Months of turmoil in the municipal bond market have investors worried and lawmakers wondering what to do to resolve the long-term fiscal problems plaguing state governments. The proposal to allow states to enter into bankruptcy proceedings is drawing a lot of attention in Washington and state capitals. The assumption is that bankruptcy status would make it easier for states to renegotiate pension and other benefit promises, potentially removing some fiscal uncertainty and making state bond holdings less risky.

Floated by – among others – former House Speaker Newt Gingrich, this proposal was discussed last week at a House Judiciary Committee subcommittee hearing on whether Congress should pass legislation that permits states to declare bankruptcy.

States currently do not have the legal right to file for bankruptcy. Proponents of the change, who also include former Florida Gov. Jeb Bush and the lobbying group Americans for Tax Reform, say it would enable struggling state governments to unilaterally rewrite pension and other deals with employees before the states' cash flow deteriorated so far that it could no longer service its debt. Federal taxpayers would benefit, too, because if states could clear the decks in this manner, they would be less likely to come to Washington seeking a bailout from Congress.

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