March 2, 2012

Ted Nesi's Interview with David Skeel on the Basics of Municipal Debt

Carroll Andrew Morse

3 points about Ted Nesi's WPRI-TV (CBS 12) interview with University of Pennsylvania Law Professor and bankruptcy expert David Skeel are worth immediately noting:

  1. In the first half of the interview, Prof. Skeel advances that same argument, based on current law, that we at Anchor Rising have been making from a wider historical perspective for a while now -- government has no inherent authority to make promises to trade away that which it does not possess...
    DS: The question is if a city or a state makes a pension promise, but does not fund the promises – which has been true in many states in recent years – what exactly is protected in the event of a default or of bankruptcy? A lot of people assume that what’s protected is the full promise, even if there’s no funding behind it.

    Although this is certainly not free from doubt – this is unchartered territory in many respects – my view is that there’s a good argument that what’s protected is the amount of money that’s been set aside. Pension obligations are a form of what we refer to in the law as a property right, and other kinds of property rights are protected up to the value of the property that’s set aside for them. So if somebody has collateral for a transaction, we treat that promise as sacrosanct up to the value of the collateral.

    This portion of the discussion should be of particular interest to those who want to invoke the "police power" as being central to the solution to Rhode Island's government-financing crisis. In particular, a strong case can be made that the future is best served not by expanding the police power to new circumstances, but instead by enforcing the proper limits on the government's appropriations power, an idea implicit in Prof. Skeel's argument, i.e. the government cannot legitimately promise everything because it does not own everything.

  2. Towards the end of the interview, Prof. Skeel explains that one possible first-cut common-sense response to the idea of a bond default -- if there's a real price to risk, then bondholders should understand that there's a real possibility of not getting every payment -- is essentially correct...
    TN: The argument I always hear back here is that Rhode Island governments can’t operate without being able to borrow money, and that without this protection we could be cut off from the bond markets. What do you make of that argument?

    DS: I disagree with the assumptions underlying the argument, which is that if you don’t completely protect bondholders all possibility of borrowing will disappear. I just don’t think there’s evidence of that. The bond market view tends to be if you do anything that prevents us from getting 100 cents on the dollar, the world is going to come to an end. And my view is, there’s just no evidence of that. The evidence is really to the contrary – healthy municipalities will pay less and have better access to the bond markets than sick ones, and the restructuring of one city is a lot less likely to have contagion effects on other cities in those states than people in the bond market tend to believe.

    I just don’t find these kinds of arguments compelling. For instance, Greece is restructuring its bond markets severely right now – the bond markets have not shut down in Europe.

  3. Finally, Newt Gingrich and Rick Santorum would like the media and academia a lot more, if every interaction between media and academics covered the details as clearly and concisely as this interview does.

Comments, although monitored, are not necessarily representative of the views Anchor Rising's contributors or approved by them. We reserve the right to delete or modify comments for any reason.

In case anyone is interested, Skeel was a guest on EconTalk on July 4, 2011:

Some good discussion on the auto bailouts and the bankruptcy process generally.

Posted by: Dan at March 2, 2012 4:00 PM

The points that Prof. Skeel makes are well understood in insolvency proceedings. In general creditors are either "secured" (they have collateral), or "unsecured". "Secureds" are protected from the claims of other creditors, up to the value of their collateral.

Where the colatteral does not equal the value of the "claim" (the total amount owed) the "claim" can be "bifurcated". The claim is "secured" up to the value of the collateral, the remainder is "unsecured". Generally, "unsecureds" take a hair cut.

Let us analogize the pension claimants to mortgage holders. Let us say the mortgage amount is $250,000, and the house is worth $270,000. The mortgage debt is "fully secured". In the event the collateral (house) is sold at full value, the mortgage holder is protected from the claims of other creditors and is paid in full.

Now let us suppose the value of the collateral falls to $175,000. The "secured claim" of the mortgage holder can be "bifurcated", it becomes "secured" to the amount of $175,000 and "unsecured" in the amount of $75,000. The "priority claim" of $175,000 will be paid from the sale of the collateral. The remaining $75,000 of the debt becomes "unsecured" and equal to the claims of all other creditors. Other assets will have to be found to satisfy the $75,000. If they do not exist, the debt will not be paid in full.

There is the rub. Typically the municipality will have "other assets", presumably subject to the claims of creditors. I am not intimate with Chapter 9, and it must be remembered that bankruptcy law is very political. It comes directly from congress and is subject to a lot of lobbying. For all of that, the problem for the "unsecured" portion of claims of pensioners is the "other assets" of the municipality. I must assume that there are other "secured claims" against it by bondholders. So, it becomes a "priority" question. Which creditors rights prevail over the others (that is a book).

A question that arises to my mind is why the pensioners would not claim "fraud" to the extent they were mislead on the solvency of the pension fund. Debts based on fraud are not dischargeable in bankruptcy.

Something to remember, the "debtor" municipality has little voice in the division of assets, those assets have been "surrendered". The 'fight" is amongst the creditors. Before that, the question would be viability. A functioning government is the desired result, the "debtor in possession" could argue about a workable plan for continued operation. I am not sure Chapter 9 permits "liquidation" in the event a plan cannot be worked out. Unsecured creditors typically have a small voice negotiating a plan. Not sure about Chapter 9,but there is usually an "exclusive period" when only the debtor can propose a "plan". The debtor always claims to have an acceptable plan at the outset. In this day of the "structured bankruptcy" this may be more true than it used to be.

Posted by: Warrington Faust at March 3, 2012 7:35 AM
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