State Bankruptcy Fears May Be Overstated

SAN FRANCISCO - Is your state about to go bankrupt?

Given the cries of "Bankruptcy!" and "Fiscal Armageddon!" echoing through state houses and editorial pages from California and Arizona to Illinois and Alabama, you might just think so.

Arizona Treasurer Dean Martin last week warned that his state's lawmakers needed to act quickly "or the state will be looking at bankruptcy next year." California newspapers have been issuing similar warnings, though Gov. Arnold Schwarzenegger prefers "fiscal Armageddon" to "bankrupt" in explaining his $40 billion budget deficit.

The former action star's phrasing is probably better. States are out of luck when it comes to the sweet protections of U.S. Bankruptcy Court. They can go broke. They can default. California and Arizona may pay some bills with IOUs. They just can't be bankrupt in the legal sense of the term.

"States can't file Chapter 9 bankruptcy protection," said James Spiotto, a municipal bankruptcy expert at Chapman and Cutler LLP in Chicago. The municipal bankruptcy code limits filings to "municipalities" or an "instrumentality of a state."

The Congress intentionally excluded states when they wrote the law in the 1930s. Spiotto said the reason is that the U.S. Constitution guarantees states' rights and limits the power of the federal government over states.

"They are sovereigns just like United States, just like Brazil or any other country," he said. "The federal government and state governments are separate and sovereign bodies under the 10th and 11th amendments."

So even though Arizona could be the Ecuador or Argentina of municipal finance, it can't follow municipalities like Vallejo and Orange County - both in California - into the bankruptcy courts.

Ecuador last month repudiated $3.8 billion of bonds owed to foreign creditors. Argentina defaulted on $81 billion of debt in 2000. Brazil, for the record, hasn't defaulted since 1990 and protested Ecuador's default.

Lest Americans feel too superior or comforted, Spiotto says at least 11 U.S. states did repudiate their debts in the 1800s. The majority were Southern states that didn't think they should pay back debts incurred by Northern carpetbaggers after Reconstruction.

Ratings analysts said that even in the current steep economic downturn, all 50 U.S. states remain solid investment-grade credits, and the fact that governors and treasurers issue dire warnings when budgets fall out of balance is part of the reason.

"States tend to have well-developed budget and revenue monitoring processes," Standard & Poor's analyst Robin Prunty said last month in a report on state credit quality. "Actively identifying the stress derived from the current revenue climate and implementing difficult and what may be politically unpopular spending and revenue measures have been the key elements of credit stability to date."

The day after Arizona Treasurer Martin warned of bankruptcy, Standard & Poor's reaffirmed the state's AA credit rating, based on the "expectation that the Legislature will make expected necessary and timely budget adjustments to offset further revenue declines and a widening budget gap due to economic weakness."

California's constitution requires that the state make debt payments before other spending. Treasurer Bill Lockyer - who has himself criticized the state's "Banana Republic" budgeting - has repeatedly said that means bond investors are safe even amid rolling budget crises.

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