State Budgets and the Bankruptcy Option

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February 15, 2011; Source: Financial Times | Not only is Congress unlikely to bail out teetering state budgets, but Republicans on Capitol Hill are thinking about enabling states to seek bankruptcy protection. House Judiciary Committee chairman Lamar Smith called state bankruptcy "an attractive alternative to state bail-outs," though he acknowledged some constitutional issues making bankruptcy unlikely if not impossible.

Smith is also concerned that giving states the bankruptcy option would encourage them to borrow more and then declare bankruptcy as a way of avoiding debt obligations. Talk about state bankruptcies has spooked the bond markets and ticked off governors who say they have no intention of looking for a Chapter 11 out.

Northwestern University professor Joshua Rauh, citing an underfunded pension fund liability of more than $3 trillion, calls this "hidden debt" and predicts that states and localities will have "to choose among the unpalatable options of cutting services, raising taxes, attempting to reduce benefits owed to public employees, defaulting on other obligations, or seeking a federal bail-out."

Is the situation as dire as Rauh predicts? The research director for the National Association of State Retirement Administrators believes that the pension system is healthier than that. They don't need nor seek financial assistance, and are typically able to pay benefits until 2030 "leaving enough time for reform, such as by reducing future benefits or raising contributions as some states have begun to do."

The Center for State and Local Government Excellence says that before the 2008 recession most state pension funds were 80 percent funded or more, but in 2009 the majority was under 80 percent, with some in the 40 percent to 59 percent range (PDF).

Add in underfunded state commitments to health benefits for retirees, the numbers escalate further. Nonprofits need to understand that the state budget deficits they have to confront are not just in current revenues and expenditures, but also in the impending debt that states owe their retirees. It won't be solved by the governor and legislature declaring bankruptcy.—Rick Cohen