Should States Be Allowed to Go Bankrupt?

Freedom Homes, Government Bailout Money
Creative Commons License photo credit: Alex E. Proimos

Veronique de Rugy, of Mercatus, has an article in Reason magazine dismissing the idea that states should be allowed to go bankrupt.  She states:

Bankruptcy may sound like a silver bullet that could solve budget woes, dismantle cronyism, fix pensions, and forestall a federal bailout. But it contains plenty of potentially counterproductive consequences. Restoring the states’ fiscal health requires fundamental changes to the way they do business. Until that happens, their balance sheets will be bleeding red ink, whether they are officially bankrupt or not.

More specifically, her concern is:

In many states, bankruptcy will be an option only if powerful unions and other entrenched interest groups see it as a way to force budget problems onto the state’s bondholders rather than public employees.

The problem I have with her argument is that bondholders would not let them get away with leaving them holding the bag.  Even without new issues of bonds, states are always in a state of roll-overs–issuing new bonds to pay off the old ones.  Any hint of default would send the price of issuing new bonds into the stratosphere.  This would then have an immediate impact on the budget either because the state would have to fund the roll-over out of tax revenue (pay-off the bond) or pay higher interest payments on the new bonds.

As such, bondholders do have an immediate way to punish a state that looks to default on their bonds.  The negative budget impact would likely result in tax increases since nearly every state has a balanced budget requirement.  That, in turn, may stoke voter backlash.  The bondholders can wait until maturity to be made whole . . . politicians don’t have that luxury.

I still can’t help but think that having the bankruptcy law on the table would change incentives in a positive direction by shaking bondholders out of their lethargy.  I agree that it isn’t a silver bullet that will work in all states, but bankruptcy may help save a few of those on the margin.  Those states that may fulfill Veronique’s prophecy may already be too far along to save anyway.

Moody’s Penalizes States with Unfunded Pension Liabilities

Here is a news items that you can file under: “what the heck took them so long?”  According to the New York Times, Moody’s finally recognizes that unfunded pension liabilities are a threat to the financial well-being of states:

Moody’s Investors Service has begun to recalculate the states’ debt burdens in a way that includes unfunded pensions, something states and others have ardently resisted until now.

States do not now show their pension obligations — funded or not — on their audited financial statements. The board that issues accounting rules does not require them to. And while it has been working on possible changes to the pension accounting rules, investors have grown increasingly nervous about municipal bonds.

Moody’s new approach may now turn the tide in favor of more disclosure. The ratings agency said that in the future, it will add states’ unfunded pension obligations together with the value of their bonds, and consider the totals when rating their credit. The new approach will be more comparable to how the agency rates corporate debt and sovereign debt. Moody’s did not indicate whether states’ credit ratings may rise or fall.

However, while this change is an important step forward, Moody’s does not go far enough as the pension burden is significantly higher than official estimates as I’ve pointed out in other blog such as “Public Pensions-A Case Study in Wealth Alchemy,” “When Will Pension Systems Go Broke,” and “Explaining How Pension Assumptions are Bogus.” The NYT article goes on:

In making the change, Moody’s sidestepped a bitter, continuing debate about whether states and cities were accurately measuring their total pension obligations in the first place. In adding together the value of the states’ bonds and their unfunded pensions, Moody’s is using the pension values reported by the states. The shortfalls reported by the states greatly understate the scale of the problem, according to a number of independent researchers.

“Analysts and investors have to work with the information we have and draw their own conclusions about what the information shows,” Mr. Kurtter said.

In a report that is being made available to clients on Thursday, Moody’s acknowledges the controversy, pointing out that governments and corporations use very different methods to measure their total pension obligations. The government method allows public pension funds to credit themselves for the investment income, and the contributions, that they expect to receive in the future. It has come under intense criticism since 2008 because the expected investment returns have not materialized. Some states have not made the required contributions either.

Moody’s noted in its report that it was going to keep using the states’ own numbers, but said that if they were calculated differently, it “would likely lead to higher underfunded liabilities than are currently disclosed.”

So, they’re only partially lifting their heads out of the sand.  See chart below from the NYT on how the debt burden picture changes for select states.

New York Times New Moodys Debt Rankings