With liquidation off the table, the effectiveness of state bankruptcy would depend a great deal on the state’s willingness to play hardball with its creditors. The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees. Ideally, bondholders would vote to approve a restructuring. But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be “crammed down” over their objections under certain circumstances. This eliminates the hold-out problem—the refusal of a minority of bondholders to agree to the terms of a restructuring—that can foil efforts to restructure outside of bankruptcy.But California would have to be willing to submit to such a procedure. Somehow I don't see the Democrats who have ruined the state being willing to take such a drastic measure to fix the crisis that their coddling of the public unions have created.
The bankruptcy law should give debtor states even more power to rewrite union contracts, if the court approves. Interestingly, it is easier to renegotiate a burdensome union contract in municipal bankruptcy than in a corporate bankruptcy. Vallejo has used this power in its bankruptcy case, which was filed in 2008. It is possible that a state could even renegotiate existing pension benefits in bankruptcy, although this is much less clear and less likely than the power to renegotiate an ongoing contract.
But Skeel makes a good point about the value of Congress passing such a bill to prepare for when California comes to Washington asking for a handout.
With the presidential election just two years away, the pressure to bail out California, Illinois, and perhaps other states is about to become irresistible. As we learned in 2008 and 2009, it is impossible to stop a bailout once the government decides to go this route. The rescue of Bear -Stearns in 2008 was achieved through a “lockup” of its sale to JPMorgan Chase that flagrantly violated corporate merger law. To bail out Chrysler and General Motors, the government used funds that were only authorized for “financial institutions,” and illegally commandeered the bankruptcy process to give the car companies a helping hand. There is, in short, no law that will stop the federal government from bailing out profligate state governments like those in California or Illinois if it chooses to do so.Beggars can't be choosers. When Jerry Brown asks for that bailout, he may be reminded of that aphorism.
The appeal of bankruptcy-for-states is that it would give the federal government a compelling reason to resist the bailout urge. President Obama is no doubt grateful to California for bucking the national trend in the election this month, but even he might resist bailing the state out if there were a credible, less costly, and more effective alternative. That’s what bankruptcy would offer.
Indeed, even those who still believe (quite mistakenly, in my view) that the 2008 bailouts were an unfortunate necessity for big financial institutions like Bear Stearns and AIG, and that bankruptcy wasn’t a realistic alternative, should agree on the superiority of bankruptcy for states. The case for bailing out financial institutions rested on a concern that their creditors would “run” if the bank defaulted, and that the big banks are so interconnected that the failure of one could have devastating spillover effects on the entire market.
With states, none of these factors applies in anything like the same way. California’s most important creditors are its bondholders and its unionized public employees. The bond market wouldn’t be happy with a California bankruptcy, but it is already beginning to take account of the possibility of a default. And bondholders can’t pull their funding the way a bank’s short-term lenders or derivatives creditors can. As for California’s public employees, there is little reason to suspect they will be running anywhere.
Bankruptcy isn’t perfect, but it’s far superior to any of the alternatives currently on the table. If Congress does its part by enacting a new bankruptcy chapter for states, Jerry Brown will be in a position to do his part by using it.