State Bankruptcy: Mitch McConnell’s Bond Math
The comments by Senate Majority Leader Mitch McConnell regarding his willingness to open hearings to explore allowing states to file for bankruptcy under Chapter 9 of the US Bankruptcy Code created a whirlwind in the municipal bond market.
Billions of dollars of general obligation bonds, the financing backbone states issue to fund their essential public services for their residents, have always been viewed as highly secure because they were bankruptcy remote. Suddenly, they didn’t seem so secure.
Floating the Bankruptcy Balloon
This is not the first time the state bankruptcy balloon has been floated to see who comes along for the ride. After the Great Recession of 2008, Prof. David Skeel of the University of Pennsylvania Law School wrote an Op-Ed piece “Give the States a Way to go Bankrupt” in The Weekly Standard. He followed up with scholarly pieces advocating the same. But he wasn’t the first. Before that, back in the early 1990s, after the recession of that period, then professors Michael McConnell and Randal Picker of the University of Chicago Law School wrote several pieces advocating similar relief for the states.
It’s apparently a popular theme to bring out during periods of economic distress, but now perhaps it’s time to take it a bit more seriously. It isn’t legal scholars writing erudite articles for prestigious academic journals. This is the Senate Majority Leader writing legislation that could become the law of the land. With an iron-clad lock on the Republican majority in the Senate, he holds considerable power as to what legislation does and does not come before that body and its committees.
Political Math and Pension Math
Certainly Judges, counselors, and experts in this complicated part of the law will opine and advocate for one side of the other, bringing out issues’ constitutional, judicial, and legislative. They are to be left to that. But in all those legal debates sure to follow, let’s not lose track of the political math. Think what you will of Senator Mitchel McConnell (R-KY) and his political leanings, but he is a shrewd politician. He knows how to count votes and frame complex public policy initiatives in popular, accessible language.
In that popular, accessible language favoring permitting state bankruptcy, what the Senator failed to mention is that his Commonwealth of Kentucky does not issue general obligation bonds. He also neglected to mention it’s bottom-level ranking in state public pension funding, 50th in the nation. If state bankruptcy is permitted, Kentucky has no outstanding state general obligation debt that would be negatively impacted, but it would presumably allow the state to renegotiate the terms the pension that tens of thousands of Kentucky pensioners rely on. It is unlikely their payments would increase.
Flipping in the Aisles
But that’s likely only part of the Senator’s political math. Of the top ten underfunded state public pensions, five states are straight Democrat controlled in both the statehouses and have majorities in federal representation: New Jersey, Illinois, Connecticut, Rhode Island, and Hawaii. Each face budget pressures and have either raised taxes or contemplated raising taxes to deal with budget deficits. Some recently had Republican governors that lost to Democrats, suggesting the electorate is not opposed to Republican rule. A local Republican push in those states to file for bankruptcy over raising taxes might be well received. Well received enough to flip those states over to Senator McConnell’s side of the aisle.
That goes for the other states that are already Republican controlled at the statehouse level: Kentucky, South Carolina, Pennsylvania. Each face difficult budget issues. The ability to file for bankruptcy gives strong bargaining leverage in negotiations. The remaining two states, with state legislatures controlled by Democrats but the Executive Branch held by a Republican (Massachusetts) or federal representation split (Colorado) are unlikely to change over to Republican majorities, but if New Jersey, Illinois, and Connecticut , each with very pronounced budget problems, were to flip, that certainly benefits the Republicans.
These are only the bottom ten states in terms of unfunded pension liabilities. Using the most current data (Fiscal Year 2018) and ranking each by state public pension funding, then linking this to the political party in the majority at the state and federal level (see the attached table), a few things quickly become apparent. There are 24 states with funding ratios under 70% and only 14 states with funding ratios above 80%. Suddenly, the power to wield bankruptcy becomes a big leverage in negotiating concessions. Add to that this year’s steep decline in the equity markets. Those underfunded ratios are likely to increase even further, offering even greater incentive to favor bankruptcy relief of some sort.
Election Year Handicapping
Keep in mind this is an election year. Gaining any electoral votes in New Jersey (14), Illinois (20), Connecticut (7), Hawaii, and Rhode Island (4 each) to add to Pennsylvania (20), Kentucky (8), and South Carolina (9) certainly helps the top of the ticket get reelected. As is well documented, the presumptive Republican nominee for the Oval Office knows a thing or two about bankruptcy.
For investors, handicapping what is likely to happen politically is about as predicable as forecasting interest rates. Even so, investors would do well to follow this latest political rumination from Washington.
Pensioners today, bondholders tomorrow.