States filing bankruptcy would be complex

By DAVID MOON, Moon Capital Management, LLC
February 6, 2011

If you thought a bailout of AIG and General Motors was controversial, wait until California and Illinois reach their final financial tipping points. GM might have a million union employees/retirees, but California and Illinois represent a combined 73 electoral votes.

And for those of us who favored addressing GM’s woes with economic Darwinism instead of crony capitalism, an insolvent state is a bit more complex than a bloated car company.

For starters, most legal observers agree that U.S. Code doesn’t even allow a state to file for bankruptcy protection. People can. Companies can. Cities and counties can. But there isn’t an equivalent federal provisions for states.

Congress could change that, or a politically motivated operative could challenge it. If so, public employees and their unions will fight the attempts, because they represent some of the largest non (or partially) secured creditors of the least healthy states.

When an employer makes a promise to pay an employee some future benefit, it has incurred a liability – no different than if it had gone to the bank and borrowed money. It owes that future benefit, just like it would owe principal and interest payments on a mortgage.

But what happens when a company – or in this case – a state, makes additional promises to its current employees each month when it doesn’t even have the money to pay the promises made to current retirees?

It is a function of government to provide for the protection of personal property rights. A pension benefit is personal property.

The state of California, however, is operating with the apparent belief that if there are still checks in the checkbook, there must still be money in the bank. “Just don’t cash the check until next week, please. Or next decade.”

Pensioners expect those checks to be cashed. Without massive tax increases in California, however, there is no money to pay those future benefits.

When a company borrows money to build a factory, it usually has a factory that it can pledge as collateral. If the bondholders are being stiffed, they can usually foreclose on the asset or force a corporate liquidation.

How would you liquidate California? Would each retiree get a small percentage ownership in a highway or prison? What about dedicated state income streams that have already been committed to certain projects or specific debt service? Would those be sacrosanct in a state bankruptcy?

The questions are answerable, but they aren’t as clear-cut as with a private company or individual.

The bigger question, however is, would a state bankruptcy be mostly objective and codified, as is the case with current bankruptcy law? Or would it be managed with certain predetermined outcomes, like the General Motors bankruptcy, where certain non-secured creditors were treated more favorably than others?

If the federal government decides to go the bailout route rather than bankruptcy, watch out. Large strategic electoral vote states like California are the equivalent of AIG and would likely receive unlimited bailout assistance in this scenario.

Like doing nothing, neither of those scenarios is very appealing.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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