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The Process of State and Local Government Debt Restructuring Explained

State and local governments, like cities, counties, school districts, and public utilities, sometimes face financial distress and struggle to pay their debts. When this happens, they may need to restructure their debts to avoid defaulting and get their finances back on track. Debt restructuring can be a complex process, but is an important tool for governments facing fiscal crises.

What Triggers the Need for Debt Restructuring

There are a few key events that can trigger the need for a state or local government to restructure its debts:

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  • Economic downturns – A recession that causes tax revenues to decline and spending on social services to increase can quickly cause budget shortfalls and make it hard for governments to service existing debts. For example, the 2008 financial crisis caused massive budget problems for many state and local governments [1]
  • Overspending or poor financial management – If governments take on too much debt or mismanage finances, they can get overloaded and unable to make debt payments without reforms. Some cities have gotten into trouble after borrowing too much to pay for expensive development projects.
  • Population decline – When fewer taxpayers move into a city or state, the tax base shrinks. But fixed costs and debts remain the same, driving fiscal stress. Detroit is a major example, having lost over 60% of its population since the 1950s [2].
  • Major litigation or legal judgments – If a government loses a major lawsuit and has to pay out a big legal settlement, it can potentially push it into financial distress and the need for debt restructuring.
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The State and Local Government Debt Restructuring Process

If a struggling government decides it needs to restructure its unsustainable debts, here is the general process:

  1. Financial review and analysis – The first step is to conduct a thorough review of the government’s finances, assets vs liabilities, debts, revenue sources, expenses, etc. This gives a clear picture of the situation.
  2. Hiring financial advisors and lawyers – Governments will usually hire restructuring consultants, investment banks, accountants, and lawyers to help navigate the complex legal and financial considerations around debt restructuring [3].
  3. Negotiating with creditors – A key part of the process is negotiating with bondholders, banks, insurers, vendors, labor unions, and anyone else the government owes money to. The goal is to get them to agree to modified repayment terms that give the struggling government fiscal breathing room. This often involves painful compromises like reducing or extending principal and interest payments.
  4. Court-supervised debt readjustment – If negotiations fail and key creditors won’t agree to debt relief, the government may file for bankruptcy or a state authorized judicial financial review. This allows a judge to impose new debt repayment plans on unwilling creditors through a legal process [4].
  5. Implementing a recovery plan – Along with debt restructuring, struggling governments usually have to make difficult budget cuts, raise taxes or fees, privatize services, layoff workers, dip into rainy day funds, and take other steps to rebalance revenues and costs into a sustainable structure [5].
  6. Restoring market access – The final step after completing a debt restructuring is for the government to regain access to capital markets to borrow at reasonable rates for infrastructure, equipment, and services. This access is lost when a government is distressed.
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Key Players in State and Local Debt Restructurings

Here are some of the main parties typically involved in negotiating or litigating a government debt restructuring:

  • State oversight boards – Created by state governments to review finances and restructuring plans for distressed local governments and school districts before they get worse. Oversight boards have played major roles in debt restructurings in New York, Pennsylvania, Rhode Island, Michigan, Illinois and other states.
  • Public unions – Labor groups representing government employees often have to make contract concessions on pay, benefits, pensions and work rules to facilitate debt restructurings. Police, firefighter, and teacher unions can have lots of legal leverage.
  • Bond insurers – Companies like MBIA and Ambac that insured government bonds against default risk are key players. They face big losses in restructurings and try to minimize haircuts and maximize recoveries.
  • Distressed debt investors – Hedge funds, private equity firms, and specialty investors that buy distressed government bonds on the secondary market for deep discounts then try to use litigation and bargaining leverage to get paid higher amounts as part of restructuring settlements.
  • Bankruptcy judges – In the most extreme cases, like Detroit and Jefferson County, federal bankruptcy judges get final say over imposed settlement terms on creditors when local governments file for Chapter 9 municipal bankruptcy protection.
  • State judges – Even without formal bankruptcy, some debt restructurings happen through a litigation process overseen by state courts. Judges have power to force losses onto unwilling creditors.

Outcomes of State and Local Debt Restructurings

There is no single template outcome for state and local debt restructurings. Every situation is different based on the unique fiscal, political and legal dynamics. But in general, the process usually involves some of the following results:

  • Reduced principal owed on bonds through haircuts, discounted buybacks, or bond exchanges from old to new debt with written-down face values.
  • Lower interest rates paid on bonds.
  • Extended maturity dates on bonds so that governments have more years to pay.
  • Wage, benefit, or work rule concessions from public sector labor unions.
  • Commitments by state governments to provide emergency fiscal aid or oversight.
  • Cuts to local government services, assets sales, and tax hikes to balance budgets.
  • Unemployment and population loss as struggling regions decline.
  • Eventual economic recovery and access to capital markets after debts become sustainable.
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No elected officials want to plunge their governments into the painful debt restructuring process if it can be avoided. And no creditors or unions want to take losses on money owed to them. But when there is no alternative, restructuring becomes necessary medicine to cure crippling financial distress. Understanding how it works can help taxpayers, policymakers, investors, public workers and everyone impacted by local fiscal crises.

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