Does bankruptcy really matter? The solvency of municipal governments in the Chicago metropolitan region.

Author:Hendrick, Rebecca

    Rising pressures on government spending, revenue, and debt in the 2000s have worsened the financial condition of governments everywhere. The 2001 recession in the United States, the Great Recession worldwide, and methods of coping with these events have dramatically increased the deficits and fiscal obligations of governments at all levels. Some have predicted these conditions will create severe fiscal distress in governments in the US and abroad and will result in more governments filing for bankruptcy than in the past (Dubrow, 2009; Laughlin, 2005). Bankruptcy is considered to be the last resort for local governments that are financially insolvent and a valuable tool to help them return to solvency (Farmer, 2013). It protects them from creditors' demands and gives them the authority to adjust and restructure debt and contracts, which can lessen financial liabilities overall and given them more time to meet these obligations (Dubrow, 2009; Laughlin, 2005).

    Despite the respite offered to local governments by bankruptcy, not all governments can file for this protection. Of the almost 90,000 local governments recognized in the US in 2007,1 only about 57% (in 24 states) were authorized either fully or conditionally by state government to file for bankruptcy under Chapter 9 of the federal Bankruptcy Code (15% had conditional authorization) (Spiotto, 2008). 2 Thus, findings from studies of bankruptcy in U.S. local governments are generalizable only to the population of local governments in states that authorize such filings. With respect to the population of insolvent governments in states that are authorized to file bankruptcy, the sample of bankrupt local governments in the US is further biased because many insolvent governments do not file for bankruptcy. The uncertainty and undesirability of the outcomes of bankruptcy give both governments and creditors incentives to avoid it and negotiate arrangements that help the government become solvent (Scorsone & Wright, 2013). Therefore, studying only bankrupt governments to understand why governments become insolvent is likely to confound state authorization and conditions surrounding the negotiation of arrangements to avoid bankruptcy with the causes of financial insolvency. It is more valid in this case to study insolvency directly in a general population of governments to determine its causes and possible remedies.

    To study insolvency directly and determine its causes, one must first define and measure the concept in order to make accurate comparisons of solvent and insolvent governments and determine its prevalence. This study presents a model and strategy for determining the solvency or financial condition of local governments in the US and distinguishing between solvent and insolvent governments. We apply this conceptualization and methodology to all 265 suburban municipalities in the Illinois portion of Chicago metropolitan area from 1997 to 2010.3 Focusing this research on suburban governments greatly broadens the population of analysis from prior studies of fiscal crises in US governments that focus on central cities, which are much larger, less prevalent, and qualitatively different than suburban governments. This time period also allows us to compare these governments' financial condition during both fiscal bad times (the 2001 recession and the Great Recession) and fiscal good times (in the late 1990s).

    We measure these governments' financial condition using a number of different indicators. First, we use a series of indicators that represent different dimensions and time frames of the phenomenon. These indicators are similar to what has been used by others in the field to differentiate between long-term and short-term solvency (Berne & Schramm, 1986; Nollenberger, Groves, & Valente, 2003; Standard & Poor's, 2012). We also define financial condition as the balance of factors within and across these dimensions (Clark & Ferguson, 1983; Ladd & Yinger, 1989), and we assume that these dimensions may be related in non-linear ways that preclude the ability to simply sum factors across dimensions to determine financial condition. Using this combined framework, we define relative insolvency on all indicators as whether a government is a member of the lowest two septiles of that indicator (for either good times or bad times) within the larger distribution. We also look at how the indicators are related to assess the frequency of insolvency among governments within the region and argue that the causes and risk of insolvency can be inferred from the joint distribution of governments on different dimensions of financial condition.

    Although our research focuses on local governments in the state of Illinois, our model for conceptualizing financial condition and insolvency has international applicability as every country in the world likely has a population of insolvent local governments. For example, a 2004 World Bank paper (Intergovernmental Finance in Hungary: A Decade of Experience 1990-2000) that describes Hungary's experiences with the 1996 Act on Municipal Bankruptcy, also describes the insolvency of local governments in that country in a manner that is similar to what is conceptualized here. Clearly, municipal bankruptcy and insolvency are important issues for local governments worldwide, although specific factors of the dimensions that determine financial condition or solvency and the measurement of these factors are likely to vary significantly across countries and even states in the US. The next section explains how bankruptcy as defined in the US presents a limited view of solvency and why a broader focus is needed to accurately identify insolvent governments.


    2.1 Bankruptcy and Insolvency: A Rare Event with a Narrow Definition

    The fact that so few local governments in the U.S. have filed for bankruptcy demonstrates how rare the event is and suggests that there are likely to be many insolvent governments that either have not or cannot file for bankruptcy. Between 1980 and 2012 only about 250 bankruptcy cases have been filed under Chapter 9, which was less than 0.3% of all local governments in the US in 2007, and most of these governments are utilities and special districts, (Deal, Heier, & Kamnikar, 2013). In fact, general-purpose governments represented only 17% of filings between 1980 and 2006 (Spiotto, 2008). Additionally, there are far more defaults on debt by local governments in the U.S. than bankruptcies,4 which demonstrates that insolvency is a necessary but not nearly sufficient condition for the occurrence of bankruptcy in the U.S. Governments that are insolvent or near insolvency according to the U.S. bankruptcy code and their creditors have strong incentives to negotiate a restructuring of government debt and other forms financial assistance to avoid filing for bankruptcy (Gillette, 2012).

    Current bankruptcy law in the US requires local governments to satisfy five criteria in order to file for Chapter 9, only one of which deals with insolvency (Deal et al., 2013; Laughlin, 2005). (5) Federal bankruptcy code defines insolvency as a local government either "not paying its debts as they become due" or "unable to pay its debts as they become due" (Laughlin, 2005, p. 40). The first definition examines whether the government has paid past and current debts and the second definition examines on the government's inability to pay future debts. However, reports of case law suggest that the solvency criterion courts use focuses on prior and near-term financial obligations and the ability of governments to generate enough cash to pay these debts (Park, 2004).

    For instance, Lewis (1994b) reports that the petition by the City of Bridgeport, Connecticut for bankruptcy in 1991, which was the largest ever general-purpose government petition at the time, was dismissed because the judge noted that "Bridgeport's insolvency should be judged by a cash flow, not a budget deficiency, analysis" (p. 520). From a different perspective, focusing on cash solvency can also mean a government that appears to have money could actually be judged as insolvent. In 2008, Vallejo filed for bankruptcy, and was sued by employee groups that argued the City was not insolvent due to the existence of reserve funds. These arguments were rejected, however, by the court due to restrictions on the funds that prevented the City from using them to pay for general operations (Scorsone & Bateson, 2012).

    The court's emphasis on the ability to pay existing bills and debt service using available funds overlooks whether governments that file for bankruptcy have the long-term financial capacity to benefit from the tools that help such governments become solvent in the short-term and remain solvent in the future. The City of Detroit, the largest city in the US to file for bankruptcy in the US as of 2013, exemplifies a government that has little long-term financial capacity and fundamental financial problems that cannot be solved through bankruptcy. Restructuring its debt and union contracts and selling assets (including paintings in the Detroit Institute of Arts) will help the city to operate more cheaply and pay down its current liabilities (The Economist, 2013; Matthews, 2013).

    However, short-term finances are not the true problem in Detroit. Detroit's population has declined from nearly 2 million in 1950 to just above 700,000 in 2010 (Borney & Gallagher, 2013). Of the remaining population, 60% live in poverty and 18% is unemployed. One third of Detroit's land area is considered to be vacant or derelict. Bankruptcy turnaround efforts will not insure that Detroit will be able to meet its spending obligations in the future and provide sufficiently for the health and safety of its population using only the declining revenue resources available within the jurisdiction.

    2.3 Fiscal Crises: The Need for a Broader Focus.

    The need to focus...

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