Municipal bankruptcy

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See also bond insurance, Build America bond, muni swaps, municipal pensions, municipal securities, and Municipal Securities Rulemaking Board.

Contents

Chapter 9 - Municipality Bankruptcy

The chapter of the Bankruptcy Code providing for reorganization of municipalities (which includes cities and towns, as well as villages, counties, taxing districts, municipal utilities, and school districts).

  • a. Purpose of Municipality Bankruptcy
  • b. Eligibility
  • c. Commencement of the Case
  • d. Assignment of Case to a Bankruptcy Judge
  • e. Notice of Case/Objections/Order for Relief
  • f. Automatic Stay
  • g. Proofs of Claim
  • h. Court's Limited Power
  • i. Role of the U.S. Trustee/Bankruptcy Administrator
  • j. Role of Creditors
  • k. Intervention/Right of Others to be Heard
  • l. Powers of the Debtor
  • m. Dismissal
  • n. Treatment of Bondholders and Other Lenders
  • o. Plan for Adjustment of Debts
  • p. Confirmation Standards
  • q. Discharge


History

The first municipal bankruptcy legislation was enacted in 1934 during the Great Depression. Pub. L. No. 251, 48 Stat. 798 (1934). Although Congress took care to draft the legislation so as not to interfere with the sovereign powers of the states guaranteed by the Tenth Amendment to the Constitution, the Supreme Court held the 1934 Act unconstitutional as an improper interference with the sovereignty of the states. Ashton v. Cameron County Water Improvement Dist. No. 1, 298 U.S. 513, 532 (1936). Congress enacted a revised Municipal Bankruptcy Act in 1937, Pub. L. No. 302, 50 Stat. 653 (1937), which was upheld by the Supreme Court. United States v. Bekins, 304 U.S. 27, 54 (1938). The law has been amended several times since 1937. In the more than 60 years since Congress established a federal mechanism for the resolution of municipal debts, there have been fewer than 500 municipal bankruptcy petitions filed. Although chapter 9 cases are rare, a filing by a large municipality can— like the 1994 filing by Orange County, California—involve many millions of dollars in municipal debt.

Purpose of Municipal Bankruptcy

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.

Although similar to other chapters in some respects, chapter 9 is significantly different in that there is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors. Such a liquidation or dissolution would undoubtedly violate the Tenth Amendment to the Constitution and the reservation to the states of sovereignty over their internal affairs. Indeed, due to the severe limitations placed upon the power of the bankruptcy court in chapter 9 cases (required by the Tenth Amendment and the Supreme Court's decisions in cases upholding municipal bankruptcy legislation), the bankruptcy court generally is not as active in managing a municipal bankruptcy case as it is in corporate reorganizations under chapter 11. The functions of the bankruptcy court in chapter 9 cases are generally limited to approving the petition (if the debtor is eligible), confirming a plan of debt adjustment, and ensuring implementation of the plan. As a practical matter, however, the municipality may consent to have the court exercise jurisdiction in many of the traditional areas of court oversight in bankruptcy, in order to obtain the protection of court orders and eliminate the need for multiple forums to decide issues.

Eligibility

Only a "municipality" may file for relief under chapter 9. 11 U.S.C. § 109(c). The term "municipality" is defined in the Bankruptcy Code as a "political subdivision or public agency or instrumentality of a State." 11 U.S.C. § 101(40). The definition is broad enough to include cities, counties, townships, school districts, and public improvement districts. It also includes revenue-producing bodies that provide services which are paid for by users rather than by general taxes, such as bridge authorities, highway authorities, and gas authorities.

Section 109(c) of the Bankruptcy Codes sets forth four additional eligibility requirements for chapter 9:

  1. the municipality must be specifically authorized to be a debtor by State law or by a governmental officer or organization empowered by State law to authorize the municipality to be a debtor;
  2. the municipality must be insolvent, as defined in 11 U.S.C. § 101(32)(C);
  3. the municipality must desire to effect a plan to adjust its debts; and
  4. the municipality must either:
  • obtain the agreement of creditors holding at least a majority in amount of the claims of each class that the debtor intends to impair under a plan in a case under chapter 9;
  • negotiate in good faith with creditors and fail to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that the debtor intends to impair under a plan;
  • be unable to negotiate with creditors because such negotiation is impracticable; or reasonably believe that a creditor may attempt to obtain a preference
Commencement of the Case

Municipalities must voluntarily seek protection under the Bankruptcy Code. 11 U.S.C. §§ 303, 901(a). They may file a petition only under chapter 9. A case under chapter 9 concerning an unincorporated tax or special assessment district that does not have its own officials is commenced by the filing of a voluntary "petition under this chapter by such district's governing authority or the board or body having authority to levy taxes or assessments to meet the obligations of such district." 11 U.S.C. § 921(a).

A municipal debtor must file a list of creditors. 11 U.S.C. § 924. Normally, the debtor files the list of creditors with the petition. However, the bankruptcy court has discretion to fix a different time if the debtor is unable to prepare the list of creditors in the form and with the detail required by the Bankruptcy Rules at the time of filing. Fed. R. Bankr. P. 1007.

Assignment of Case to a Bankruptcy Judge

One significant difference between chapter 9 cases and cases filed under other chapters is that the clerk of court does not automatically assign the case to a particular judge. "The chief judge of the court of appeals for the circuit embracing the district in which the case is commenced [designates] the bankruptcy judge to conduct the case." 11 U.S.C. § 921(b). This provision was designed to remove politics from the issue of which judge will preside over the chapter 9 case of a major municipality and to ensure that a municipal case will be handled by a judge who has the time and capability of doing so.

27 states prohibit muni bankruptcy

"...States can’t enter Chapter 9 bankruptcy, and 26 of them prohibit their municipalities from filing, according to Knox and Levinson. “A municipality in those states must seek enactment of a specific statute particular to it authorizing the filing. It goes without saying that a floundering municipality faces an uphill battle in such states.”

That hasn’t stopped municipalities from talking about it more than they have since 1994, when Orange County, California, suffered through the country’s biggest municipal bankruptcy. Bondholders have to worry if it’s more than just talk.

Below is the list of 27 states.

  • Alaska
  • California (added 10/11/11 source)
  • Delaware
  • Georgia
  • Hawaii
  • Illinois
  • Indiana
  • Iowa
  • Kansas
  • Maine
  • Maryland
  • Massachusetts
  • Mississippi
  • Nevada
  • New Hampshire
  • New Mexico
  • North Dakota
  • Oregon
  • Rhode Island
  • South Dakota
  • Tennessee
  • Utah
  • Vermont
  • Virginia
  • West Virginia
  • Wisconsin
  • Wyoming

Muni defaults may prove systemic risk

"...Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.

Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work."


Vallejo approves blueprint to exit bankruptcy

The Vallejo City Council unanimously approved a financial blueprint Tuesday night to exit California’s largest municipal bankruptcy in more than a decade.

The five-year road map tackles $195 million in unfunded city pension obligations, cuts payments for retiree health care, reduces pension benefits for new employees, raises pension contributions for current workers, and creates a rainy-day fund.

“This five-year plan looks out and says, basically, we will be treading water for five years,” interim city manager Phil Batchelor told the council. He is Vallejo’s third manager since the San Francisco Bay Area city filed for Chapter 9 bankruptcy protection in May 2008.

Harrisburg bailed out by PA

The state of Pennsylvania has stepped in to help its capital city, which in recent days came perilously close to defaulting on its debt, said Pennsylvania Governor Edward Rendell on Sunday.

"This is not a bailout," Rendell told reporters about the grants and loans the state is sending Harrisburg. "This money is due the city of Harrisburg. We're just front-loading it and expediting it."

Rendell said he met with Harrisburg Mayor Linda Thompson on Thursday evening about the city's bond payment of $3.29 million due Sept. 15.

Unable to make the payment, Harrisburg turned to its bond insurer for the funds. Rendell was concerned the insurance company might then in turn sue the city to recoup the money.

The state will expedite fire protection funds of nearly $1 million to the city. It will also advance $2.6 million from a municipal pension assistance fund.

Rendell said Pennsylvania would provide the city with assistance grants and loans totaling $850,000 to hire an outside adviser to sort out the financing surrounding the city's trash burner.

Pennsylvania's capital of Harrisburg said it will skip a $3.29 million municipal-bond payment due in two weeks, marking the second-largest general-obligation municipal-bond default this year.

The city's inability to make the payment, which is expected to be covered by its bond insurer, may feed worries about parts of the $2.8 trillion municipal-bond market, particularly bonds issued by smaller entities that may have fewer resources than states or larger governments.

Paying bondholders is typically a top priority for governments, which want to ensure investors will lend to them the next time they seek to borrow.

But sharply lower tax revenues in the recession—after accelerated municipal borrowing over the past two decades—has made payback more challenging for some governments.

Smaller bond offerings like Harrisburg's tend to be sold primarily to individual investors and are thinly traded.

A missed payment is "a bad signal," said Alan Schankel, managing director at Janney Montgomery Scott in Philadelphia, adding that it raises the concern that some distressed issuers may be more likely to skip bond payments guaranteed by insurance companies.

"Once that starts, it gets easier to default on something else," he said.

Jefferson County, Alabama

"In its 190-year history, Jefferson County, Alabama, has endured a cholera epidemic, a pounding in the Civil War, gunslingers, labor riots and terrorism by the Ku Klux Klan. Now this namesake of Thomas Jefferson, anchored by Birmingham, is staring at what one local politician calls financial “Armageddon.”

The spectacle -- a tax struck down, about 1,000 county employees furloughed, a politician indicted over $3 billion in sewer debt that may lead to the largest municipal bankruptcy in history -- has elbowed its way up the ladder of county lore.

“People want to kill somebody, but they don’t know who to shoot at,” says Russell Cunningham, past president of the Birmingham Regional Chamber of Commerce.

One target of their anger is Larry P. Langford, who was the county commission’s president in 2003 and 2004 and is now mayor of Birmingham. The 61-year-old Democrat goes on trial today, charged in a November 2008 federal indictment with taking cash, Rolex watches and designer clothes in exchange for helping to steer $7.1 million in fees to an Alabama investment banker as the county refinanced its sewer debt.

Jefferson County’s debacle is a parable for billions of dollars lost by state and local governments from Florida to California in transactions done behind closed doors. Selling debt without requiring competition made public officials vulnerable to bankers’ sales pitches, leaving taxpayers to foot the bill for borrowing gone awry.

Under Langford’s stewardship, the county bet on interest- rate swaps, agreements that a representative of New York-based JPMorgan Chase & Co. told commissioners could reduce their interest costs. Instead, the swaps -- covering more than $5 billion in all -- blew up during the credit crisis after ratings for the county’s bond insurers fell.

JPMorgan, through spokeswoman Christine Holevas, declined to comment for this story.

Thousands of public borrowers across the U.S. chose a similar strategy, and many are now paying billions of dollars to escape the contracts, said Peter Shapiro, managing director at Swap Financial Group in South Orange, New Jersey. Even Harvard University, the world’s richest academic institution with an endowment of $26 billion, fell for Wall Street’s financing in the dark: It paid $497.6 million to investment banks during the fiscal year ended June 30 because it chose to cancel $1.1 billion of interest-rate swaps...

...Payments on Jefferson County’s debt, which switched from 95 percent fixed-rate financing to 93 percent variable-rate bonds hedged with swaps, eventually ballooned to $460 million a year, or more than twice the sewer system’s annual revenue.

Three of the five current commissioners are resisting voluntary bankruptcy. A filing would vault this county of 660,000 residents over Orange County, California, which lost $1.6 billion on derivatives in 1994 and ranks as the largest municipal insolvency to date.

Jefferson County’s collapse shows how people calling themselves financial engineers created borrowing schemes in the $2.8 trillion municipal-bond market that incorporated risk without the benefits of transparency. As state and local governments embraced floating-rate debt and interest-rate swaps, or agreements to exchange periodic interest payments with banks or insurers, they stopped requiring competition in bond sales...

...The county revealed in July that it had defaulted on $46 million of accelerated principal. It might already be in Chapter 9, the federal bankruptcy option for cash-strapped municipalities, except that it has received agreements from JPMorgan and other banks to hold off on forcing it to make accelerated payments on more than $800 million of unwanted bonds.

In August and September, amid the cuts that stemmed from the occupational-tax judgment, Jefferson County residents got a taste of what bankruptcy might look like. As the county began putting about 1,000 workers on leave without pay, one disgruntled employee allegedly e-mailed bomb threats to officials and was promptly arrested, according to the Jefferson County Sheriff’s Office.

Lines Form

Lines soon formed outside the courthouse as such tasks as renewing driver’s licenses slowed.

A kind of legal civil war broke out when three county agencies, the sheriff’s department, an indigent-care hospital and the tax-assessor’s office, sued the county commission to stop the budget cuts on the grounds that they posed a danger to public safety.

Bettye Fine Collins, the commission president, declared the situation, “our Armageddon.”

The fight over the occupational tax, a 0.50 percent levy on personal income, dates to 1999 when state lawmakers repealed it. The county appealed that action and won a series of state court decisions until January when a judge ruled the repeal was legal.

That left county leaders to find $75 million in cuts while they took the case to the Alabama Supreme Court, which upheld the lower court’s ruling in August. In parallel action, the state legislature reauthorized a modified version of the tax at a lower rate, 0.45 percent.

Workers Reinstated

Commissioners reinstated the furloughed workers this month, putting most on 32-hour work weeks. They have also sought a $25 million line of credit from Birmingham-based Regions Financial Corp.

The legislature may have saved the county from uncharted territory. With the occupational tax crunch and the sewer-debt crisis, Collins said she had feared that, “In the worst-case scenario we could be drawn into bankruptcy on both sides.”

In August, Bank of New York Mellon Corp., as trustee for owners of about $3 billion in sewer warrants, filed suit in Jefferson County Circuit Court seeking an appointed receiver for the sewer system. The receiver should have authority to raise rates enough to meet the debt service, the bank said in the complaint, which is pending. A federal judge turned down a similar request in June, saying he lacked jurisdiction.

The sewer system is already charging customers about 300 percent more to drain bathtubs or flush toilets than a dozen years ago...

..Above National Average

By one county estimate, average annual bills are now about $750, compared with the national average of $331, according to a 2007 survey by the Washington, D.C.-based National Association of Clean Water Agencies, a coalition of utilities.

It’s impossible to boost them enough without putting them beyond the means of many residents, County Commissioner Jim Carns says. “We’re like a guy making $50,000 a year with a $1 million mortgage.”

Carns and Commissioner Bobby Humphryes, both Republicans, say they reluctantly favor bankruptcy, in part to prevent the appointment of a receiver who might seek increases. “We need a cram-down on the debt,” says Carns, adding that the county can afford to service less than half the obligations, about $1.4 billion worth. A bankruptcy court would have authority to reduce the amount owed.

Democrat Shelia Smoot, along with Democrat William Bell and commission President Collins, opposes filing voluntarily.

Detrimental for 50 Years

“It would be detrimental to our community for the next 50 years,” she says.

Orange County, after its 1994 default, was forced to take on “a crushing load of long-term debt,” according to a post- mortem published four years later by the Public Policy Institute of California, a nonprofit San Francisco-based economic research organization.

The county’s borrowing costs increased, forcing it to “divert tax funds from other county agencies (e.g. transportation) so the county government could borrow money to pay bondholders and vendors,” according to the report. The poor were hurt in particular. “Their services were cut during the bankruptcy and have not been fully restored.”

Boston revenue bonds default

Boston’s Crosstown Center — a hotel, retail and parking development championed by Mayor Thomas Menino for public funding — has defaulted on revenue bonds issued through the city in 2002.

A default notice to bondholders was issued on Monday, according to recently disclosed documents. The notice covered senior revenue bonds and subordinate revenue bonds.

Bondholders include several municipal bond mutual funds. That group, for example, includes the Nuveen Massachusetts Premium Income Municipal Fund, which held Crosstown Center bonds valued at $963,000, according to a recent securities filing.

The city is not party to the default, a Boston redevelopment official said. The developer on the project, Crosstown Center Hotel LLC, is the borrower and will have to negotiate with bondholders to work out a settlement on the default.

For now, about $3.6 million in funds established by the bond indenture are being held by Wells Fargo, the newly appointed trustee for the bonds, according to the default notice.

In 2002, the City of Boston, through the Industrial Development Financing Authority, issued $43.4 million in bonds to help finance the $140 million development of a Hampton Inn & Suites hotel, retail space and parking at 811 Massachusetts Ave. in the city’s Roxbury neighborhood. At the time, Menino and developer Kirk Sykes fought for the project and heralded it as one of the largest minority-owned developments in the country.

Menino was not immediately available for comment.

In a recent notice to bondholders, Crosstown Center LLC said it drew about $491,000 from an emergency reserve fund to cover the debt-service payments on the senior and subordinate revenue bonds issued by the city in 2002.

Paul Bogart, regional controller for Crosstown Center Hotel LLC, said the draw from the debt service reserve fund constituted a material event, according to an Oct. 2 letter.

In October trading activity, senior revenue bonds from the project traded for 52 cents on the dollar.

Detroit weighing Chapter 9

Detroit -- Detroit Public Schools, facing a $259 million deficit and diminishing cost-cutting options, has a recent California court ruling on its side as officials weigh Chapter 9, experts say.

Chapter 9, a rarely used form of municipal bankruptcy, could allow the district to discard its labor agreements, said retired U.S. Bankruptcy Judge Ray Reynolds Graves, who has been advising the district's emergency financial manager, Robert Bobb. "The bond obligations and the labor contracts are the big financial burdens on DPS," Graves said. "Failure of the constituents to make sacrifices will make Chapter 9 inevitable. If people don't want to make deals, then (the district will) have to file."

Moody's says munis default less than corporate bonds

Municipal bonds, especially those backed by the full faith and credit of issuers, default less than company debt and may provide investors with more of their money back, Moody’s Investors Service said.

The average default rate for Moody’s-evaluated investment- grade municipal debt in the five years after issuance from 1970 through 2009 was 0.03 percent, compared with 0.97 percent for similar corporate issues, the New York-based company said today. Of 54 municipal defaults in the period, only three were general- obligation bonds, Moody’s said.

“All of the revenue-producing power of a municipality can be brought to bear to service the debt” that carries a general obligation, Moody’s analyst Jennifer Tennant said in her report. That “drives the low default history of state and local government bonds.”

That record may be tested as the deepest recession since the Great Depression cut state and local government revenue by 6.7 percent in the third quarter of 2009, the U.S. Census Bureau said in December. Harrisburg, the capital of Pennsylvania, is considering bankruptcy as the city contends with $68 million in debt payments this year, more than its budget for police, parks and other services.

State tax collections in the first three quarters of 2009 fell the most in 46 years, the Albany, New York-based Rockefeller Institute of Government said last month.

‘Far From Over’

“While the recession may be over for the national economy, it is far from over for the finances of state governments,” the institute said in a report Jan. 7.

The majority of the 51 defaults in non-general-obligation bonds since 1970 were issued to finance universities, hospitals and housing projects, Moody’s said.

Municipal bonds traded for higher prices than corporate bonds after defaults in the study period, Moody’s said. The average 30-day post-default trading price for municipal bonds was 59.9 cents on the dollar, versus 37.5 cents for corporate senior unsecured debt, it said.

Defaulted municipal bonds eventually produced an average of 67 cents on the dollar for investors in post-default settlements, Moody’s said, with the amounts ranging from 100 cents to less than 5 cents. It didn’t provide comparable figures for corporate bonds.

Muni default is a "choice"

Matt Fabian, Managing Director of Municipal Market Advisors, discusses the reasons he doesn’t believe there is a “looming collapse of the municipal market.” Also; recent earnings statements show that bond insurers are still in trouble. Podcast download

Nightmare scenarios haunt states

One question keeps coming up as governors and legislators grapple with a seemingly never-ending stream of gloomy budget news that keeps getting worse: How bad can it get?

The answer, according to experts and a look through history, is probably that it could get worse than it has been in a generation — maybe even a lifetime — but not catastrophic.

“If revenues don’t pick up, states are going to be in a pretty tough spot when we get to 2011,” said Kim Rueben, a state and local tax policy expert with the Urban Institute. “Do I think it’s going to be the end of the world as we know it? No.”

Bankruptcy, at least the scenario where a judge would take control of a state’s finances, is off the table. Bond defaults, the cardinal sin of public finance, seem highly unlikely for states. Another federal bail-out is plausible. Some state governments may even be fundamentally overhauled. But the worst for most states will sound familiar: service cuts, tax hikes, IOUs, layoffs, furloughs and political gridlock.

In other words, Rutgers University public policy professor Carl Van Horn said, state budgets for next year will look a lot like those passed for this year — “only worse.”

In the halls of many state capitols, many others are repeating that same refrain.

California legislators spent the last year closing a $60 billion gap for the last two fiscal years. Already, though, legislative analysts predict the state will be short another $20 billion by June 2011. The bad news is expected to continue even after that, with gaps of roughly the same size persisting through at least 2015.

“The scale of the deficits is so vast that we know of no way that the legislature, the governor and voters can avoid making additional, very difficult choices about state priorities,” the report from the Legislative Analyst’s Office stated.

Outgoing Virginia Gov. Tim Kaine, a Democrat, is preparing a budget plan for the state’s next two years, when the state’s revenues are expected to drop $3.6 billion. Kaine said he is worried about the proposal, even though his successor, Republican Bob McDonnell, will determine the budget’s final form.

"The things that get put in front of me in terms of cuts are ... tougher and tougher, and somewhere in whittling down that $3.6 billion number, I know I am going to get a cut that I don't want to make," Kaine told The Associated Press.

The nuclear option: bond defaults

Believe it or not, things have been far worse for states. Consider, for example, Arkansas during the 1930s.

Arkansas was already in bad shape when the Great Depression hit. In 1927, the state took over the task of building highways from local authorities, because the locals built far more roads than they could pay for. The state takeover included new revenue for the roads, but it also authorized the state to build even more highways.

The result, said University of Arkansas Little Rock history professor Fred Williams, is that the state debt mushroomed. The local economy took a big hit when a third of the state flooded in 1927, and the stock market crash two years later made things worse. By 1933, Arkansas piled up $160 million in debt. That meant, of its annual $14 million budget, the state spent $13 million on debt service for roads.

The state simply couldn’t keep up with its bills. In 1933, Arkansas defaulted on its bonds — the only state to do so during the Great Depression — and its state government essentially functioned on federal money for two years. It started digging itself out only when it passed a sales tax, and even then, the state had to stop building roads for 16 years.

The Great Depression default wasn’t Arkansas’ first missed debt payment. The state was one of eight states, along with the territory of Florida, to miss its bond payments in the early 1840s.

That wave of defaults came in the wake of the Panic of 1837, a banking crisis that triggered a five-year recession. Generally, the Northern states of Illinois, Indiana, Maryland, Michigan and Pennsylvania were unable to pay debt service for bonds they used to build canals and other infrastructure improvements. Arkansas, Louisiana and Mississippi in the South, along with the territory of Florida, ran into trouble when state-backed banks for large landowners became insolvent.

The defaults didn’t cripple the states’ ability to borrow for long, but, in Mississippi’s case, the state’s refusal to pay bondholders hung over the state government until 1996. That’s when the state Supreme Court dismissed a case brought by the heirs of British bondholders who sought $13.8 million for the $1.5 million of debt they held, plus 152 years of simple interest.

With the toll the Great Recession is taking on state governments, many people have asked whether the crisis again would lead to defaults on state bonds. New York Gov. David Paterson (D), who invoked the possibility of late payments to vendors and a credit rating downgrade to convince his own legislature to make mid-year cuts, raised the prospect that California would default.

California state officials quickly rebuked him.

After a newspaper columnist also broached the specter of a possible bond default, state Finance Director Mike Genest, state Treasurer Bill Lockyer and state Controller John Chiang asserted that even humoring the idea of a California bond default hurt the state.

“To suggest, much less assert, California will default is irresponsible. It hurts investors. Most important, it endangers the financial interests of taxpayers. They pay the tab if unfounded fears of default further erode California’s credit standing,” the three wrote in a letter to the Sacramento Bee.

The officials argued that in California, which has the worst bond ratings of any state, bondholders will be paid no matter what. Its annual debt payments are only about $6 billion, compared to $90 billion in yearly revenues.

Earlier this year, Lockyer said the only way California would default is a “thermonuclear war.” In November, Genest said even that might not be enough. “I’m not even sure if thermonuclear war would prevent us. It would depend on whether it fell on the treasury,” he said.

In fact, few people realistically expect California — or any other state — to skip its bond payments anytime soon. Alex Grant, a San Francisco investor who focuses on state and municipal bonds, said California’s bonds are still attractive, despite the state’s poor financial shape. “There’s a lot of press about (defaults) but I don’t know if necessarily the professionals who deal with it on a daily basis are that concerned about it. I think they’re viewing it as an opportunity,” said Grant, a portfolio manager with the RS Tax-Exempt Fund. Grant, whose firm's investments include California bonds, said the low risk of default and the high returns make California bonds good investments.

The California constitution protects bondholders by requiring them to be paid right after schools. Indeed, California’s controller in February put a rare 30-day hold on paying most state bills, including personal income tax returns, to guarantee there would be enough cash in the bank to pay schools and bondholders.

Even without such laws, though, states have plenty of motivation to honor their debts: they want to keep bondholders happy. So even in a state such as Vermont, where the constitution doesn’t include specific protections for bondholders, officials say there is virtually no chance of default. Vermont Treasurer Jeb Spaulding (D) said the Green Mountain State won’t have any problems paying its roughly $70.7 million in annual debt service, which is barely 7 percent of its $1 billion general fund.

“The state has pledged its full faith and credit and all the potential revenues of that state to support those bonds,” Spaulding said. “I don’t think it’s within the bounds of reality that states are going to default on their bonds.” Other doomsday scenarios

Bond defaults are not the only nightmare scenario keeping state budget experts awake at night. Genest, who is quitting at the end of this year as California Gov. Arnold Schwarzenegger’s (R) budget director, said at a Washington, D.C., gathering in November that he researched several drastic options to solve the Golden State’s seemingly intractable budget problems. Whether California could declare bankruptcy or something like it was one possibility, he said. Basically, that would give the state protection from its creditors, while a judge would oversee a major reorganization of state finances.

For a company or a person, going bankrupt means the bankrupt party cannot pay its creditors. The debts are too high and income isn’t enough. An outside mediator, usually a judge, decides which creditors should get paid how much. The referee also can order major changes in a company to make it viable going forward, which is how General Motors and Chrysler were overhauled during bankruptcy earlier this year.

But governments are a different story. It’s assumed they can raise taxes or cut services and therefore find money to pay their creditors, explained George Mason University law professor Todd Zywicki.

That said, Congress gave municipalities the ability to declare bankruptcy during the Great Depression, because so many local governments were struggling. Congress chose not to give states the same option, because it wanted to avoid interfering with states’ constitutional protections against lawsuits. As a result, there is no firm legal process that states can follow to get protection from their creditors.

That doesn’t mean states are in the clear, though. Courts still have a hand in determining what services states can cut and how much they must spend to remedy situations, such as jail overcrowding, that courts find unacceptable.

Such is the case in California. Federal courts have ordered the state to reduce prison overcrowding by a third. The state is also operating under several court-ordered mandates to provide certain medical services for Medi-Cal recipients. Medi-Cal is California’s Medicaid program, a joint state-federal venture that provides health insurance for poor Americans.

Perhaps the most visible example is the court-appointed receiver who runs the state prison health system, independently of the state corrections department. Other court rulings blocked cuts in home health care services for disabled patients and prevented the state from using gas tax money in a road fund for general operating expenses instead.

“The biggest nightmare scenario for me is this: What if we get to the point where we cannot obey the courts and all of their orders to fund Medi-Cal and pay for Medicaid services?” Genest said at a Washington, D.C., gathering in November.

Too big to fail?

A far more likely outcome, experts said, is that the federal government would come to the aid of states again. Already, the $787 billion stimulus package, some $300 billion of which is directed to or through states, passed early this year, has cushioned the recession’s blow to states by paying more money for Medicaid and schools, the largest two expenses on state ledgers.

“I can’t imagine the federal government not extending (Medicaid relief) and stimulus money for schools,” said Rueben, the Urban Institute economist. Indeed, President Obama suggested earlier this month that some of the leftover money in a fund used for bailing out Wall Street should go to help states and local governments. He did not provide much detail.

Federal intervention has happened before. Congress provided some relief for states following the 2001 recession. Congress in 2003 gave states $20 billion to help patch budget gaps after that downturn. Half of that amount was in federal funds to cover Medicaid costs.

Although relatively rare, a precedent for a federal rescue was set way back in the early days of the Republic, when Alexander Hamilton persuaded Congress to assume the Revolutionary War debts of the original 13 colonies.

Members of Congress likely will be skittish about providing more relief, but federal lawmakers’ recent decision to extend the stimulus package’s tax credit for first-time homebuyers shows Congress wants to ensure nothing drags down the recovery, Rueben said.

If all else fails, California and other troubled states could make the “too-big-to-fail” argument when asking for a federal bailout, said Zywicki, the George Washington law professor. The federal government turned down California’s pleas for help twice — once last year and again this spring — but it may have to revisit that position if the state’s outlook darkens.

“The reality may be that people perceive that there’s an implicit federal government guarantee of the debts of states so that when push came to shove the federal government would not allow California to default,” said Zywicki.

Rethinking the duties of state government

Talking to a national group of statehouse reporters this summer, Indiana Gov. Mitch Daniels (R) suggested that the Great Recession would force state policymakers to rethink what types of services states can provide, or even afford.

The head of the Michigan House of Representatives’ non-partisan fiscal agency, Mitchell Bean, said lawmakers there have cut so much during the state’s eight-year recession that they must now eliminate entire programs. More across-the-board cuts simply won’t save enough, he said. They could, for example, stop paying for prescription drugs for Medicaid recipients. They could rework their criminal sentencing laws so that the state doesn’t have to house as many prisoners. Legislators could target cash assistance programs for the poor or support for public universities, Bean said.

There is some precedent for major changes during major crises. In the Great Depression, North Carolina overhauled its universities, highways and health services, based on the recommendations of a study requested by Democratic Gov. O. Max Gardner on ways to streamline government.

But the protracted fiscal crisis that could linger another several years may actually prevent state officials from stepping back to think strategically, Rutgers’ Van Horn said. They simply may not have time.

“Long-term thinking doesn’t apply to short-term budgets,” he said.

For example, Van Horn said, if a state decided to privatize state parks or change its retirement options for new employees, the budget savings wouldn’t come for years. Those changes don’t solve lawmakers’ immediate money problems, he said.

To make matters worse, the vast majority of today’s state leaders haven’t ever had to confront a recession as deep as the one now devastating state budgets, Van Horn said. The last downturn to come close to the current one occurred in the early 1980s, a generation ago. That means the current crop of elected officials “learned that a boom follows a bust.”

Speaking as an economist, Van Horn said, “That’s not true.”

Rueben is more optimistic but concedes that it will be tough for lawmakers to look at the bigger picture.

“I do think there is going to have to be a fundamental thinking through of what government should be doing,” she said. “Whether that’s done in a measured way or it’s just we’re going to keep patching and not really think about what we’re doing is the open question.”

State shutdowns and finding solutions

Ultimately, budget crises in some states can even lead to the closing down of state government for brief periods, said Chris Mooney, a political science professor at the University of Illinois Springfield.

State shutdowns, or at least the credible threat of one, may be one of the few things that convince lawmakers to make the more difficult, sometimes unpopular decisions, like raising taxes and cutting services, he said.

“Kids have to go to schools, cops have to be on the streets, social services have to be provided,” Mooney said. The shutdowns rarely last more than a week, because so many vulnerable people depend on state government, he said. “People starve to death otherwise. Kids die otherwise.”

To break the political gridlock, leaders — especially governors — must step up and offer a plan, Mooney said. “It always takes leadership to do things that voters don’t want. Somebody’s got to say this is what needs doing,” he said.

— Stateline.org intern David Harrison contributed.

Contact Daniel C. Vock at dvock@stateline.org.

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