So What Happens When California Goes Bankrupt

And there's no question that it's going to eventually. Technically it's already there since its debts exceed its assets and it's only able to keep going via constant infusions of credit. California's 2010-11 budget is $86 billion dollars and about 23% of that will have to be borrowed to make up for the budget deficit.

On top of that the state has an accumulated debt, pension and unemployment fund obligation of over $290 billion i.e. about four years worth of state tax revenue. The state machine keeps grinding on but as soon as there's a hiccup in the credit supply, you're going to start seeing missed paychecks within a few weeks.

However if the owners have been particularly profligate and irresponsible (which pretty much describes California's government to a tee), the the court can assign a trustee to run it until it gets back on its feet. A sort of benevolent fiscal dictator who would have the power to unilaterally make cuts and renegotiate state contracts. Which sounds just like what California needs.

There's just one catch - it may not be constitutional.

In particular it may run afoul of the Guarantee Clause of the Constitution, which says that "The United States shall guarantee to every State in this Union a Republican Form of Government." So the question becomes whether receivership for a state is constitutional. Professor Bainbridge has good post up on this issue though he doesn't take a stand on this particular question and includes this quote:

This leads me to wonder if a state could be deemed “not republican” under the Guarantee Clause if it goes bankrupt. Suppose that California came to Congress seeking a loan. If Congress said, “OK, but only if you amend your constitution to do X, Y, and Z,” that could pass muster under the Spending Clause if the reform proposals were sufficiently related to fiscal issues. But suppose California just defaulted on its debt. Would Congress then be justified in putting the state into receivership for some period of time?

So if California can't be forced into receivership, what then?

Well Congress could rescind its statehood and make California a territory again until its affairs were in order and then re-admit it. Basically it would be a mini-version of Reconstruction similar to how the Federal government ran Southern states after the Civil War. Of course this has political and constitutional problems of its own. Not to mention the fact that this would be hugely unpopular with California voters and their representatives.

So the most likely outcome is that California will simply repudiate its debt and refuse to pay. It is sovereign immune so any state debt holders will have no recourse in the courts and are basically SOL. In fact this kind of debt repudiation has happened before in the US - several states (mostly Southern) did just this back in the 1840's and again in the 1870's.

Sure the state would be cut off from any credit for quite a while - but not forever since there always seem to be new suckers who will loan money to bankrupted states and nations. And since this would have the least impact on the personal power of the politicians in charge of California, I'm guessing this is the route they'll take. So if you or your investments hold any CA bonds (or IL or MI ones for that matter), I'd start dumping them now since their value is very likely to go to zero in the next year or two.

posted by Maetenloch at 03:19 PM

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