Boston - Senate Majority Leader McConnell remarked on Wednesday that he favors allowing struggling states to declare bankruptcy over direct state and local aid through another stimulus package.
Importantly, while localities have an avenue for declaring bankruptcy under US law, states do not. The applicable law that governs municipal bankruptcies is Chapter 9 of the US Bankruptcy Code. Chapter 9 was enacted in the 1930s to provide financially distressed municipalities access to the federal bankruptcy system so they could reorganize their debts. (By contrast, corporations file bankruptcy subject to Chapter 11 of the bankruptcy code.)
A "municipality" can be a debtor in a Chapter 9 proceeding, but only with the permission of the state. (Note that 12 states allow it, 16 states conditionally allow it and 22 states have no provisions for municipal bankruptcy.) A municipality is defined as a "political subdivision or public agency or instrumentality of a state." States cannot fall within this definition, and therefore do not have access to Chapter 9.
It would take an act of Congress
Allowing states to file for bankruptcy would require an act of Congress. We see no practical legislative path forward, as there would need to be agreement in the Democratic House plus a filibuster-proof majority in the Senate. Even then, such an act would be subject to legal challenge at the Supreme Court, which since 1934 has opined that under Article 1, Section 10 of the US Constitution, states are prohibited from impairing the obligation of contracts.
In summary, even if Congress amended the federal bankruptcy code to authorize states to file for bankruptcy, the Supreme Court would still have to decide whether such debt repudiation would violate the contracts clause in Article 1 of the Constitution.
No plan in the works
To be clear, there is no Senate plan to allow states to file for bankruptcy. Instead, we believe Senator McConnell's comments suggest that Republicans are divided on providing any meaningful future aid to the states.
Interestingly, this stands in stark contrast to President Trump's views, reflected in an April 21 tweet, that after the House and Senate pass the Paycheck Protection Program and Health Enactment Act, "we will begin discussions on the next Legislative Initiative with fiscal relief to State/Local Governments for lost revenues from COVID-19."
Similar to the Great Recession
During the Great Recession of 2009/2010, state revenue declined by 12%, and states were forced to take extraordinary fiscal actions to balance their budgets — often by raising revenues and cutting expenses. In the five years that followed, state and local governments shed almost 750,000 jobs. While this helped to increase efficiency in many governments across the country, the loss of these mid-level jobs is part of the reason that the recovery from the Great Recession was so muted.
Similar to the Great Recession, we expect that states will experience significant declines in revenues stemming from the COVID-19 crisis. However, most states are entering this crisis from a position of strength, as state liquidity reached an all-time high in 2019. Further, through the CARES Act, the federal government will provide states with $150 billion in grants to offset COVID-19 expenses — equating to almost 14% of state tax revenue. And through the Municipal Liquidity Facility, states have the ability to borrow up to $500 billion from the Federal Reserve, which would also help offset any short-term liquidity pressures.
Bottom line: While we do expect that some weaker states will be downgraded due to the economic disruption caused by COVID-19, we do not anticipate that any state will default on its debt. Nor do we believe that there is any appetite in Congress to pass laws that would allow states to file for bankruptcy.