McConnell's bankruptcy suggestion boomerangs

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Senate Majority Leader Mitch McConnell, R-Ky., has suggested that Congress should allow states to file for bankruptcy.

Critics say Senate Majority Leader Mitch McConnell’s suggestion that Congress should allow states to file for bankruptcy would undermine efforts to quickly restart the economy and could damage the municipal market.

Senate Democratic Minority Leader Chuck Schumer said Friday on National Public Radio’s Morning Edition that McConnell’s comment was “so far out of the mainstream I think he’s going to have to walk it back.”

Schumer said the backlash “has given even more momentum for state and local assistance,” making McConnell “increasingly isolated.”

However, McConnell’s comments have made President Trump equivocate about his support for state and local financial assistance.

Trump tweeted earlier in the week that he supported relief for state and local governments, but at Thursday's White House briefing on the coronavirus he didn't dismiss McConnell's suggestion.

“I've spoken to Mitch about it,” Trump said. “I've spoken to numerous senators about it and we're working with senators that are on the other side of the issue and we'll see what happens.”

Trump said he plans “to do what's right for the people of this country,” and consider the fact that “some states have not done very well for many years, long before the virus came,” citing Illinois as an example.

Illinois has one of the worst-funded state pension systems in the nation and the weakest ratings among states at just one rung above junk.

Illinois carries a $137 billion unfunded pension tab for a system just 40% funded and is weighed down by an $8 billion bill backlog, and about $30 billion of bonded debt. Fitch Ratings, Moody’s Investors Service, and S&P Global Ratings all assign the state a negative outlook.

Illinois Gov. J.B Pritzker recently released revised revenue estimates that warn of a $2.7 billion tax loss in the current fiscal year and $4.6 billion in the next.

Pritzker has denounced McConnell’s suggestion of allowing states to file for bankruptcy.

“The cost of borrowing, the cost of doing business goes way up, much beyond where we are now…our state would be in a world of hurt,” Pritzker said. “States are not allowed to declare bankruptcy and that’s a good thing.”

The liberal-leaning Center on Budget and Policy Priorities said bankruptcy “could significantly raise states’ cost of issuing bonds to pay for major transportation projects and other investments that boost the economy.”

“In reality, states would use the money to avoid massive layoffs and deep spending cuts due to the public health emergency and its economic effects,” Michael Leachman, CBPP’s senior director of state fiscal research, wrote in a blog post Thursday. “If they impose these cuts, the recession will be considerably deeper and longer.”

McConnell’s comments came Wednesday during a radio interview in which host Hugh Hewitt asked if the federal aid might be used for underfunded state pension plans.

“States pay retirees’ pension benefits out of separate trust funds,” Leachman said. “States and localities do use general funds to make regular payments toward future pension obligations, but those payments only amount to about 4.7% of their spend, according to Leachman.

The National Governors Association has requested $500 billion in aid from the federal government.

The National Conference of State Legislatures estimates state governments could cumulatively experience a $300 billion to $400 billion shortfall in revenue in fiscal 2021.

The Center on Budget and Policy Priorities estimates the shortfall at $500 billion for states in fiscal years 2020-2022.

Separately, the National League of Cities, U.S. Conference of Mayors and National Association of Counties are requesting $250 billion.

A bipartisan Senate proposal to provide $500 billion in grants to state and local governments in a new tranche of coronavirus aid is expected to be formally introduced in the Senate next month by Sens. Robert Menendez, D-N.J., and Bill Cassidy, R-La.

Michigan Gov. Gretchen Whitmer told MSNBC on Thursday her state is anticipating a $3 billion shortfall in the fiscal year that ends Sept. 30 and $4 billion in 2021 fiscal year.

Whitmer said she was “really disappointed” to see McConnell’s comments. “I just think that it's incredibly irresponsible,” Whitmer said, adding that she’s “grateful” that Treasury Secretary Steve Mnuchin, the White House and the Democratic leadership in Congress “have some sort of understanding.”

However, some Republican conservatives are standing by McConnell’s go-slow approach to aiding state and local governments.

House Republican Minority Whip Steve Scalise of Louisiana told Fox News on Thursday he wants to ensure the $150 billion Coronavirus Relief Fund for state and local governments is properly spent before Congress approves additional aid.

"Before they start talking about a bailout from the federal government from problems they had prior to COVID-19, let's make sure that this money that was spent, that they are just getting now, was spent properly," Scalise said.

Irma Esparza Diggs, senior executive and director of federal advocacy at the NLC, described McConnell’s bankruptcy suggestion as “a complete about-face.”

Irma Esparza Diggs, senior executive and director of federal advocacy at the NLC described McConnell’s bankruptcy suggestion as “a complete about-face.”

“It’s like we took two steps forward with both sides saying that they would include state and local money in the fourth stimulus,” said Diggs. “To me it shows that too many decision makers here in Washington are just out of touch with what’s happening on the ground.”

As a result of McConnell’s comments, the NLC and other state and local government groups will need to provide hard data and case studies to persuade Congress.

Diggs said that the White House Office of Intergovernmental Affairs has “made it clear that we needed to make a strong case that we in fact need this money” and it’s not because of unfunded liabilities or poor fiscal management.

State governments, meanwhile, are temporarily weathering the crisis with record level rainy day funds to draw on. But the relative size of those funds significantly vary by state.

On a practical level, allowing states to file for bankruptcy would require congressional agreement to change the federal bankruptcy code.

Market representatives and civic groups say doing so would cause damage to the municipal market at a time that it is in recovery mode.

Frank Shafroth, who worked on the 1988 bankruptcy amendments that permitted Chapter 9 for cities and other local governments, said allowing state bankruptcy would erode the 10th Amendment provisions which provide that powers not delegated to the federal government by the Constitution, nor prohibited by it to the states, are reserved to the states respectively, or the people.

Shafroth’s comment was made on his George Mason University Municipal Sustainability Project blog.

Shafroth questioned whether the constitution’s Contract Clause prohibits state governments from “impairing the obligation of contracts.” And, the Supreme Court in 1977 reiterated that a “state cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money (on something else.),” Shafroth wrote.

The road for state bankruptcy legislation would prove much steeper than municipal bankruptcy as “Congress and the president would have to act–and the respective state would have to enact legislation to enable such a filing,” Shafroth wrote.

Another hurdle would involve the third branch of government as the U.S. Supreme Court would have to rule whether the contracts clause of Article 1, Section 10 of the Constitution bars states from seeking bankruptcy, even were Congress to grant such authority.

McConnell’s comments are “ill informed, reckless and, not surprisingly, lack of compassion,” said Michael Belsky, executive director of the Center for Municipal Finance at the University of Chicago’s Harris School of Public Policy. Like Shafroth, Belsky too raised the specter of a legal challenge based on the 10th Amendment.

The potential for market damage runs high. “His comments also will have the impact of raising borrowing costs for states as they battle what is turning out to be a depression as bond investors will certainly take pause and expect a risk premium,” Belsky said.

“Their request for revenue replacement is not to squander it away on past problems but rather to meet increased unemployment and healthcare expenses as well as just providing basic services for the day in and day out needs of their residents,” Belsky said, suggesting that any legislation could restrict spending such as was done with the American Recovery and Reinvestment Act in 2009 that was directed to infrastructure projects.

John Mousseau, president and chief executive officer and director of fixed income at Cumberland Advisors, likened McConnell’s comment to the 2010 prediction by Meredith Whitney, a noted bank analyst, predicting hundreds of billions of dollars of municipal defaults were coming. They never materialized.

She caused lots of market damage and outflows from municipal bond funds before sanity resumed and yields moved lower than they had been before she made her remarks, according to Mousseau.

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