The current budget compromise’s “borrowing” of money from state and local governments could trigger a wave of municipal bankruptcies. There is no provision for states going bankrupt. Inasmuch as states are sovereign entities under our federal system, and protected from suit by sovereign immunity and the Eleventh Amendment, states can simply refuse to pay. However, such a move would certainly trigger a crash in the state’s credit rating and might permanently hamper the state’s ability to borrow money. Just like some banana republic, California would require an IMF-style bailout. That may yet occur, but what is happening now will likely trigger municipal bankruptcies across the state.

More on the flip.

Under Proposition 1A of 2004, the state may borrow local government monies in a fiscal emergency. The current budget proposal includes several billion in such transfers. It is not at all clear to me that these are ‘borrowings’ at all, and appear to be permanent takings; as such, they are probably subject to challenge in court. (Not as a “taking” but as a violation of 1A-2004.)

The City of Long Beach claims that the current deal would deprive them of an additional $48m on top of a deficit almost that size. Nearby, in Orange County, the small City of Placentia is saying>:

Placentia city officials are howling in effort to keep state hands out of their coffers. The plan to seize millions could bankrupt the city, they say.

“We may have to declare bankruptcy – that’s how serious this is,” said City Administrator Troy Butzlaff. “This is something the system can’t endure. We just avoided bankruptcy by doing all the right things; by cutting back, by getting concessions from staff, by cutting $4.5 million over last year’s budget.”

Chapter 9 bankruptcy exists entirely for the purpose of adjusting municipal debt. It is much easier for municipalities to rewrite collective bargaining agreements under Chapter 9 that under the normal restructuring-style bankruptcy (Chapter 11).

Since the state of California can simply not pay, it has greater leverage in restructuring its debt, but may pay a higher long term price in its borrowing. (Arguably, the risk of a Chapter 9 is “built in” to the risk premiums on credit extended to municipalities, and, while the risk of sovereign default is built in to loans extended to California, going forward the calculus would be more changed in the latter case than in the former)

Is this a good idea? Would the state of California be more likely to get a federal bailout? (a loan facility, a direct cash payment, or a debt sur-guarantee by the treasury?) Yes, more likely than the cities. I don’t know the answer if it’s a better idea to protect the state’s credit than it is to create a further series of municipal bankruptcies. I think that will depend on whether you live in such a place.

The state’s fisc is structurally broken. Local governments strain under the same revenue strictures. California already has a long list of infamous chapter 9s, such as Vallejo in 2008 and Orange County in 1994.

One could argue that we simply have too many local government agencies. That may be the case. But unless there is a strong overlap of services, there wouldn’t be much savings. Nevertheless, given the current baseline, I would predict we will have between 2 and 6 municipal bankruptcies in 2009, with LAFCOs considering the elimination of smaller cities and districts.

UPDATE:

The Prop 1A-2004 borrowing has passed both houses.