of any recent “bankruptcy solutions” that meaningfully reduced pension obligations. For example the Detroit bankruptcy included only very modest pension modifications and cases out of California a decade ago left pensions untouched.
Over the long-term, states and local governments have managed many storms and we think this crisis is no different. While the path forward may be rocky, we believe recent measures, including the Coronavirus, Aid, Relief, and Economic Security Act (CARES Act) and the Federal Reserve’s $500 billion Municipal Liquidity Program offer flexibility to states and local governments. And if the pandemic-induced shutdown persists, we believe there may be more federal aid to come.
We think it is also important to remember that 49 of the 50 states are constitutionally required to balance their budgets. In the aftermath of the Global Financial Crisis in 2009 and 2010, state governments largely embraced fiscal austerity and relied on new revenues, including increased federal support, to weather the storm. California, which experienced significant budgetary imbalances, voted to increase its personal income tax rate to the highest in the nation to shore up revenues. As the current crisis evolves, similar measures are likely this time around.