Why State Bankruptcies Are Unlikely

Senate Majority Leader Mitch McConnell’s comments that he would favor allowing states to declare bankruptcy rather than receive aid from the federal government led to questions about the impact on state finances and the municipal bond market. Based on input from managers, this is an unlikely scenario.

(Estimated reading time: 2 min 31 sec)

Here’s a brief summary of the important points about this issue:

  • The U.S. Bankruptcy Code prevents states from declaring bankruptcy. New legislation would need to be enacted to change the code.
  • Even if that happened, there is debate about whether such a law would violate the U.S. Constitution’s 10th Amendment, which says that states are sovereign entities and are responsible for their own financial affairs outside of the influence of the federal government.
  • States would also need to alter their own constitutions and pass legislation that gives governors the authority to seek bankruptcy protection.
  • States would need to pass an “insolvency” test, which is seen as unlikely given states’ abilities to raise taxes, cut costs, and draw down cash reserves. They may have a fiscal crisis, but “insolvency” is unlikely given these tools.
  • Bankruptcy is not the right solution. Eric Kim, head of the state government group at Fitch Ratings, said in an article in The Hill that “companies will file bankruptcy to address long-term liabilities, but states’ main issue is currently the economy and lower revenues rather than long-term liabilities. Declaring bankruptcy doesn’t fix the economy.”

The economic downturn resulting from COVID-19 will likely wreak havoc on many state budgets. However, many states entered 2020 with more reserves than they had prior to the last crisis. According to a March piece from Pew, “A decade after the Great Recession, states collectively have amassed their largest fiscal cushion in at least two decades. As most states closed out their 2019 budget year, a surge in tax collections drove the total held in savings and leftover budget dollars to a record high. More than two-thirds of states—the most yet—could cover a bigger share of spending with rainy day funds alone than they could just before the downturn. Thanks in large part to two consecutive years of widespread budget surpluses, fiscal 2019 was a banner year for states’ financial reserves, which provide a pool of money to help plug budget gaps during economic downturns and respond to other unforeseen challenges, such as the coronavirus outbreak.”

Further, aid programs such as the $500 billion Municipal Liquidity Facility and portions of the recently passed CARES Act that will provide funding for certain COVID-19 expenditures will also help to soften the blow. Finally, if changes were made to Chapter 9 proceedings to allow states to file for bankruptcy, access to capital markets could be significantly impaired and, at the very least, would raise the cost of borrowing. This source of funding is essential to help them manage through the economic challenges that lie ahead.

However, the playing field is not even, and some states and municipalities are better able to weather the economic downturn than others. We continue to believe that active management for municipal bonds remains essential.