Penn Law prof: State bankruptcy won't panic investors

The University of Pennsylvania Law School's Prof. David A. Skeel Jr., an expert in bankruptcy and governance, among other things, gave aid and comfort to those who suggest states should find orderly ways to avoid paying their debts in their current fiscal crises at Wednesday's hearing by a House oversight committee.

Read Skeel's testimony here. Highlights:

- If states run out of money, under current law, "there are only two real options.... Simply default..." or let the Federal government "bail out" states like it did for Bear Stearns, Fannie Mae and AIG in 2008.

- A better choice would be for Congress to "enact a bankruptcy law for states," as it did in the Depression for cities.

- Bankruptcy would help states avoid the Contracts Clause (Article 1, Section 8) of the Constitution, which otherwise pervents states from "altering an existing obligation."

With bankruptcy, Skeel says states could "restructure a union contract absent the union's agreement," which Skeel feels is better than existing "draconian" alternatives "such as firing large numbers of workers" or passing laws to restrict public-worker unions.

States could also require payment of bonds before pensions, Skeel added, to make sure breaking contracts doesn't panic bond investors and drive up state borrowing costs.

- "Congress could reduce any temptation" to file bankruptcy frivolously "by making it more difficult to file for bankruptcy," just as the municipal-bankruptcy law forces cities to get state permission before filing under Chapter 9 of the US bankruptcy code.

I asked Skeel via e-mail if he'd thought through the moral and practical impact of having states walk away from their retirement promises to workers, and the likely effect on bondholders, other borrowers, and other parties to state contracts. Skeel called those worries "overblown" in his testimony and "exaggerated" in his note to me.

I also asked why bondholders should have priority over elderly pensioners. "I actually don’t favor giving them priority at all.  I just used that as an illustration of the flexibility" of bankruptcy, Skeel answered. "I wish I had made that a bit more clear."