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Real Clear Markets

California Is Ground Zero for Muni Bankruptcies

When will lawmakers start rethinking how municipalities should operate?

Harris Kenny and Leonard Gilroy
July 26, 2012

Debates about the role of government are shifting from libraries and lecture halls to kitchen tables and coffee shops as municipal bankruptcies flare up across the country. And California is ground zero.

Several weeks ago Stockton, Calif. became the largest city (by population) to declare bankruptcy in U.S. history. Mammoth Lakes and San Bernardino subsequently filed, and other municipalities, like Compton, are reportedly close to the edge too. The rapid succession of these filings has stoked fears of widespread municipal defaults, however the nature of each bankruptcy has been different from city to city. It is important to understand the causes of each filing to get a sense of how real the threat of municipal bankruptcies is in the future, and how current government officials can avoid the same fate for their city.

Stockton was the first in this wave of filings and its situation may end up being the most universally informative. The city's insolvency stems from a host of problems, including collapsing property tax revenue, unrealistic economic development projects, unsustainable compensation promises to public employees, and an ill-timed pension obligation bond.

Stockton became the first to test out the state's new mandatory mediation phase for municipalities considering bankruptcy, which was put in place by Assembly Bill 12-506. After mediation failed, the city filed and it is currently in bankruptcy court tying to sort through the rubble.

City leaders in Stockton are now asking the court to approve principal reductions for the city. In other words, the city is not only trying to reduce the interest it owes bondholders, but the original amount it borrowed too. According to Steven Church of Bloomberg, no U.S. municipality has successfully done this since at least 1981. While it's difficult to estimate the impact that sort of decision might have, it will likely affect Stockton's largest creditors including California Public Employee Retirement System (CalPERS) and Wells Fargo Bank North America. It will also likely increase the city's cost of borrowing in the future.

In Mammoth Lakes, the AB 12-506-mandated mediation also failed. In this case, mediation failed for a single reason: because their largest creditor, Mammoth Lakes Land Acquisition (MLLA), did not participate. The city inked an aggressive economic development deal that fell through after the Federal Aviation Administration rejected one critical component - the expansion of the town airport's runway. The City of Mammoth Lakes then reneged on its end of the development deal, leading a court to determine MLLA is owed $43 million.

In the City of San Bernardino, it's difficult to say exactly what's happening because of how opaque the environment is there. The city reportedly collected $78 million in revenue in the 2011-12 fiscal year. However, one reason it's so difficult to understand what's happening is that the city attorney recently alleged that city staff had falsified 13 of the last 16 years of budget data under the watch of multiple city managers and finance officials. This occurred amid ongoing housing market woes, pushing the city over the edge. If that is true, then the projected $45 million budget deficit the city reportedly faces right now - half of which is payments for unfunded liabilities in workers' retirement and compensation accounts - might be even worse. In this case, the failure of the city appears to be both pension related and as a result of mismanagement.

If several more bankruptcies pile up, it will look like California's decades-long boom was a modern gilded age. And while there may be some truth to that impression, it's hard to prove.

First, recent signs of distress don't necessarily signal that the state's economy has a rotten core because each of the aforementioned cities has unique circumstances that led it to bankruptcy. As a state, California remains a major trade hub to/from Asia, a home of technological innovation and the beneficiary of an economy that continues to draw immigrants across its borders.

Also, California's bankrupt cities are only a drop in the U.S. municipal bond market bucket. Over 50,000 U.S. municipalities have bonds on the market right now, worth approximately $3.7 trillion. Some investors have higher exposure to the toxic municipal debt in the system, such as CalPERS or California municipal bond ETFs (exchange traded funds); but the average investor is not likely to have concentrated exposure to the California municipal bond market.

Cate Long, a guest contributor to Reuters.com, recently explained, "American cities and states are enduring a lot of fiscal stress, and in some cases their municipal bonds are showing stress too. But overall the muni bond market feels comfortable with the debt of U.S. states and cities. The data does not suggest a broad meltdown." Broadly speaking, municipal bonds, like U.S. Treasuries, are still considered a safe, secure and tax-friendly place to park capital.

While each city is unique, some themes are emerging from the fiscal rubble of the past month. Local governments share some issues that make for a more difficult environment at the local level.

Local governments remain vulnerable to the U.S. housing market. A recent report by the Rockefeller Institute finds a negative trend in property tax collections, which matters because in California local governments rely on property taxes for anywhere from 70-80 percent of their total tax revenue (in line with the U.S. average of 73.9 percent).

Lawmakers' first concern is settling bills accrued by previous officials. This includes anything from retirement and other post-employment benefits, to economic development projects and initiatives. Failed economic development projects serve as an albatross around the neck of cities that are in the process of reinventing themselves.

The next concern of lawmakers is addressing current spending concerns, which are more difficult to address. Public employee costs make up anywhere from 50-80 percent of spending at the local level. These personnel services come in vital areas like public safety (policy, fire, etc.). Aspects of these duties include public employee pensions and retiree healthcare, to name a few.

Finally, there's no linear solution to fiscal woes. Instead, lawmakers must comprehensively rethink how municipalities operate. The "Yellow Pages Test" (i.e. if you can find a service commercially available in the phone book, then start there by privatizing that) is a good place to start. The principle concern here is whether or not these activities are a core function of government. Other options include monetization of assets, and privatization of public-private partnerships.

It's true that municipalities around the country are under duress. Several have filed for bankruptcy, like Jefferson County, Alabama and Central Falls, Rhode Island; meanwhile other municipalities like Detroit, North Las Vegas, and Harrisburg, Pennsylvania, are either in receivership, have declared fiscal emergencies, or are on the brink of doing so. But despite the daunting challenges, most municipalities aren't ultimately going to file for bankruptcy.

This doesn't mean things aren't going to get worse before they get better. Whether we call it bankruptcy or not, fiscal woes are looming all around, demanding policymakers step up and do the hard work of streamlining government and balancing their budgets.

Harris Kenny is a policy analyst and Leonard Gilroy is the director of government reform at Reason Foundation. 


Harris Kenny is Policy Analyst

Leonard Gilroy is Director of Government Reform


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