The headline story is that Stockton, Calif. is now the largest U.S. city to file for bankruptcy. The Northern California municipality failed to come to terms with its creditors during a state-mandated mediation period and set in motion a filing for Chapter 9, the city-government version of Chapter 11. The total debt load has been reported as $700 million, although other sources have put it at somewhere between $500 million and a billion.
Stockton's story is being widely presented as a sad case of a city that tried to expand into being a bedroom community for the San Francisco Bay Area and got hammered by a combination of a busted housing boom and city retiree pension and health-care obligations. The loss of property tax revenue and the cost of taking care of former firefighters and cops forced the city to borrow too much money, and the debt load eventually became too great.
So why did the mediation process (which I thought could be a great way for cities to avoid bankruptcy, a costly process to finance) break down? It probably comes down to Stockton's bondholders — investors who bought its municipal debt, which like all "muni" debt, carries tax advantages. The muni market is huge and attractive, totaling about $3.7 trillion.
Bankruptcies like Stockton's are rare, although a number of cities in California are currently in financial trouble, including Los Angeles, which is facing a $200-million budget deficit. On balance, municipal bonds are generally considered to be relatively safe investments — "relatively" because some experts think that we're heading for a muni meltdown, while others think the muni market is still solid.
Last year, Moody's, the ratings agency, looked at Stockton's debt and didn't necessarily see a bankruptcy on the horizon. This is from the California Bond Advisor, referencing a Moody's note from November 2011:
Moody’s now considers the City of Stockton a triple-B credit, no matter what rating you look at; the city’s issuer rating, a proxy for a general obligation bond, has been cut to Baa1 from Baa2. Stockton’s lease revenue bonds, Series 2006A, were cut to the lowest investment-grade level, Baa3, from Baa2. The city’s taxable pension obligation bonds fell to Baa2 from Baa1. Moody’s lists as a strength the fact that the city’s staff and council are committed to achieving structural budget balance, Even so, “the downgrade and negative rating outlook reflect the fact that the city’s precarious financial position is being severely challenged by recent events,” Moody’s said. “These events threaten to increase general fund (GF) costs to levels beyond what the city’s carefully balanced budget could afford.” Stockton has “low debt levels but substantial variable rate risk,” [my emphasis] Moody’s said. The city’s large tax base is a plus, though the area is “economically challenged” following the recession. “The city has been resolute to date in addressing its financial difficulties,” Moody’s said. “However, the potential challenges keep mounting, and increasing in size. The city's willingness to make more, substantial expenditure cuts may be severely tested if these new challenges materialize in substantial amounts.”
And materialize they did, more than substantially. But what about this assessment that Stockton had "low debt levels?" $700 million doesn't sound all that low! However, even though Moody's was cutting Stockton's rating, it hadn't yet cut it to "junk" status. Stockton, as late as last year, was still investment grade, meaning that institutional investors, such as mutual funds, could still buy its debt.
Reuters provides a breakdown of who has Stockton's debts and how much:
The California Public Employees' Retirement System, which manages Stockton's pension plan, tops the list. The retirement system has a $147.5 million claim for unfunded pension costs.
Other top creditors include investors holding $124.3 million of Stockton's pension obligation bonds, $40.4 million of the city's variable rate demand obligations, $35.1 million of the city's public facilities fees bonds and $31.6 million of the city's parking garage debt.
Wells Fargo Bank NA is listed as the trustee for the investors.
The interesting piece here — and the debt that Moody's identified as being the most troubling — is the variable rate stuff. I don't know what the rate on that debt was or would adjust to, but even though it was only about 6 percent of Stockton's total debt burden, it was the nastiest. From this PowerPoint deck, it appears that the variable rate debt was devoted to financing a new city hall, located at 400 E. Main St. Some of that debt had evidently already been defaulted on earlier this year, allowing the location to be seized by Wells Fargo or an agent acting on its behalf.
Moody's has now cut Stockton's bond rating into default territory. But those bondholders may figure that they stand to do better in the Chapter 9 than they would have done if they'd agreed to slash their investment in Stockton during the mediation period.
There are layers within layers and wheels within wheels with this story. I've reached out to some experts to unpack just how truly bad Stockton's situation was last year versus now, when it's clearly reached the white-flag level. Updates to follow.