Politicians are quietly mulling possibilities for states to declare bankruptcy and work their way out of crushing debt burdens that include hefty pension obligations, The New York Times reports.
Unlike cities and towns, states currently can't seek protection in federal bankruptcy court, and changing that status could have constitutional implications since states are considered sovereign entities.
Some say allowing states to declare bankruptcy and alter contractual promises to pensioners lowers the risks of federal bailouts.
However, such a move could also hurt those invested in municipal debt.
"All of a sudden, there’s a whole new risk factor," says Paul S. Maco, a partner at the firm Vinson & Elkins and former head of the Securities and Exchange Commission’s Office of Municipal Securities.
More than $25 billion has flowed out of mutual funds that invest in municipal bonds in the last two months, according to the Investment Company Institute.
Some have said the recession coupled with contractual obligations are straining local state and municipal finances to the point that defaults are likely, including star analyst Meredith Whitney, who accurately predicted the banking crisis of the last few years.
Others says cities and states can work out their financial woes, adding the problem isn't uniform in nature.
"There is no doubt that many issuers of municipal bonds are facing budget and funding challenges that are unprecedented in the postwar era, but we caution against treating the universe of state and local debt obligations as uniformly troubled or treating the municipal market as a homogenous sector," the National Federation of Municipal Analysts says in a statement, Reuters reports.
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