Every year, for the past 20 years, more than one million Americans have filed for bankruptcy. There's a cottage legal industry in helping debtors "wipe the slate clean," though personal bankruptcy stays on your credit report for ten years. And not all debts are wiped away in bankruptcy, notably most debt to the IRS and federal student loan obligations. Some forms of bankruptcy require payback of a portion of loans. But for the most part, the businesses and credit card companies swallow the losses, passing the costs on to consumers. Few individuals, with perhaps the exception of Donald Trump, are too big to fail.
Individuals are not the only ones who file for bankruptcy. Major corporations have also used the bankruptcy laws to "reorganize" - wiping out shareholder equity, and even forcing their lenders (the bondholders) to receive less than they had been promised. Almost every major airline today, with the exception of Southwest, has a bankruptcy in its history. General Motors and Chrysler both filed for bankruptcy, as did Lehman Brothers and Washington Mutual, and energy giants Texaco and Enron. They weren't too big to fail.
But what happens when a city or state finds its finances in dire straits? Several cities have taken the bankruptcy route, notably Stockton, CA and Detroit, MI. The provisions of the bankruptcy code for cities depend on state laws. In 1934, Congress passed the Municipal Bankruptcy Act (revised in 1937), which said state would make laws overseeing all municipal bankruptcies. A subsequent 1978 revision of the Federal bankruptcy code created Chapter 9, for reorganization of municipalities.
In recent years, in the municipal bankruptcies that have been filed, the parties involved - employees, tax-payers, business creditors, lessors of public buildings to the municipality, and the general lenders - bondholders, have all been forced to make adjustments. But so far, those currently receiving pensions from municipalities have basically been spared - although healthcare benefits for retirees have been reduced or cut.
States cannot declare bankruptcy, because states are sovereign governments. And since states can increase taxes on residents in order to pay their obligations, they cannot evade those debts by filing for bankruptcy. That means even states like Illinois, which owes more than $110 billion to the state's pension funds, and has $7 billion in unpaid bills to service providers, cannot file for bankruptcy. It must first cut expenses - or increase taxes. It's eventually a self-defeating strategy, because state residents leave! People are smart enough to figure out the best place to live based not only on state income taxes, but sales taxes, educational systems, and the weather! Many simply relocate when the tax burden becomes too great.
As for the Federal government, there is no law or precedent for filing for bankruptcy, no matter how much debt the Federal government piles up to be repaid at some distant point in the future. Not only does the Federal government have huge taxing ability to repay its debt obligations, it also has the ability to PRINT the money!
So as long as people are willing to hold the currency - and these days the U.S. dollar is the currency most in demand around the world - and as long as citizens are staying here to pay the taxes, it appears the Federal government can keep piling up the debt. That is, until the day when our creditors will no longer take dollars or U.S. government IOUs.
What About Puerto Rico?
Puerto Rico is the next financial crisis to hit the headlines - and may revise our thinking about "too big to fail." Puerto Rico is on the edge of what would be called "bankruptcy" - but there is no legal format for Puerto Rico to file for bankruptcy. In the 1978 revisions of the Federal bankruptcy code, Puerto Rico, which is a territory and not a sovereign state, and its municipal corporations were specifically exempted from the ability to file a Chapter 9 bankruptcy. In recent days, Puerto Rico scraped together just enough to make its most recent interest payment, but with more coming due a default looms.
In early December, the U.S. Supreme court agreed to review a new law passed in Puerto Rico that would allow it to restructure some $72 billion worth of debt outside Chapter 9. Creditors and bondholders have objected to the restructuring. (Many of those bonds are held in diversified bond funds which are often included in 40l(k) retirement plans!) Investors bought the Puerto Rican IOUs believing they would certainly be paid, since the U.S. Bankruptcy law precluded default or restructuring. A Supreme Court ruling is expected in June, 2016.
All of this should give investors second thoughts. If Puerto Rico is to be bailed out by taxpayers at the expense of investors and creditors, can the U.S. government ever let, say, Illinois fail the way they let Lehman Brothers go down? And can the State of Illinois afford to let Chicago and its pension funds fail - causing havoc among firefighters, police, and teachers?
Attractive high yields come with a risk. And in some cases, the full risk hasn't been priced into the market. The government has made a big deal about forcing banks to restructure so they won't be "too big to fail." But when push comes to shove, will any U.S. Government, Congress, or Fed be willing again to allow a colossal bankruptcy? I doubt it. And that's The Savage Truth.