Financial markets have been rocked recently by predictions of a rash of municipal bankruptcies this year and talk among Republican leaders of drafting a law allowing states to go bankrupt as well.
The $3 trillion municipal bond market — where states and cities go to obtain loans — was hit hard last month by a well-publicized prediction by star financial analyst Meredith Whitney that between 50 and 100 city and county governments could fall into default this year.
Fierce denials from city leaders enabled the market to stabilize somewhat. But no sooner had investors who would stand to lose billions from such bankruptcies regained their composure than two prominent Republicans — former House Speaker Newt Gingrich and former Florida Gov. Jeb Bush — rattled them again by promoting a plan to enable near-insolvent states such as California and Illinois to go bankrupt as well.
The GOP proposal, which is being drafted into legislation in the Senate, is aimed at preventing any federal bailout of state governments as they contend with severe budget challenges caused by high joblessness and welfare caseloads and dwindling federal stimulus funds.
The market reaction to the Gingrich proposal was so sharp that within days other Republican leaders moved to downplay the possibility of any change in bankruptcy law for states. House Majority Leader Eric Cantor, Virginia Republican, said he thinks states already have all the legal tools they need to wrestle down bloated budget deficits and recalcitrant unions.
"There will be no bailout of states," he told reporters on Capitol Hill. "The states can deal with this, and have been able to do so on their own." The House Judiciary Committee will hold a hearing this month on whether states should be able to declare bankruptcy.
Public-employee unions, liberal groups and some top Democratic lawmakers have denounced the idea. Democratic California Treasurer Bill Lockyer called it a "phony crisis" that Republicans have drummed up to roil markets and make life difficult for big-spending states with large debts to finance.
The bankruptcy debate promises to remain lively this year, as the threat of fiscal crisis and bankruptcy remains high among strapped local governments. Few Wall Street analysts expect as many defaults as Ms. Whitney is predicting, but many say the nation should brace for an onslaught of solvency problems nonetheless.
"This is not to suggest a near-term epidemic" of municipal bankruptcies is on the way, considering that they have been rare in the past, said Dot Matthews, analyst at CreditSights research group.
"But we would note that extrapolating from the historical rarity of such cases into the future could be naive, given the degree of stress being faced by many local governments," she said.
For a city, the principal attraction in filing for bankruptcy, she said, is being able to reject labor contracts and pension obligations that have become unaffordable. Bankruptcy courts have the power to dismiss some or all of such debts as part of a municipal bankruptcy reorganization.
U.S. states and cities are beset by an estimated $3 trillion in unfunded pension obligations that are starting to come due and are increasingly crowding out other budget items, interfering with the government's ability to provide services to the public.
The states that are in the worst shape — notably, California, Illinois, New York and New Jersey — are struggling with mammoth pension obligations, but even states in better financial shape, such as Maryland, have looming pension troubles.
The financial bombshell posed by these pension obligations has prompted the Securities and Exchange Commission to launch investigations into whether several states and cities have made adequate disclosure to investors about their pension liabilities, including reportedly Illinois, Rhode Island and Harrisburg, Pa.
Mr. Gingrich and Mr. Bush offered their bankruptcy proposal with an eye toward helping states take the steps they need to alter their pension and other employee obligations over the stiff opposition of often-intransigent unions.
They argue that states should be able to voluntarily file for bankruptcy, just as municipal governments at present can reorganize under Chapter 9 of the bankruptcy code. Their plan would not allow states to be forced into bankruptcy like an insolvent corporation because states are sovereign under the Constitution.
In an op-ed piece in the Los Angeles Times last week, the two Republicans argued that the "mere existence" of the bankruptcy option might prevent states from ever having to go bankrupt because it would be such a powerful weapon against unions.
"If government employee union bosses know that they could have all their contracts annulled [through bankruptcy], they may be far more accommodating," they wrote.
But state legislators and many analysts say such drastic measures would be unwise and unnecessary because states already can periodically revise their union contracts and have taxing powers and other powerful tools that well-run states with political resolve have used to balance their budgets.
Moreover, a large share of states' budget problems involve burgeoning spending on Medicaid, unemployment, and other federally mandated programs, and do not stem from employee contracts, they say.
"Letting states go bankrupt won't solve anything, and would create new problems," said Nicole Gelinas of the Manhattan Institute. "While Congress may intend the bankruptcy idea to avoid a bailout of struggling states, all the talk might bring us closer to just that."
"Muni bondholders, worried about states' finances, might be panicked by fears that lawmakers will change the rules midgame" and the resulting market turmoil could drive some hard-pressed governments to the brink of bankruptcy, she said.
Issuance of municipal bonds dropped 66 percent last month partially in reaction to adverse publicity about bankruptcy as well as the end of the federally subsidized Build America Bonds program.
The talk about bankruptcy particularly spooked small investors, who pulled their money out of municipal bond mutual funds at record rates, according to the Bond Buyer newspaper.
Brian Gardner, Washington analyst at Keefe, Bruyette & Woods, doubts that the bankruptcy proposal will go far in Congress because it raises knotty legal and constitutional questions and has the potential to cause further adverse market reactions.
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