By Pengjie Gao (University of Notre Dame), Chang Lee (University of Illinois at Chicago), and Dermot Murphy (University of Illinois at Chicago)
Recent high-profile municipal default cases in Detroit, Puerto Rico, and various cities in California have underscored the importance of state laws for dealing with default proceedings, or even preventing default from occurring in the first place. However, the effects of these laws, or lack thereof, on municipal borrowing costs remain unclear. Does unconditional state support for distressed local municipalities lead to lower local borrowing costs? If so, are there tradeoffs?
The authors address these questions by examining differences in distress-related laws and statutes across states. Some states have proactive policies in place that activate when their local municipality is exhibiting signs of fiscal distress (“Proactive states”). Meanwhile, other states allow unconditional access to the Chapter 9 bankruptcy procedure, with no laws in place for dealing with distressed municipalities (“Chapter 9 states”).
The authors find that these differences significantly affect local borrowing costs. In particular, Proactive states have lower borrowing costs and significantly lower yield reactions following default. Furthermore, Proactive state yields are less sensitive to economic conditions because of the implicit insurance that becomes particularly valuable when economic conditions are weak. There is also a significant contagion effect in Chapter 9 states that does not exist in Proactive states, in that a default in a Chapter 9 state is more likely to lead to higher yields for other bonds located in that state. However, the authors also provide evidence that borrowing costs at the state level are somewhat higher in Proactive states because of the partial transfer of local credit risk to the state.
The full article is available here.