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.