Puerto Rico and New California State could be the next two states admitted into the Union.
A U.S. Bankruptcy Court decision wiping out half of Puerto Rico's general obligation bonds represents a potential Death Star precedent against Wall Street buying municipal bonds from states without a balanced budget.
The reason that high-tax rate and potentially insolvent states like California, Illinois, Connecticut, New Jersey, and Maryland have continued to have access to massive new borrowing is Wall Street's ability to sell general obligation municipal bonds to high-income individuals who can benefit from receiving federally tax exempt interest. Most muni investors also believe that the federal government will bail out any state financial crisis.
Few Americans understand that the first two attempts at a central bank of the United States failed and were shut down in 1811 and 1840. A series of inflationary panics from 1833 to 1839 led to the state bond defaults in the 1840s by Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, Pennsylvania, and the territory of Florida. Despite such historic risk, municipal bonds outstanding have soared to $3.9 trillion.
Despite the U.S. territory receiving $22 billion a year in federal subsidies and its residents being exempt from paying federal income taxes, Puerto Rico was an economic disaster in 2015 with a median household income of $18,626 versus $56,500 for the U.S. mainland. Low incomes are mostly due to 86 percent of islanders speaking Spanish in their home, after politicians banned English from public schools in 1948.
With a workforce of 1 million, Puerto Rico retained 285,000 public-sector union jobs by selling $73 billion in municipal bonds. That worked out to a municipal debt burden of $34,000 and unfunded public pension debt of $20,300 for every man, woman, and child.
But after two devastating hurricanes, Congress appointed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) commission in 2016 to manage the commonwealth's finances. Puerto Rico filed for bankruptcy in May 2017.
President Trump shocked Goldman Sachs and other Wall Street "vulture capitalist" hedge funds that had bought tens of billions of dollars in defaulted Puerto Rico municipal bonds for as low as 30 cents on the dollar when he emphasized in October 2017 that the U.S. government will not bail out bankrupt Puerto Rico's municipal debt.
Wall Street vulture investors in Puerto Rico general obligation bonds thought they were protected from loss under the contracts clause of the U.S. Constitution that prohibits states from wiping out any state or private debt. The U.S. Supreme Court further ruled in 1977 that states cannot refuse to meet legitimate financial obligations, simply because they would prefer to spend the money on something else.
By determining that Puerto Rico was insolvent when it sold general obligation bonds in 2012 and 2014 to fund utility and agency revenue shortfalls, the U.S. Bankruptcy Court found a "clear violation" of Puerto Rico's constitutional balanced budget requirement. The ruling permitted the PROMESA's board to request on January 15 that the Court invalidate $6 billion of the island's $13 billion in general obligation municipal bonds.
A study by the National Conference of State Legislatures reported that every state has a constitutional balanced budget requirement except Minnesota, Mississippi, New Hampshire, Vermont, and Washington. But none of the high-tax-rate and potentially insolvent states like California, Illinois, Connecticut, New Jersey, and Maryland have specific constitutional enforcement structures.
A Bankruptcy Court precedent that Wall Street investors are at risk of having their investment invalidated if they buy municipal bonds from states without balanced budgets will serve as a spectacular balanced budget enforcement structure.