Allowing the states to declare bankruptcy may save Washington some money, but we will all feel the pain. by Bill Gee
(centrist)
Monday, January 24, 2011
Representative Paul Ryan (R) from Wisconsin is working on legislation to remove some of the moral hazard from the state budget process by allowing states to declare bankruptcy. This proposal, favored by 2012 Presidential hopeful Newt Gingrich, would allow states that are currently bound to pay all of their obligations and maintain balanced budgets to renegotiate the terms of union contracts, pension plans, and debt instruments such as municipal tax-free bonds. On the surface, the proposed legislation looks like a good idea, but we should prepare ourselves for some unintended consequences should this legislation pass.
The problem is simple enough. State governments are broke and the national debt is threatening to swallow us into a black hole. For years, state governments have been promising more and more to its citizens, its workers, and those who purchase its debts, and they have failed to provide the revenue to support those promises. Already, states have had to slash programs, lay off thousands of employees, and leave road construction jobs unfinished. Despite some of the most aggressive cost-cutting measures in recent memory, all but one state in the US is "in the red". The option to declare bankruptcy is off the table, which leaves only two options remaining - raise taxes, or beg for money from Washington or a combination of both. The 2009 Stimulus provided states with much-needed stopgap funding, but the newly elected Republican majority in the House has already told the states that once the Stimulus funds are exhausted, no more money will be forthcoming. The Illinois state legislature has already raised income taxes by 66%, but this will unlikely be enough to fill that state's budget gap. Bankruptcy may be the only thing that can save the states from themselves, but it will take an Act of Congress to allow it to happen.
Anyone who has been through bankruptcy understands the basics of how it works. What you or your business is saying is that your income cannot sustain your debt obligations. Therefore, a bankruptcy judge or a trustee contacts your creditors, renegotiates the terms for those debts and either reduces the interest/payments for those debts or discharges them completely. For the states, this will be a windfall that will allow them to renegotiate pension plans and other contract provisions. This would include teachers, police, firefighters and a myriad of other unionized state workers. This would also allow them to reduce the interest on state municipal bonds. In some cases, the bond obligations may be discharged completely. On the surface, it sounds like a good idea, but there is a catch...
Municipal Bonds, also called Muni-Bonds, or Tax-Free Bonds have been considered some of the safest investments in the bond market, which is why they are owned by some of Wall Street's largest investors as well as by pension funds, 523 Plans, Health and Life Insurance Companies, etc. This is how they work on the state level.
Your state needs a new highway. The state Transportation Board decides that they do not wish to ask the state legislature to increase taxes to pay for the new highway, so they authorize a bond (with voter approval) that will spread the cost of the new highway over a period of ten to fifteen years. They will pay a nominal interest rate on that bond, about 3% to 7%, and when the bond matures, they will pay the bond off in full, or they will pay a portion of the balance and issue a new bond to pay off the rest. To make these bonds more attractive to investors, they include certain provisions. First, the interest received is not taxable income. Second, the bond is guaranteed because the state has the authority to raise taxes in order to pay off the interest and balance of the bond.
Now you get the idea why these bonds are so attractive. In essence, they are a risk-free/tax-free investment that pays a predictable level of cash income over a long period. Therefore, any investment instrument that is required to make periodic cash payments to its members can enjoy the benefits of this tool.
Unfortunately, just as with the sub-prime fiasco, the state municipal bond market was abused, this was the result of a combination of moral hazard and market demand.
Moral Hazard: State legislators saw the bond market as a means of easy money for pet projects. They could get the project done, which made their voters happy, and they did not need to raise taxes either, which also made their voters happy. The interest paid on the bonds was within current budgets, and when the bonds became due, they would simply issue new bonds to cover the balance. In the meantime, new projects would come along, which would require new bonds until the interest alone on the debt started to eat into state operating budgets. This ability to "kick the can" to the future created the moral hazard on the part of state governments and the belief that taxpayers would simply accept higher taxes to pay for bond balances created the moral hazard on the part of the investors.
Market Demand: The availability of risk-free/tax-free investment income was a temptation too great for investors to ignore. While investing in US Treasury bonds provides the same level of security, the tax-free aspect fueled demand for these securities to a level where almost every major investor had at least some of their portfolios locked into this market.
So what happens if states can suddenly declare bankruptcy?
1) Many existing bonds will lose their value. This could have serious consequences for pension funds, college savings plans, mutual funds, and any other investment that depended on these securities for low-risk instruments. Workers may find their pensions gone even if they never worked for the state a day in their lives!
2) The Muni-Market will freeze. Investors will no longer view these investments as risk-free, so fewer funds will be willing to buy them. Without the ability to issue new bonds, states will have to pay off the outstanding principle to their existing investors. However, since the state is already in bankruptcy, current bondholders will have to write off the value of their investments.
3) Insurance Companies may go bankrupt. Insurance companies, especially casualty, life and health companies enjoyed the security and predictability of the municipal bond market when investing the premiums they collected. Since insurance companies are required by law to keep about 75% of the premium they collect (on average) in reserve (to pay claims), losing a significant portion of their portfolio to bad debt would seriously undermine a company's ability meet its obligations and underwrite new policies.
In other words, our states' obsession with making promises and shifting the responsibility onto the municipal bond market has created a worst-case scenario. True, bankruptcy protection will help state governments to reorganize their finances, but the market has created such a complex web of interdependency that any effort to unwind this financial mess is likely to be felt by everyone in the economy both here and abroad. So do not be surprised if Paul Ryan's bill, assuming it gets past the House and Senate, gets a veto from the President.
Did you like this article? If you did, Thumb It! 2
thumbs so far
The views expressed
in this article are those of Bill Gee only and
do not represent the views of Nolan Chart, LLC or its affiliates.
Bill Gee is solely responsible for the contents
of this article and is not an employee or otherwise affiliated
with Nolan Chart, LLC in his/her role as a columnist.
