There are fiscal cliffs at every level of government, and it doesn’t help that states and many municipalities cannot legally go bankrupt.
Last week marked this season’s first pow-wow between Illinois’ union and legislative leaders regarding what has become known as a pension “funding crisis.” It surprised nobody (least of all Illinois’ Democratic House Speaker, who failed to attend) that this summit produced nothing new. Meanwhile, the pension driven deficit “widens by $17 million a day,” according to Bloomberg. The situation has become so dire, that the state has postponed a $500 million bond offer in hopes that some kind of solution will ameliorate the consequences of the latest S&P downgrade to A-.
Head southwest, and last week also marked the deadline for the latest hearing in the San Bernardino bankruptcy proceedings. Bankruptcy rules have so far protected the city from its obligations to the California Public Employees’ Retirement System (CalPers) until it has come up with a sustainable plan to pay off all its debts.
Finally, last week marked the final satisfaction to the fiscal meltdown in Central Falls, Rhode Island. The town filed for municipal bankruptcy in August 2011 and emerged 15 months thereafter. In the meantime, former mayor Charles Mureau pled guilty to federal corruption charges. He has now been sentenced to two years in prison for accepting gifts and directing city contracts to a political ally.
Though lately the federal “fiscal cliff” and its consequences have garnered national attention, Americans have paid comparatively little notice to the fiscal cliffs in their own backyards. Estimates of unfunded liabilities for state and local pensions vary, depending on who’s tabulating, but numbers like $1.4 trillion or $4.4 trillion are in the realm of possibility.
The fact that states have complete discretion over legislating how municipal debts are handled has further obscured their severity by complicating the way municipal bankruptcy is perceived.
A Hidden Problem
The Constitution gives Congress the responsibility to “establish…uniform laws for bankruptcies throughout the United States.” This it has done, more or less ably, in the Title 11 Bankruptcy Code.
Bankruptcy is important to commerce for reasons that are quickly obvious: It protects debtors from any kind of debtor’s prison and helps to ensure that creditors get as much of their investment back as possible. The process works smoothly in cases concerning private individuals (Chapter 7) and corporate enterprises (Chapter 11).
Chapter 9, which deals with municipalities, is trickier. And states simply cannot file for bankruptcy at all. The reason is simple: Much of the usual work of settling debts takes place in federal bankruptcy court. But due to the Constitution’s 10th Amendment, a federal bankruptcy court has no real power to enforce fiscal “solutions” on debt-laden municipalities. States have capitalized on these restrictions by putting up statutory barriers that prevent cities from filing a Chapter 9. Reasons for this are obvious enough—protecting a state or region’s credit rating and reputation as a good place to move to and start a business, as well as keeping control of finances in state. As a result, only 12 States provide blanket authorization to file Chapter 9, and a full 22 States prevent access altogether. The remaining 16 have restrictions and processes that vary from strict to lenient. In Illinois, a Governor-appointed commission has to decide filing is necessary, after first trying everything else to save the situation. In Idaho, on the other hand, the municipality simply has to adopt a resolution to authorize the filing.
These differences in state policy render any figures on Chapter 9 filings obsolete, and make it difficult to conduct any nationwide analysis of municipal financial health. It should not be surprising that the states with the least restrictions on filing come up as the states with the highest number of filings. Of all states, Nebraska tops the list, followed by California, Texas, and Alabama. These statistics do not conform to other measures of fiscal health: Texas, which continues to grow rapidly, would not be so high on the list in that case. Even California, lambasted these days as the most fiscally irresponsible state, may not be worthy of such a reputation. Despite such high profile Chapter 9 filings as Stockton (the largest city to ever file), Mammoth Lakes, Vallejo, and most recently San Bernardino, its pension funding problems are marked by some rating agencies as less serious than the ones in Illinois. And how many Chapter 9 filings are recorded from Illinois since 2010? Zero.
Since Chapter 9 filings are no comprehensive indicator of a city or region’s financial health, citizens and investors are forced to rely on other instruments—such as bond ratings agencies like Standard and Poor’s. But these are likewise flawed. The rating agency Fitch, for instance, ignores distinctions in state laws.
“Bond ratings tell you virtually nothing about whether or not a city is on the verge of service-level insolvency,” writes Mark Funkhouser, director of the Governing Institute. “A government’s bond rating is a lagging indicator of its financial condition. Waiting for a downgrade to adopt more prudent financial practices is like waiting until your car slams into a tree before you hit the brakes.”
Is Bankruptcy So Bad?
Municipal bankruptcy, though, might be the bitter medicine necessary to get a community back on track. This is especially true when compared to some kind of bailout or loan package that states use to put the problem off. At the very least, bankruptcy keeps the issue localized—so that fiscally insolvent cities and interest groups aren’t being permanently propped up by other regions within a state.
Mark Funkhouser, in his article “The Subtle Slide into Municipal Bankruptcy,” writes:
Filing for bankruptcy is a legal event, with a public declaration occurring on a precise date. Insolvency, however, is a financial condition that creeps in unannounced. Cities like Stockton and Central Falls were insolvent long before they declared bankruptcy….Once a city is in deep trouble, the only way citizens are going to be protected long-term is through bankruptcy. When a city declares bankruptcy, citizens can begin to get their services back. In bankruptcy, the city can determine the “net present value” of a reasonable stream of taxes and fees and then spread the pain among bondholders, employees and citizens to bring expenditures in line with that value.
It is easy to see at which stage of development Illinois and San Bernardino currently stand in relation to their fiscal woes: Central Falls—a closely supervised road to recovery, with the satisfaction of justice served to their former embezzling mayor; San Bernardino—in the unenvied position of fiscal protection while they sort out how to pay their debts; Illinois—a state of rapidly dwindling denial, in which solutions are quickly becoming beside the point.
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