The debtor submits itself to a court, which tries to reach the fairest possible settlement with creditors. It's messy, but it usually works for the best.

Federal bankruptcy code permits cities, school districts, and other local governments to file bankruptcy.

Some have done so, and I expect many others will in the coming years. Cities like Detroit and others in California have used bankruptcy to renegotiate their pension plans and other debts.

States are a different matter.