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On state bankruptcy and bond traders

by Bob Morris, published

The hard Right, spearheaded by Newt Gingrich, wants a law that would let states file bankruptcy. Many states, especially California, are in dire financial straits, and their fiscal houses absolutely need to be made solvent. However, such a law is also widely seen as an attempt to break public pension plans and unions along with it.

House Majority Leader Eric Cantor opposes a bill allowing state bankruptcies. Given his clout, the bill attempt seems dead. Besides, even if it did pass, it would immediately be challenged in court as unconstitutional. Cantor also opposes federal bailouts of states. This leaves states with apparently few options except to cut spending, raise taxes, and try to renegotiate agreements, especially pensions.  

Further complicating such attempts is that state bonds and pensions are often done through separate legal entities. So, a bankruptcy by a state doesn't necessarily mean the bankruptcy judge would be able to reach through to public pensions or bond debt issued by other entities. Even so, some, like CalWatchdog, passionately state the case for why California should go bankrupt.

Let's travel in the Wayback Machine, shall we, to the early 1990's, back when President Clinton found his economic agenda stymied. He remarked at a meeting, "You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of bond traders?" The unspoken subtext in the current discussion about states filing bankruptcy invariably circles around whether bondholders will take a haircut should states be unable to meet obligations. In a bankruptcy, bondholders might well be forced to take 70 or 80 cents on the dollar, with payments delayed too. The thought of this makes them deeply cranky, and as President Clinton discovered, they have real power.

The Irish legislature recently passed measures which will leave the country in significant debt for years, if not decades. That country will pay back bondholders at 100% on debt issued by their banks, which were up to their eyeballs in dodgy mortgages. Thus the Irish public will be paying for excesses committed by a few. This hardly seems right or just, and is precisely the point CalWatchdog is making about California.  The Irish government just collapsed as a direct result of this. Doubtless the new one won't be quite so bond-friendly.

Bond holders say that defaults or haircuts will have unseemly effects. They weep crocodile tears that default will only hurt those who default, because bonds will then be harder to get and cost more. (Gosh, that sounds like a threat, doesn't it?) But Iceland recently called their bluff, defaulted on all bond payments, and is now recovering. Their world didn't end.

We will probably see the functional equivalent of state bankruptcy soon. Too many states have obligations they can't possibly meet and the federal government is in no position to bail them out. One version of this may come if and when states default on bond payments. That's when the real fireworks will begin.

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