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State Bankruptcy: An Idea That's Ready for Primetime?

Tuesday, 18 Jan 2011 | 3:53 PM ET

Changing federal bankruptcy law to allow individual states to file is an idea that appears to be gathering momentum—and opposition.

Under current US bankruptcy laws, the states are prevented from filing for bankruptcy—as municipalities now are permitted to do in about half the states. But the rhetoric is heating up, according to an article in the LA Times, in the weeks since my colleague Nicole Lapin reported on the topic.

On the one hand, many of those who support changing the law say they are just being realistic about the precarious finances of the states. Those who support the idea say that deficit-ridden states simply cannot afford to support the unfunded pension and health-care liabilities with the state public employees' unions. And, moreover, unions have very little incentive to enter into serious negotiation with the states in order to solve problems together.

Of course, there are those who see more nefarious motives.

For one, some believe state bankruptcy is merely a stalking horse to break the back of the public employees unions.

For example: " Chuck Loveless, director of legislation for the American Federation of State, County and Municipal Employees, says the groups agitating for the state bankruptcy option are doing so 'for the express purpose of reneging on collective-bargaining agreements'. 'We take this very seriously,' he said. 'They're trying to create this hysterical atmosphere.'"

And then there is Newt Gingrich. It seems the former speaker of the house is supporting the state bankruptcy provision. According to the LA Times: "Newt Gingrich, emphasize another motivation: They see the idea as a way for Congress to make clear to the states that they shouldn't come looking for a federal bailout."

(Gingrich mentions New York, Illionois, and California by name.)

There is also the flipside of the argument: Beyond the politics an ideological fervor, the actual financial costs could be overwhelming.

Again, from the LA Times:

"Faced with even the slight possibility of a bankruptcy filing by a state — and therefore the risk that the terms of the state's bonds could be renegotiated — investors would have to factor that into the interest rates they demand on munis. The result could be yields even above current levels that are now at two-year highs on many long-term issues.

"Higher borrowing costs, of course, would be another blow to cash-strapped state and local governments."

"It would just wreak havoc," Jeff Esser, chief executive of the Government Finance Officers Assn., said of the state-bankruptcy idea. His group's 17,500 members are state and local finance officials."

But the other options aren't palatable either.

California is currently engaged in 'deep spending cuts', as well as an extension of tax hikes. Here on the East Coast, the troubled city of Camden, New Jersey just laid off 25 percent of its workforce—including 168 police officers, which represents nearly half of its force. And the state of Illinois has just raised its state income tax rate by 66 percent.

In short, don't look for the issue of states in financial crisis to disappear from the headlines anytime soon. And as long as the issue is outstanding—and apparently insoluble—look for discussions to continue on the viability of state bankruptcy.

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