The town of Stockton is lurching toward a Chapter 9 municipal bankruptcy. But thanks to a law that Gov. Jerry Brown recently signed, before a California municipality can head to bankruptcy court, it needs to submit to mediation. What this means is that the city and its creditors sit down a less formal environment than a court of law and try to iron out a solution. Generally speaking, this means that bondholders (for example) will accept a "haircut" on debt up front, rather than fighting it out on court.
If a mediation can lead to a successful resolution, it can be a real boon for the city that's in trouble. Bankruptcy is expensive. The lawyers have to be paid and the whole process has to be financed so that the municipality can continue to operate while its litigating. We're talking tens of millions of dollars.
A Chapter 9, like its more familiar private-sector cousin, a Chapter 11, can also drag on for years. Vallejo — which recently earned a leading role in a scathing Michael Lewis Vanity Fair piece about California's miserable municipal finances — was in bankruptcy for three years.
One reason for this is that creditors are barred by Federal law from pushing debtor municipalities into liquidation. In a Chapter 7 bankruptcy in the private sector, a companies assets are sold off to pay debt. The company then effectively ceases to exist. That's not an option in a Chapter 9, for obvious reasons: cities provide important public services that can't just go away.
Stockton got crushed by the housing downturn and its debts are steep: the budget deficit will add up to $15 million by the end of this year and overall debt is something like $340 million. It's credit rating is pretty much rock-bottom, meaning that issuing new debt and refinancing old debt is a non-starter. And like many California cities, it's stuck with legacy pension and benefit obligations from flusher times. An important piece of mediation will be convincing retirees — not exactly a flexible bunch — to keep the city out of bankruptcy.
Bankruptcy has actually gotten kind of interesting in the past few years, as proceedings have divided into two types (at least where liquidations aren't concerned). In the case of a company like Tribune Co., which owns the Los Angeles Times, litigation drags on for years as various combative creditors battle it out for every scrap they can recover.
In the middle, you have strategic bankruptcies, of the sort that some allege American Airlines just entered, which are designed to gain concessions from unions.
But the point is that bankruptcies — in the private sector, anyway — are now either quick and painless or long an agonizing. Everyone knows what the problems are in Stockton, just as everyone knew what they were in Vallejo. But there's no reason why Stockton should have to spend three years fighting over them, only to emerge in possibly worse shape.
So this mediation round will serve as a critical test of whether municipal bankruptcy, an uncommon events but one that California could be facing with greater frequency, can be modernized to be a better deal for everyone involved.