What Would It Mean If U.S. States Went Bankrupt? - YouTube

The coronavirus pandemic is hitting America hard.

Countless Americans are being advised to stay home as much as possible.

And governments are telling nonessential businesses to stay closed.

But governments themselves are also taking a hit.

Much of the economy has either slowed down dramatically or ground to a

halt. And with all that lost economic activity come the tax revenues

governments depend on to pay for their massive budgets.

On April 21st, Senator Mitch McConnell said he would support the idea of

letting states declare bankruptcy.

Later, he walked back his comments.

But the episode resulted in a firestorm of media commentary.

"Come on, man, that is completely and utterly irresponsible.

This is no time for bankruptcies and wishing bankruptcies."

"The most un-American, uncharitable, ugly statement of all times." Of

course, there are reasons to be concerned about state's fiscal health.

"I think the big difference between this downturn and what we saw in the

Great Recession or the recession of 2001, 2002 is the speed with which it

came on and the severity with which it came on.

That really makes it unprecedented from a credit standpoint.

States entered this in a stronger position, but they're going to have to

use all of the tools that they have available to them to maintain their

credit quality through this."

An array of industries have been badly hurt since the coronavirus began to

spread. Travel and tourism have tanked.

Stores are shuttered and restaurants are relying on takeout and delivery

to try to stay afloat.

As all that business dries up, so do the sales and tourism taxes that go

with it. Some states, such as Washington, Arizona, Nevada, Louisiana, and

Tennessee all rely heavily on sales tax for their revenues.

A number of states with high sales taxes collect no state income tax at

all. But income taxes are also taking a hit.

A staggering 30 million Americans have filed for unemployment benefits.

The federal government has also extended the tax deadline from April 15th

to July 15th, and many states have adjusted their own deadlines

accordingly. That means that for the next three months, they will have to

do without whatever state income tax revenue would otherwise remain.

Meanwhile, states have to keep paying for services.

Roads need to be maintained.

Government workers still need to be paid.

And governments are now also saddled with medical and unemployment

expenses. There could be more hurt ahead for city and state finances

across the U.S.

By law, municipalities such as cities can declare bankruptcy.

But states cannot, and they never could.

However, some in the legal world have argued that state bankruptcy should

be a viable option and it's a better alternative to bailouts.

University of Pennsylvania law professor David Skeel is one of them.

He and fellow U Penn professor Robert Inman co-authored an editorial on

May 5th arguing that McConnell was right to say that emergency aid from

Congress should not be a bailout for state deficits that have nothing to

do with the pandemic. They argue that Congress should act as an insurer of

last resort and only hand out aid to states for losses incurred during the

pandemic, and not for pre-existing problems.

Skeel has argued in the past that states in deep financial trouble should

be allowed to file for bankruptcy.

Inman is skeptical.

But it is clear that McConnell is not the only person who has expressed

support for the idea.

So legally, why can cities, towns, or school districts declare bankruptcy

when states are unable to?

Since 1937, the federal bankruptcy code has allowed municipalities to

declare bankruptcies. Municipality is a broad term that basically includes

all kinds of subdivisions of states, such as towns, cities, and counties,

but also school districts and some government organizations within a state

that collect revenue but don't cover a geographic area, such as a bridge

authority. But the contracts clause of the U.S.

Constitution prohibits states from impairing the obligation of contracts.

Subsequent Supreme Court decisions have generally supported the notion

that states cannot refuse to pay their debts.

"So in our constitutional system of federalism, there's really only two

sovereigns. There's the sovereign United States government and there's the

sovereign state governments.

There's no such thing as a sovereign city government.

And so the idea is that the United States has been thought not to be

allowed to do things that would impair the ability of the states to

function as governments.

But there's no similar principle that would prevent the federal government

from doing things that would impair the ability of cities to function as

governments, because cities are not dual sovereigns the way states are."

So for states to even legally allow themselves to declare bankruptcy.

Congress would have to pass a law adding language to the federal

bankruptcy code that explicitly allows states to declare bankruptcy.

Then individual states would have to each pass a law that allows them to

declare bankruptcy.

Finally, the Supreme Court would have to determine that all that

legislation does not conflict with the Constitution.

So if a state declared bankruptcy, then necessarily that means that some of

their creditors would not get paid in full what the state owes them.

And so those creditors would take that case to the Supreme Court and argue

that it was unconstitutional for the states to be relieved of the debt to

the creditors. So that's how we get to the Supreme Court.

That would be the last step in the process.

So if it's even possible, it's not a process that would be likely to happen

quickly. The question of whether states should be able to file bankruptcy

is a thorny one. And there are some critics of the idea that say allowing

states to file for bankruptcy would, for example, raise the risk of

lending money to states.

It could also put the interests of creditors against the interests of

states. But the idea does have support.

David Skeel, the University of Pennsylvania law professor, made the case

for letting states go bankrupt when the country was in the depths of the

recession, spurred by the financial crisis of 2008.

At the time, several cities and states were in deep financial trouble,

which some, such as Skeel, attributed to runaway expenses.

"Allowing states to file for bankruptcy would save taxpayers a great deal

of money," he said. Such laws could be squared with the Constitution and

could be structured in a way that ensured bankruptcy courts did not

override the states abilities to pass their own laws.

"Anyone who proposed even a decade ago that a state shouldn't be permitted

to file for bankruptcy would have been dismissed as crazy," Skeel wrote in

2010. "But times have changed."

"States always have the ability to pay their debts by raising taxes.

There's some views that would say that's not a good thing to do.

And then states also have the ability to pay their debts by borrowing.

But there's often even more consensus that that's not a good thing to do.

And a lot of states actually operate under their own state, a balanced

budget amendment which are in their state constitutions.

So states could change those.

There's no federal requirement that states balance their budgets.

But a lot of states have imposed that requirement on themselves.

And so if you think that a state should keep a balanced budget, it

shouldn't raise taxes and it doesn't- And the state doesn't have enough

money to pay all its bills.

Then bankruptcy starts looking attractive.

Right. So I think there's some there's some people who want to take those

other two options off the table.

And then they say, well, if you're not going to contemplate those other

two options of raising taxes or borrowing money, then bankruptcy is the

most orderly way to figure out how a state is going to pay pay some bills

if it doesn't have enough money to pay all of them.

But I think, you know, people on the other side of that partisan divide

have not been as opposed to states sometimes raising taxes or sometimes

borrowing. And those would be alternative ways of getting the bills paid

without really requiring the creditors.

But the situation prompts another financial question: whether coronavirus

is even putting states in a position where they would need to declare

bankruptcy if it was a legal option.

And none of the research from the three largest credit rating agencies in

the U.S. suggest any states are in danger of defaulting on their debt

obligations. "Nearly all of the states are in very strong credit position.

And that's not even something that they need to think about.

There certainly would be constitutional issues of the federal government

somehow overseeing state finances.

But it's not an issue." In fact, states tend to have pretty high credit

ratings. "So two-thirds of our states are in our two top rating

categories. And that really reflects the broad range of powers that states

have over their finances.

They determine what taxes they have.

They determine what tax rates they have."

The reason is that despite the trouble they face, states have a pretty high

degree of financial flexibility.

They tend to have very large tax bases.

Of course, that varies depending on the size of the state's population and

the health of its economy.

But overall, their sheer size gives them a deep well to draw from.

They also have two fundamental levers to pull.

They can raise taxes and cut spending.

States can push some expenses down to local governments.

Aside from that, they can also issue debt.

State debt issuance activity has been relatively flat over the last

decade. "States generally only borrow for capital purposes to build

schools, jails, essential government facilities.

They don't really borrow for operations overall.

They're in a strong position as it relates to debt.

We might see some states do deficit financing through this crisis

depending on how bad the revenue situation is.

That is atypical for the sector.

But it is another option for states that also generally have very good

market access." In fact, many states are not out of cash yet.

The financial recovery of the last 10 years or so has allowed many states

to build up rainy day funds that can be quite large and hold some of them

over for a while. In mid-April, the median available state governmental

fund was 8% of fiscal 2018 year spending, according to Fitch, one of the

three major credit rating agencies.

"25 states had reserve levels high enough to cover the largest revenue

decline they had had before coronavirus.

And we, of course, don't expect that states will solely solve their budget

problems with reserves, and coronavirus probably has created revenue

problems that their reserves can't handle altogether.

We expect to see states take structurally-balanced solutions, but they have

significant powers over their finances."

As of April 30th, credit rating agency Moody's had not downgraded any

states because of the coronavirus pandemic.

It had, however, lowered outlooks on a few states.

A lowered outlook means there could be some downward financial pressure on

states, and it also means that they are at a greater risk of a downgrade

in the future. In early May, Moody's lowered its outlook on all U.S.

states from stable to negative, citing uncertainty as to when life will

return to normal across the country.

That does not mean states are all going to be downgraded, but it does mean

the economic downturn has accelerated, and there are rising state revenue

headwinds, especially in sales and income taxes.

"That sector outlook really reflects that the operating environment for

states is much weaker than it was going into the coronavirus crisis.

The employment situation has weakened significantly.

Consumer sentiment has weakened significantly.

Spending has weakened significantly.

And all of that is having negative impacts on state tax revenue.

We estimate that in the current fiscal year and the next fiscal year that

starts July 1, that state tax revenue will be 15% lower than it was in the

last fiscal year."

The three states that have Moody's lowest credit ratings are Illinois, New

Jersey, and Connecticut.

All three have deep structural financial difficulties that pre-date the

pandemic. Of the three, Illinois is by far in the worst shape.

"There are two states in particular, Illinois and New Jersey, that had

pre-existing credit conditions coming into the coronavirus crisis.

Those two states have very high fixed costs for debt service pensions and

retiree health care relative to their revenue compared to other states.

That just limits their financial flexibility and how they will be able to

manage through this.

That contrasts sharply with triple-A rated states like Utah or Tennessee

that have very low fixed costs.

And that just gives them a lot of runway to be able to manage through this

crisis." Credit rating agency Standard and Poor's lowered its outlook on

New Jersey April 29th, in part because of coronavirus-related effects.

The state still has an A-minus rating, well within investment grade.

However, Fitch downgraded Illinois to BBB-minus, the lowest investment

grade, on April 16th.

But even for states in relatively good shape, there are a number of

concerns on the horizon.

"The problem for state finances probably really started in March, when

social distancing and quarantine policies really began to have an impact

of economic shutdown.

And that's had a very sudden and severe impact on sales tax revenues, in

particular because people are really only consuming the essentials right

now: groceries, pharmaceuticals, and the like.

And those largely aren't taxed.

Sales taxes for states are about 30% of overall revenue.

But in some states, that's as high as 70%.

Despite a record $115 billion dollars in aggregate cash reserves on hand

for all states combined, few will be able to cover their projected tax

losses with cash, Moody's said in a recent report.

The agency expects coronavirus will reduce state tax revenues by $160

billion dollars from fiscal year 2019 to fiscal 2021.

Fiscal 2021 tax revenue is expected to be $200 billion dollars less than

governments would otherwise collect if there were no downturn and moderate

growth. Even if an upturn were to begin in 2022, Moody's base case

projection doesn't see state tax revenues returning to 2019 levels until

2024. "Achieving revenue consistent with a moderate growth path is even

more out of reach," the agency said.

Arizona, for example, finished 2019 with a $1 billion dollar surplus.

But a recent report from the state's Joint Legislative Budget Committee

projected a $1 billion dollar deficit by 2021, due in large part to the

effects of the virus.

There are other red flags popping up around the country that credit

agencies are watching.

Hawaii's State Council on Revenues recently lowered the general fund

revenue forecast by about $300 million dollars through the next fiscal

year, primarily due to coronavirus effects.

In the state of Washington, the Department of Health asked for an

additional $100 million dollars from the state legislature to combat the

virus. In California, San Francisco's city controller recently reported

sharp declines in hotel occupancy and airport traffic, and he estimated

city revenue losses in the tens of millions of dollars.

2019 was a record year for tourism in the city, according to the San

Francisco Travel Association.

Tourism brought in $819.7 million dollars in taxes and fees for the city

that year, a 6% increase over 2018.

About 51% of that amount came from hotel taxes alone.

The Federal Reserve established the municipal liquidity facility to help

state and municipal governments deal with cash flow pressures.

The facility will purchase up to $500 billion dollars of short-term notes

directly from U.S. states, including the District of Columbia, U.S.

counties with a population of at least 500,000 residents, and U.S.

cities with a population of at least 250,000 residents.

The federal government has set aside one $150 billion dollars for state

and local governments through the CARES Act, and there will also be an

additional $10 billion dollars through Medicaid per fiscal quarter, much

of which is likely to be eaten up by virus costs.

There is also a $45 billion dollar Disaster Relief Fund and $25 billion

dollars for mass transit.

But state and local governments are asking for another $750 billion

dollars from the federal government, five times the enough allocated in

the CARES act.

And there is no clear idea of when case numbers will drop low enough to

allow the country to get back to work.