Cash-Strapped States Seeking A Way To Declare Bankruptcy

States are looking for relief.

As they confront massive debts and diminished revenue, some state officials are trying to determine whether they could take a drastic and illegal step: declaring bankruptcy, the New York Times reports. Such a move, though currently out of the question, might free states from some of their most burdensome debt and allow them to rebuild their crippled finances.

After years of spending generously, and after decades of hiking pension promises to employees, states now find themselves squeezed. Diminished tax revenue is, in many cases, insufficient to cover long-term obligations, as states face a combined pension fund shortfall of $3 trillion, according to two finance professors' estimate. Bankruptcy would, in theory, allow states to rework these obligations, potentially causing pain for retirees and bondholders, and likely spreading uncertainty through financial markets.

Even holders of state bonds -- traditionally considered a rock-solid investment -- could end up taking a loss, the NYT says.

All talk of state bankruptcy is in hypothetical terms, as there remains little, if any, precedent. The most recent example of a state credit event happened during the Depression, when Arkansas defaulted on its debt. But legal bankruptcy protection, in which states would theoretically be able to restructure their obligations in court, is unconstitutional, since states are considered sovereign entities.

Even municipal bankruptcy, which is allowed under some state constitutions, is rare. The current poster child is Vallejo, Calif., which was driven into bankruptcy nearly three years ago in an attempt to escape mounting labor costs. The biggest example is Orange County, which declared bankruptcy in 1994 after the treasurer gambled on Wall Street with the public money, and lost. He was later sentenced to prison time.

Some American cities have flirted with bankruptcy. Harrisburg, Pa., has gotten legal advice on a potential filing. Hamtramck, Mich., has sought bankruptcy protection and been denied by the state of Michigan.

Perhaps the only precedent one can point to is a crisis simulation at The Economist's Buttonwood Gathering in New York City, held in October. Performing the roles of Federal government officials were, among others, former Treasury secretary Robert Rubin, former National Economic Council director Laura Tyson and former chief of staff Josh Bolten. Their task was to simulate the Federal government's response to a state's request for a bailout.

For the most part, the actors were able to stay in character -- until Tyson fumbled, accidentally referring to the fictional state New Jefferson as "California."

Analyst Christopher Whalen, for his part, says he believes California will default on its debt.