Why Bankruptcy is Not a Magic Wand for Illinois

Via The Daily Bell

What if everyone declared bankruptcy, would that solve all financial woes? Or rather, would it be the ultimate debt bubble burst? Bankruptcy is a “solution” that would become disastrous if everyone were to use it. So can it truly be considered a solution at all? It just shifts the financial burden to someone else.

Most people just don’t care though, because usually, it is the big bad credit card companies or debt collectors who seem to be getting screwed. People with mountains of debt are told that they were preyed on by lending companies. Look at this excerpt from an article by a law firm about the myths of bankruptcy.

We are all so programmed all our lives to pay our bills and to think we have to that it’s just hard to believe that…if we file bankruptcy…we may NOT have to.  The law says that you have to pay all your bills all the time, but the law also says: “except if you file bankruptcy”.  If it helps, think of filing bankruptcy as something that works like magic. “Now you owe…POOF!…now, you don’t“.   Why?  Because that’s just how it works.

That’s just how it works. But how does it work when we are not talking about an individual declaring bankruptcy?

Whispers are starting among debt-laden states, and Illinois is starting to talk bankruptcy.

So can they just wave a magic wand and, poof, all their worries go away? No, but they can transfer all their worries onto the lenders.

Chapter 9 bankruptcy protection could be extended to states if Congress took up the issue, although Stanford Law School professor Michael McConnell noted in an article last year that he believed the precedents are iffy for extending the option to states. Nevertheless, Illinois is in a serious financial pickle, which is why radical options such as bankruptcy are being floated as potential solutions.

Ratings agency Moody’s Investor Service earlier this month downgraded Illinois’ general obligation bonds to its lowest investment grade rating, citing the state’s growing pile of unpaid bills and its mounting pension deficit. Illinois, by the way, has the lowest credit rating of any state. Lower ratings mean higher borrowing costs, since lenders view such borrowers as riskier bets.

And indeed Illinois is quite the risky bet for lenders. Lenders may have assumed that since states could not go bankrupt, they would eventually be paid back, with massive interest rates added on. This means the state would either have to substantially cut its spending or raise taxes.

In a state with such robust unions, who arguably helped drive the debt crisis when it comes to unfunded pensions for state employees, it is unlikely that spending could be seriously curtailed. The Illinois Supreme Court overturned a law that would have reduced pensions because it violated the Illinois Constitution which says the state cannot change what they agreed to for retirement benefits.

So that leaves raising taxes. But who is going to pay the sky high tax rates when everyone flees?

Adding to the state’s financial pain is a shrinking tax base. For the last three consecutive years, Illinois has lost residents. Its population is now at its lowest in a decade. Tepid wage growth on top of fewer residents puts a strain on the state’s ability to grow its tax revenue.

Bankruptcy is being sold as a panacea to financial irresponsibility, but what exactly changes when the debt is wiped clean or drastically reduced? The same politicians will be in power. Will they suddenly change their big spending ways?

And what happens to those unfunded pensions? Illinois could have to borrow more of anyone will lend, at an even higher interest rate, in order to pay for them. Or they will continue the cycle of raising taxes and scaring off residents. What happens if the pensions ultimately cannot be paid?

There is nothing magic about bankruptcy. For individuals, it can at least be a wake-up call to be more fiscally responsible. A government, however, cannot change in the same way, because it is a headless conglomerate of interests, lobbies, and citizens all pushing and pulling for their own particular view.

Fiscal responsibility is the only answer for individuals and governments. Under no circumstances should debt be taken on which is unable to be paid back, as is the case in unfunded liabilities.

Would Congress Authorize Bankruptcy For Illinois And Other States? Yes, Inevitably

Authored by Mark Glennon via WirePoints.com,

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident. -Arthur Schopenhauer.

For Illinois or another state to formally go bankrupt, the United States Congress would have to pass legislation.

Would they? I think so.

In fact, bipartisan support is reasonably foreseeable and, ultimately, that legislation is unavoidable, which will trump any debate.

The legal question whether Congress could extend bankruptcy to states was addressed in my earlier article so I won’t rehash that here, except to say I think David Skeel is right. He’s a law professor at the University of Pennsylvania who also serves on Puerto Rico’s oversight board in its bankruptcy-like proceeding authorized by Congress under PROMESA. He wrote wrote firmly that the “constitutionality of bankruptcy-for-states is beyond serious dispute.”

In Congress, reasons will vary for initial political hostility to bankruptcy-for-states.

Some conservatives view state bankruptcy as a form of bailout and will be particularly averse to helping Illinois, which they understandably think deserves its fate. Others may view it as federal intrusion on state sovereignty, which is also what the constitutional objection is about.

But bankruptcy is really the anti-bailout alternative, and turning Illinois around is important to the national economy. We are now a drag on the national economy despite assets that should make us a powerhouse of jobs and production. Illinois GDP has lagged the nation’s significantly for ten years. A federal bailout is happening automatically, at least in a small sense, in the form of food stamps, housing assistance, Medicaid and similar programs. A fresh start for Illinois would reduce its federal tab for those costs and grow Illinois’ tax base for federal revenue.

Respecting state sovereignty, remember Congress would only be offering states the option of using bankruptcy, just as it has already done for municipalities; nothing would be forced on states.

The left will fear the power of bankruptcy to reduce pension payments, but it’s essential to remember the Bankruptcy Code would not be expanded “as is” to states. Changes would be made on which all sides should find common ground.

One such change should allow for progressivity or means testing in some form for any pension cuts. That is, the fat cats should be reduced proportionately more than smaller pensioners who truly need their annuity. The Bankruptcy Code currently treats all unsecured creditors uniformly, including unfunded pension liabilities.

Another possible change that progressives might like is statutory recognition of the concept of “service insolvency.” That’s the idea that failing to provide basic services should count in the initial determination whether a government qualifies for bankruptcy.

The left wouldn’t like how collective bargaining agreements can be terminated along with all other contracts bankrupt parties don’t like. But remember that state policy on collective bargaining and other labor matters is not dictated by bankruptcy. A bankrupt government can opt to keep or renegotiate whatever labor contracts it has.

The municipal bond industry will object fiercely since unsecured debt could be reduced. They’ve already focused on the issue, having earlier sponsored a national ad campaign opposing PROMESA, fearing it would set a precedent for states.

But progressives and free marketeers alike should shed no tears for existing bondholders. They took the risk that bankruptcy law could be changed to impact them.

All will fear higher future borrowing costs. That’s legitimate but finite. Once a bankruptcy proceeding is underway, new lenders get special protection to assure normal operation and, assuming a successful bankruptcy, a clean balance sheet and better credit ratings result. The key will be to line up support for federal legislation as best as possible behind the scenes and move very quickly once it’s proposed.

Won’t all states suffer higher borrowing costs because of the additional risk? In the very long run they will be forced to borrow less to assure the markets of no risk of getting near bankruptcy. Is that such a bad result?

Stop here and assume everything I’ve said so far is wrong. Assume still further reasons why bankruptcy is a bad option — it will be fraught with unknowns and is inherently unfair to those to whom promises were made, which is true.

None of that will matter because it will become evident there’s no alternative. This isn’t about whether bankruptcy is a good option. It’s about whether it’s the only option.

Look no further than pensions to see why. The Illinois Supreme Court has made crystal clear that, under the Illinois Constitution, pension promises can’t be cut for services already rendered, which are Illinois’ $130 billion liability (using silly, official numbers). That leaves only two means to do that — bankruptcy or a state constitutional amendment deleting the pension protection clause. But the amendment might not work anyway because of issues under the United States Constitution, and it would take years to put through even if the General Assembly acted to put it to a public vote, which it has shown no interest in doing.

And the unfunded pension obligations are insurmountable in themselves. That’s why no serious proposal by anybody in the current budget debate has pretended to address those liabilities. They all propose continued annual contributions to the pensions that underfund them, growing the pension debt each year.

Meanwhile, despite that underfunding, Illinois’ death spiral worsens. The tax base shrinks, state revenue drops, people and employers flee and services are cut.

Bankruptcy for Puerto Rico was initially scorned, but PROMESA ended up with bipartisan support, passing 297-127 in the House and 68-30 in the Senate.

One part of their experience is worth particular note. Lawsuits by creditors were stayed — basically, put on hold — under PROMESA. That stay expired on May 1 and a torrent of lawsuits began on May 2, forcing Puerto Rico to file its bankruptcy-like proceeding the very next day. It’s difficult to see how Illinois can avoid a similar wave of lawsuits at some point, and only an organized insolvency proceeding — bankruptcy — can fairly manage and prioritize an overwhelming number of claims.

The sooner we pass through the stages of ridicule and violent opposition, as Schopenhauer called them in that quote above, the less painful this will be for everybody.