State governments have had a major role in how municipalities deal with severe fiscal distress, HJ Sims director of credit analysis Richard Larkin says in a paper.
In 22 states municipalities cannot declare themselves bankrupt, while 12 states allow local governments to to do so with little or no preconditions, and 16 states permit bankruptcy filings under certain conditions or with state approvals.
"The likelihood of municipal bankruptcy depends not only on whether state law allows it, but also depends on the fiscal culture and intergovernmental relationships between states and their cities, counties and school districts," Larkin wrote.
"In New York, Pennsylvania and Michigan, the administrations and legislatures took active roles in overseeing and assisting New York City, Philadelphia and Detroit, enabling those cities to avoid the stigma and long-term consequences of bankruptcy. In Alabama and California, it can be argued that those states not only did little to assist local units in distress, but may have exacerbated the financial stress by their actions or inaction."
In 1975 New York City "was insolvent, couldn't meet its debts as they came due, and its financial books were in disarray." While it could have easily turned to bankruptcy, the state took several steps to restore the city to fiscal health. While it did provide money for the city, more importantly the state set up the Emergency Financial Control Board and the Municipal Assistance Corp.
The board could veto city budgets as well as city contracts. The corporation used the city's taxing power to independently offer bond issues to finance and refinance debt for the city. By 1981 the city could sell bonds on its own credit.
After five years of deficit financing Philadelphia lost access to the bond market in 1991. The state created the Pennsylvania Intergovernmental Cooperation Authority, which operated much like New York's EFCB and MAC. Using a five-year financial plan, "Philadelphia was able to balance its budget and restore investment grade ratings by the fifth year of the plan."
While Detroit has had three decades of major fiscal stress from 1975 to the present, at crucial points Michigan has revised expenses and revenue sharing with the city and backed city bonds.
After a multi-billion dollar sewer system rehabilitation program pushed Jefferson County, Ala., into financial disaster, a state court in March 2011 rejected a county income tax that provided 25% of its revenue. Despite repeated requests, the state Legislature has persistently refused to approve a replacement tax.
In the major bankruptcies that took place in California — Orange County (1994), Vallejo (2008), and Stockton and San Bernardino (2012) — the state declined to intercede or assist the cities.
Several historical developments are contributing to municipal distress in California, Larkin wrote. In 1978 the passage of Proposition 13 rolled back property taxes and put tight limits on how much property taxes could go up each year. In 1988 Californians passed Proposition 98, requiring a substantial portion of the state budget be used for K-12 education. These and other factors may lead to future major defaults in California, Larkin wrote.