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Written by: Mark Stockwell, VP, Municipal Credit Analyst
During a radio interview last week, Senate Majority Leader Mitch McConnell (R-KY) indicated that he would prefer that states use the bankruptcy code to address their pension liabilities rather than have the federal government allocate additional funds to “bail out pensions by borrowing money from future generations.” McConnell was responding to a commentator’s suggestion that states should be authorized to file bankruptcy to address growing liabilities. The comments came as Congress has started considering additional financial support for state and local governments to offset precipitous declines in tax revenue caused by Covid-19. Despite McConnell’s comments, we expect that Congress will eventually provide additional assistance to state and local governments. We also expect that there will be no substantive initiatives in Congress to authorize state bankruptcy. However, given McConnell’s comments, any state leaders who want direct federal assistance for state pensions should expect to be disappointed.
As states are currently excluded from filing Chapter 9 (municipal) bankruptcy, Congress would need to amend the bankruptcy code to authorize state bankruptcy filings. The idea of state bankruptcy authorization usually surfaces during periods of fiscal stress, but there has often been bi-partisan opposition to pursuing any such initiatives. Responses to McConnell’s comments appear to follow the previous pattern. House Speaker Nancy Pelosi (D-CA), whose support for a revision to the bankruptcy code would be needed for its passage, has dismissed McConnell’s idea. Additionally, she has indicated that the next stimulus package will include a “major package” for state and local governments. President Trump echoed her statements and argued that as part of the phase four stimulus package, states will need assistance. “I think most Republicans agree too, and Democrats,” he added.
We also expect that any Congressional action to authorize state bankruptcy, while unlikely, would face constitutional challenges. There is no a consensus among constitutional scholars that a state could file for bankruptcy under the U.S. Constitution. Furthermore, most state officials have opposed initiatives to authorize state bankruptcy filings. The consensus so far has been that Chapter 9 would not provide a long-term benefit to states.
We also note that the utilization of Chapter 9 to cut pension liabilities among municipalities has been limited. Bankruptcy judges in the Stockton, CA bankruptcy (2012) and in Detroit (2013) hinted that bankruptcy could possibly be used to cut pensions for current employees and retirees. While some retirees agreed to a 4.5% cut to their pensions in the Detroit settlement agreement, the Stockton judge approved the bankruptcy plan even though it excluded pension cuts. While there have been proposals for pension cuts in the restructuring of the Commonwealth of Puerto Rico’s debt, Puerto Rico’s restructuring has been authorized under special legislation, not Chapter 9.
The federal government has a long-standing record of supporting the states during turbulent times, and expectations are that this trend will continue through a phase four stimulus package. The timing is unclear, but Congress is not expected to return to Washington until May 4th, and a package will likely occur quickly thereafter. Given the severity of the global pandemic, state and local governments are facing unprecedented fiscal strain from revenue falling at the same time Covid-19 expenses are increasing. While any stimulus measure enacted would not make entities entirely whole, it would provide much needed and expected relief that could aid in covering some shortfalls, stimulating job growth and economic development, and protecting the health and well-being of citizens.
It is also important to note that despite our view of state bankruptcy being unlikely, we do not believe all is clear for bondholders in states/municipalities with weak finances. For example, bonds issued by the state of Illinois have underperformed meaningfully since the Covid-19 crisis began. We expect this price action to continue for municipalities with weak financial profiles and speaks to the importance of sound and thorough credit analysis, both in good times, and in bad.
Source: Bloomberg, Office of Senator Mitch McConnell, April 22, 2020.