Under existing laws states cannot go bankrupt due to the fact that the code does not allow for it.  Due to the current state budget crisis some states are looking for ways around the current code.  The 50 states collectively spent $500 billion more in the last two years than they took in, in taxes, and unfunded pensions are estimated at another $1 trillion.  This poses a looming threat.

The threat is so strong that Arizona took drastic measures in 2010 by selling off the State Capitol building, the Supreme Court and the chambers of the house and senate.  They are currently leasing them back on a long-term agreement from the private investors.  Illinois, New Jersey and California are estimated to be in even deeper trouble.

Meredith Whitney, a top banking analyst who spent thousands of man hours delving into state balance sheets, is predicting that within the next 12 months we will see states and municipalities default.  Bankruptcy would at least give the states an opportunity to restructure for success, hopefully.

Bankruptcy is always good for the debtor, it wipes the slate clean and the debtor goes on its way feeling relieved.  Bankruptcy is bad for the creditors who take pennies on the dollar and sometimes get left with nothing.  The creditors who will be most hurt if states go bankrupt will be individuals with pensions who spent their lives working for the states, and bond holders who effectively lent the states money for a small rate of return.

Many retirees that have pensions require those funds to live on.  If pensions are wiped clean or renegotiated this could leave those retirees relying on the state aid more heavily, a sort of catch 22.

Bond holders would be considered unsecured creditors which would mean they would have to get in line, in the back.  Making bonds, a once considered safe haven investment not so safe.  Funds would have to come from asset sales which almost always shorts creditors their principle.

Finally, if states declare bankruptcy it will make it much harder for them in the future to raise financing.  Who will want to lend them money?  If they are able to raise funds it will come at a much higher cost as the risk assumed will be considered much higher.  It will be interesting to see how this plays out over the next year or two, but one thing is for sure, I won’t be buying any bonds as the risk has become too high.