Congressional Bankruptcy Rumblings Worry California

John Wildermuth
Journalist and Political Commentator

Remember way back last February when Carly Fiorina suggested that California may want to think about filing for bankruptcy and the state’s political mavens erupted in peals of laughter?

“Rookie mistake,” they solemnly declared. “Everyone knows states can’t declare bankruptcy.”

Time to stop laughing. Turns out that the GOP Senate candidate might not have been wrong, just early.

A New York Times story last week reported that some Washington Republicans are quietly looking into the possibility of changing the federal bankruptcy law to let states file for protection from their creditors, as cities and counties have been able to do since the 1930s. The idea is that by filing for bankruptcy, states can unilaterally dump union contracts, slash pension plans and make other needed cuts to get out from under their crushing debts.

Of course in the 234-year history of the union, it’s never been done before, but the attitude of a number of academics and conservative politicians seems to be along the lines of “Times are tough, so what the hell.”

Picture California’s $25 billion deficit as a ticking time bomb that could destroy the state. If someone uses the bankruptcy clippers to cut the red wire of debt, it could save the state. Or it could cause an instant explosion that would cause more devastation than the debt bomb would have.

As a movie, it sounds pretty exciting. As a plan for California’s future, it sounds way too exciting.

The fact is, nobody knows what effect a bankruptcy filing would have on California or any other state, which is reason enough to be very, very wary.

In a Nov. 29 article in the conservative Weekly Standard, David Skeel of the University of Pennsylvania law school argued that allowing states to go bankrupt would allow them to cut union contracts, restructure their debts and keep them from asking for any federal bailout.

“The effectiveness of state bankruptcy would depend a great on the state’s willingness to play hardball with its creditors,” Skeel said.

But while Republicans and plenty of other Californians have no problem with seeing the state whack the pay of public employees and hack back their pension benefits, those workers wouldn’t be the only victims in a bankruptcy filing. Since bankruptcy affects all the state’s creditors, the people and institutions that own billions of dollars in California bonds could watch those values plummet.

Vallejo, which declared bankruptcy in 2008, announced earlier this month that it only would repay its unsecured creditors between 5 cents to 20 cents on every dollar it owes. How easy do you think it’s going to be for the city to get loans in the future? Or convince anyone to buy its bonds?

That’s the point state Treasurer Bill Lockyer made in a scathing statement he put out in reference to suggestions that anyone is thinking of allowing states to go bankrupt.

“To the folks in Congress cooking up this baloney: Don’t bother,” he wrote. “States didn’t ask for it. We don’t want it. We don’t need it.”

“Bankruptcy would devastate states’ ability to recover from the recession and make the infrastructure investments that create good jobs.”

California’s credit rating already is the worst in the nation, which means it pays higher interest rates than other states on its general obligation bonds. If there was even a suggestion that this state – or any other state — could default on those bonds, California’s lending costs would go way up, if banks were even willing to lend at all.

But as Lockyer is quick to note, the state has never defaulted on a bond and isn’t likely too, since by law bondholders have second call on state funds, behind only K-12 education.

As for the consequences of a California bankruptcy? Well, according to state Department of Finance numbers, in 2009 California had a Gross Domestic Product of $1.89 trillion, making it the eighth biggest economy in the world, just behind Italy and ahead of Brazil, Spain, Canada and India.

A bankruptcy, even in the best circumstances, could rock financial markets not only across the country, but also around the world.

Even if states do get the go-ahead to head to bankruptcy court, it will be a very different proceeding from the legal remedy used by businesses and individuals.

Because states have sovereignty, they would have to choose to declare bankruptcy; they couldn’t be forced into it by an angry unpaid creditor. And even if it chose to file, the state, not the courts, would retain control over the wheels of government and decide what cuts to make.

Don’t expect Lockyer, or any other California official, to volunteer for bankruptcy. While the state has plenty of debts, it also has plenty of tax dollars coming in on a regular basis. And many of the state’s most troubling structural woes, such as the unfunded pension debt, are long-term problems that don’t need to be solved immediately, although sooner is always better – and cheaper.

“With respect to our budget shortfalls,” Lockyer said in his statement, “we have the tools to fix them without taking a wrecking ball to our economies and taxpayers.”

The treasurer might not sound as confident come June, if California voters don’t approve – or even vote on – the tax package proposed by Gov. Jerry Brown.

But even as Republican leaders in Congress try to hastily retreat on the bankruptcy talk, supporters still have to answer one important question: Do you really know what will happen if a state declares bankruptcy or are you willing to roll the dice on the economic future of 50 state governments?


John Wildermuth is a long-time writer on California politics.

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