Can states default on their debt? The state of California has been in the news recently because of a $24.3 billion gap in funding. Is it possible that we may soon hear of a state actually going ‘bankrupt’? What are the economic and political ramifications if California takes such a step?
The Bond Raters
California state municipal bonds are rated investment grade by the major bond ratings agencies. Of course, in the recent past, these very same entities have had to fight criticism that they didn’t properly rate tranches of mortgage debt. In fact, a major complaint about the ratings agencies is they are too slow to act and there are too many conflicts of interest when rating securities.
Currently, ratings agencies often have a financial stake in the success of new financial products that they rate. Here is a look at how this relationship can work. The SEC, a much maligned agency, has actually recently railed against the agencies and called out the conflicts of interest. In my slightly cynical opinion, I feel that it’s possible California may already be in default on some of their obligations by the time the ratings agencies downgrade their debt to speculative levels.
And History Ain’t Changed…
California is like a beloved family member who’s always got some scheme to make cash. Over and over again, he (she?) finds himself in financial dire straights, only to be bailed out by some external event. That’s how California historically has made it through budget shortfalls. This time, however, California ran out of luck.
Earlier in the year, California already enacted a ‘temporary’ tax increase to shore up their estimated budget gap at the time. Unfortunately, the shortfall was much more than expected. California has an interesting way of passing new budget resolutions… it puts them to a public vote. The last vote failed. The state is now threatening to send out IOUs in lieu of actual money. California has run out of options.
Can Municipal Bonds Default?
There is a section of the bankruptcy code, Chapter 9, Title 11, which applies specifically to municipalities. It’s possible the title could be interpreted loosely to extend to the entire state. This would allow California to renegotiate its legacy pension and union contracts and emerge from bankruptcy a leaner state. Chapter 9 bankruptcy has been filed before, many times.
The most famous case of a Chapter 9 bankruptcy was Orange County, in 1994. This article has a pretty thorough explanation of how different types of municipal bonds were treated in the bankruptcy. It’s important to note that even if some money is paid, it may take months or even years to see that money. So yes, municipal bonds can default, and they have before. I believe a state could declare bankruptcy even knowing a state has never declared it. The question is, will it come to that?
The Politics of Default
In 1975, New York City faced major budget issues. On October 29, President Gerald Ford gave a speech saying there wouldn’t be a bailout for the city. The next day, the New York Daily News ran the headline, “Ford to City: Drop Dead“. Ford ended up losing in the next election to Jimmy Carter (linked? Probably. Ford lost New York…). The political ramifications of making a tough decision are remarkable.
If California is actually about to default on their debt, would it be politically smart to let them default? California is 14% of the country’s econonomy and a whopping 55 electoral votes. California has voted safely Democrat since Bill Clinton’s first term in 1992. It would not be politically expedient to let California fail, and it certainly would put ANY administration in a tough position. Even though California’s best medicine would probably be a bankruptcy, it would be politically untenable.
Conclusion
“Too big to fail,” is a common phrase heard throughout this recession. Yes, California could probably find a way to file a bankruptcy under Chapter 11. No, I don’t think California be allowed to fail politically. Regardless, there is certainly a risk that the situation could change for the worse and California will be “too big to bail out.” Time will tell.
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