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What happens when a city defaults?

September 3, 2010

What happens when a city defaults?  The answer may impact your investments
By Albert Gallatin,

This week Harrisburg, Pennsylvania announced it would miss its quarterly scheduled bond payment.  Although holders of the bonds would still get paid, thanks to bond insurance which most investors demand from municipal issuers, the default by the city nonetheless is troublesome.  The failure of a State or local government to pay back their borrowings is extremely rare, which is part of the reason the government entities can borrow money at relatively cheap interest rates.  But the financial crisis in 2007 and the continuing economic malaise has put a severe strain on government resources.  And it is not just cities that are in desperate straights: some of America’s biggest States, such as California, New York and Illinois, appear to be on the brink of default.  California has already resorted once to issuing IOUs to some of its creditors, and may be forced to do so again in the near future.

The failure of a city like Harrisburg to pay off its debt, though disturbing, is not unprecedented.  In fact, US bankruptcy law explicitly provides remedies for creditors of US local governments.  In the case of a State, however, the bankruptcy code does not apply, owing to the fact that States are sovereign political entities. If a State misses a bond payment there is no clear process for resolving claims.  The market widely assumes that the federal government would never allow a State to default, and continues to loan to troubled borrowers like California on nearly the same terms they give the most fiscally sound states like Virginia. But in today’s tea-party climate DC is in no mood for future bailouts.  If a big State defaults it is unlikely the federal government will come to the rescue.  Investors should keep this in mind when reviewing their bond portfolios.

  
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