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Illinois Is Hopelessly Screwed: Is Bankruptcy the Answer?

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by Mark Glennon, Wirepoints:

Could a formal bankruptcy proceeding for the State of Illinois be the answer to it’s fiscal crisis? If you think that’s out of the question, as many do, you’re wrong. On the contrary, though Congress isn’t working on it now, the option is quite viable, though subject to obstacles and open issues. The question is certain to gain growing national attention as a number of states sink further into insolvency, so it’s time to get up to speed. I have yet to see a single Illinois politician or reporter raise the question, but plenty of others outside the state are talking about it for Illinois. More on that later.

 

This article summarizes the basic issues.

First, why? Why would Illinois or any other state consider bankruptcy? Just as for insolvent corporations and municipalities that reorganize, a successful state bankruptcy would provide a fresh start by putting a state on a sustainable path that frees up funding for needed services — funding that’s getting crowded out by legacy debts. It would do that in three primary ways:

  • Debt that cannot be repaid gets cancelled. In the case of governments, that includes unfunded pension liabilities insofar as there’s no realistic hope of paying them. For Illinois, that means part of its $130 billion pension debt could be erased notwithstanding the state constitutional pension protection clause. Unsecured bonds and other debts could also be cut. Illinois will never have a truly balanced budget or be restored to competitiveness unless those cuts are made, as we’ve written so often before.**
  • Unfavorable contracts and leases can be cancelled in bankruptcy, which include employment contracts and collective bargaining agreements.
  • Bankruptcy provides an orderly, rational process to sort out who gets what. Without it, a free-for-all eventually sets in for any entity that can’t meet its obligations. Creditors start suing and racing to courts to get the first judgement liens. Bankruptcy halts that tsunami of litigation and foreclosures.

There are constitutional objections to expanding bankruptcy to states. Bankruptcy for governments is a matter of Federal legislation — Chapter 9 the United States Bankruptcy Code. Today, it covers only cities, towns and other municipalities, but not states.

Expert legal opinions differ on whether Chapter 9 could simply be expanded by Congress to states, but my sense is that the weight of opinion is that Congress could, and eventually will, do so.

Congress unquestionably has the power to make bankruptcy laws — it’s expressly granted in the Constitution. Further, its power to apply bankruptcy to municipalities was upheld by courts over seventy years ago. Skeptics think putting state finances under control of a Federal bankruptcy court would upset the notion that states, unlike municipalities, are “sovereigns.”  They cite the 10th Amendment, which reserves to states powers not granted to the Federal government, and the 11th Amendment, which prohibits lawsuits in Federal courts against a state by citizens of another state. For those interested in the details, see the article linked here by Michael McConnell, a Stanford Law School professor.

A leading expert on the other side is David Skeel, a law professor at the University of Pennsylvania. He wrote outright that, “The constitutionality of bankruptcy-for-states is beyond serious dispute.” The key, as he sees it, is that bankruptcy would be entirely voluntary, which should eliminate any concerns about Federal intrusion on state sovereignty.

A professorial legal analysis, however, probably wouldn’t matter in the end. Courts often bend the rules or make new ones when major emergencies or humanitarian issues arise. Even Professor McConnell, who doesn’t like the idea of state bankruptcy, agrees with that:

If we were facing a genuine fiscal meltdown, which could be solved only through bankruptcy or some equivalent process, and if the use of that process enjoyed the support of Congress, the President, and the affected states, it is not hard to imagine the Court swallowing its theoretical objections.

Beyond the legal issues, some fear that merely authorizing the option of bankruptcy would drive up state borrowing cost because potential bond buyers would face the added risk of having debt cancelled. That’s probably true for states in or near insolvency, but wouldn’t it also instill the needed borrowing discipline never to get to that point?  Bankruptcy would only be available upon insolvency — that’s already required under the Code — which means inability to pay what’s owed. If you can’t pay you won’t pay, bankruptcy or no bankruptcy, so it might not make a difference in the long run. In any event, higher borrowing costs would only result during the period from when it was authorized to when a state filed.

Remember that most objections to bankruptcy come from the municipal bond industry, so take them with a huge grain of salt. That industry primarily just wants to protect against losses on bonds already issued. The state shouldn’t be concerned about those; only future borrowing costs should matter. Future borrowing costs are lowered, not raised, if a successful bankruptcy reduces legacy debt.

And remember that the muni bond industry is already well aware that Congress could extend bankruptcy to the states. Rest assured they know all that’s being written here, and much more. They are way ahead of the curve. To some extent, they’ve already built bankruptcy risk into what they will pay for state bonds. And their efforts to shore up their position to assure they come ahead of taxpayers and other creditor are underway, discussed in our earlier article.

Public employee unions and their supporters also don’t like bankruptcy because of the threat it poses to pension obligations. That’s perhaps rational, if you assume states will in fact eventually find some way to pay scheduled obligations. Not Illinois, in my opinion. All sides need to get on the same page about the plain math. And a bankruptcy court should not be expected to cut pensions if it’s indeed feasible to pay them in full. Unions would be wise to recognize that bankruptcy courts so far have typically favored public pensioners over unsecured bondholders. However, time is not on the pensioners’ side: The muni bond industry is hard at work doing all it can to get first liens and other mechanisms to attain priority over pensions.

Read More @ Wirepoints.com



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