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.

No legislation has yet been introduced, however. In fact, the bankruptcy proposal has encountered opposition from both left and right. House Majority leader Eric Cantor has said it's not needed because the states have sufficient room to balance their books by cutting spending or raising revenues. In that he found himself in agreement with California State Treasurer Bill Lockyer, a Democrat, who said, “We don’t want it. We don’t need it. Bankruptcy would devastate states’ ability to recover from the recession and make the infrastructure investments that create good jobs.... With respect to our budget shortfalls, we have the tools to fix them.”

But for investors, the question is whether a bankruptcy statute for states would make their interests any more secure and bring some reassurance to a bond market that has suffered violent ups and downs over the past three months. Here, too, it encounters skepticism.

Jonathan Williams, director of the tax and fiscal policy task force for the American Legislative Exchange Council (ALEC), an organization of conservative state legislators, says his group has yet to take a public stand on state bankruptcy. But he noted that if this was an option for states, it could have a “ripple effect in the bond market.”