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COVID-19 Impact to States - Possible State Bankruptcy

COVID-19 Impact to States - Possible State Bankruptcy

Revisiting the Idea of Allowing States to Declare Bankruptcy

In a radio interview on Wednesday, 4/22 Senate Majority Leader Mitch McConnell voiced his concern with providing additional financial stimulus to cities and states, casually floating the idea of allowing them to declare bankruptcy instead. By federal law, states are not permitted to file bankruptcy, unlike municipalities or local governments which are often permitted to file Chapter 9 under state law (although this is a rare occurrence).

This idea was last brought to Congress – and promptly rejected – during the Great Recession ten years ago. We expect a similar outcome this time around.

This isn’t the first time such an idea has been brought to Washington – it was last addressed during the Great Recession ten years ago. However, at that time the idea was promptly condemned by Republican and Democratic Governors alike as well as Wall Street, claiming it was an unnecessary measure that could cause more harm than good. The discussion was dropped after a single hearing within the US House of Representatives. We expect a similar outcome this time around – already there have been quite a few negative reactions to McConnell’s statements from politicians on both sides of the aisle (déjà vu).

While there is no doubt state governments are hurting right now with declining revenues resulting from actions taken to curb the spread of COVID-19, it is important to remember states are not in immediate danger of default. Congress has already passed legislation to provide aid for reimbursement of COVID-19 related expenses, and the Federal Reserve has created a short-term lending facility for state liquidity needs. So, yes states are struggling, but they have received some support for their immediate needs.

There is no doubt states are hurting from revenue declines, but no state is at immediate risk for default. Federal support has been provided for immediate needs to soften the blow.

However, should state revenues remain depressed, there will be no choice but to make steep budget cuts, likely in the areas of education and public safety that tend to represent a large portion of the budget. You can imagine how popular those spending reductions will be…

McConnell is framing additional federal stimulus for the states as a bailout for bad policy decisions made in the past, specifically calling out pension funds. In our opinion, this is a bit like, to use an old adage, throwing the baby out with the bath water. While there are a handful of states with seriously underfunded pension obligations (Illinois being one of the worst offenders), every state currently has ample cash to continue pension payments for the next few years. Remember, this is not a pension crisis or a state government crisis – this is a health crisis affecting us all. If the federal government does not provide additional aid to states, local governments will have no choice but to significantly reduce spending on services provided.

This is a national health crisis that is blind to party lines. If states do not receive additional federal aid, they will have no choice but to make steep budget cuts to services, and you can imagine how popular that will be...

This is not a party issue. That is to say the revenue hit impacts “red states” and “blue states” alike. The bipartisan National Governors Association, comprised of 26 Republican and 24 Democratic governors, has publicly supported additional federal aid, which we expect to be more indicative of “public” political opinion. While the idea of further increasing the federal deficit causes unease for many, it seems the "lesser evil" as the potential for state bankruptcy could have far worse implications for the everyday lives of its residents.

What’s more, should states be granted the ability to file bankruptcy, that will lead investors to demand higher yields or interest on debt obligations to compensate for the added risk of potential default. In the end these increased interest costs will be paid by the state’s residents via additional taxation, and we’re pretty sure we can safely say no one wants to pay more state taxes.

At this point, we would not anticipate making any changes to our investments with exposure to local governments via municipal bonds. Ultimately, we expect additional federal stimulus will be granted to states, just as aid is being provided to small businesses and hospitals with the latest bill before Congress. Expect political upheaval through the negotiations process, per the usual tug of war, with a compromise both parties can live with.