Bankruptcy works: Why Congress should consider bankruptcy for states

In 1975, New York City was on the brink of bankruptcy. The City did not have the cash to make municipal bond payments and continue to pay for vital services or its public retiree and healthcare benefits. Consequently, New York City was on the verge of defaulting on its municipal bonds. In the face of this reality, New York City pursued three options: seeking aid from the federal government, negotiating a deal with its public unions or filing for bankruptcy. The federal government rebuffed New York City’s request for a bailout. Faced with the option of a municipal bankruptcy, the unions agreed to invest $2.5 billion of their pension funds in municipal bonds, which were used to bail the City out. The unions’ investment put the pensions of thousands of public employees and retirees at risk, but it enabled New York City and the unions to avoid bankruptcy and positioned the City to build a strong, long-term fiscal foundation. New York City avoided bankruptcy because it had the option to file for bankruptcy. 

Unlike New York City and other municipalities, states cannot file for bankruptcy. Yet, today, states are in a similar or worse fiscal position than was New York City in the 1970s. Collectively, states have budget deficits of more than $130 billion, unfunded pension and healthcare plans of more than $1 trillion, and billions of dollars of unpaid bills to public schools and universities, hospitals and social welfare programs. In addition, municipal bond yields have risen to levels not seen since our economy was in the throes of the economic crisis. States are in crisis and are floundering in their attempt to find a solution.

Currently, states are increasing taxes, cutting spending, selling state assets or increasing borrowing to achieve short term solutions to their fiscal problems. But the fiscal problems are long term and structural. At some point, states will run out of short term solutions and the long term problems will become overwhelming, placing states on the precipice of failure. Can Congress actually let a state fail? This is the conundrum.

While states are too big to fail, they are too big to be bailed out. Without a bailout and without the ability to file for bankruptcy, it is entirely realistic that a state will default on its debts and fail - an event that would lead to a complete disruption of the capital markets. But all is not lost. We can learn from experience. As the story of New York City’s 1975 fiscal resolution demonstrates, the mere option to file for bankruptcy will provide insolvent states with the tools and leverage needed to repair their fiscal house for the long run.

Accordingly, Congress should provide insolvent states with the ability to file for bankruptcy. Of course, it may be politically dangerous for a congress person to say the word “bankruptcy” in the context of the states. The word “bankruptcy” conjures up harrowing images for the public. The public may envision services shutting down and chaos on the streets if states were able to file for bankruptcy. Public unions and public employees will view state bankruptcy legislation as an attack on their retirement and pension payments. Consequently, the public needs to be educated that not only does bankruptcy work, it works well. It does not need to result in services shutting down; in fact, it may be what allows services to continue. And, while unions may need to compromise on their pension obligations, it is almost always true that a negotiated result is better than a court imposed result. Importantly, the specter of bankruptcy may allow states and their unions to resolve issues without the states ever having to file for bankruptcy, because the states and the unions will be incentivized to reach an out of court solution rather than risking a bankruptcy court-imposed resolution. 

Experience dictates that a bankruptcy alternative for states may be critical and necessary to enable states to work out their fiscal issues in a comprehensive way and position states for long-term stability. Without the ability to file for bankruptcy, states simply do not have the tools at their disposal to actually fix their problems. Instead, states will be forced to rely on short-term fixes for long-term problems. Of course, when the short term fixes run out - and that may occur sooner than anticipated - a state will be out of options. Its only real option will be to ask the federal government for a bail out and that is an option that will risk our entire economic foundation. Instead, Congress should give the states a chance and provide them with the option to file for bankruptcy, an option that will enable the states to design and implement a comprehensive plan for long-term fiscal health.

Jonathan S. Henes is a partner at Kirkland & Ellis LLP