The Breakdown

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San Bernardino bankruptcy caught the bond market by surprise

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41817 full

You'd think a $3.7-trillion municipal bond market would watch over the cities that issue debt like a hawk. But of course, that can be tough when you're talking about something that big. And although ratings agencies like Moody's and S&P monitor the finances and prospects of default for thousands of cities, they don't always have a clue what's going on inside city hall.

Shocking as it may sound, right up until it voted to move toward a Chapter 9 declaration earlier this week, San Bernardino's bonds were rated "investment grade" — meaning that institutional investors and big mutual funds could buy them. Some of the city's bonds have been downgraded to "junk" status now, reports Reuters. But from the perspective of the bond market, San Bernardino didn't look like a city facing a fiscal crisis with effectively no money in the bank, the inability to meet its payroll, and a possible scandal brewing over whether the city has accurately represented its finances to the outside world.

Cate Long — who writes the MuniLand column about municipal finances and bonds for Reuters — and I went on "The Patt Morrison Show" to discuss what she called the "perfect storm" of fiscal and economics problems that San Bernardino is facing. Cate follows the municipal bond market on a daily basis, and she confirmed what I expected: that San Bernardinio's move to possible bankruptcy was more or less a complete surprise. 

This contrasts with the back-to-back bankruptcies of Stockton and Mammoth Lakes, two cities of greatly different size, and with very different financial problems. Stockton is the largest U.S. city to enter Chapter 9, at almost 300,000 people. Mammoth Lakes is much smaller, and its inability to move through the state-mandated pre-bankruptcy mediation process was the result of a $43-million legal judgement that it couldn't renegotiate.

In both cases, even before bankruptcy loomed, the bond markets had plenty of time to prepare.

San Bernardino was a different story. However, according to economist John Husing, just because the bond markets were surprised, California residents shouldn't have been. 

San Bernardino is an old "charter city," which basically means that more than 100 years ago, San Bernardino's government was established by the city itself, rather than by what's called the "general law" of California. Most of California's cities are general law cities, but the biggest cities are all charter cities.

"Because these charter cities are old," Husing said, "they have huge infrastructure issues." 

Those issues are a drag on revenues. And when revenues are reduced, as they have been in San Bernardino by a drastic decline in sales-tax and property tax money — $6.5 million since 2008, according to a June 26 analysis from the city — shortfalls develop in the budget.

Husing said that there are other inland California cities that could wind up suffering the same fate as San Bernardino. The end of redevelopment didn't help either. I spoke late yesterday with Jim Morris, Chief of Staff to San Bernardino Mayor Patrick Morris, and he expressed dismay at Gov. Jerry Brown's decision to take back $6 billion in state funding that had been going to cities. 

Husing understood why San Bernardino city government might be so upset about this. He said that over $5 million from the city's redevelopment funding was going to offset operating costs.

Even with all these fiscal challenges, the bond markets weren't pricing in a sudden San Bernardino default. And as far as the overall bond market goes, this string of bankruptcies in California isn't setting off a panic. Some of San Bernardino's bond's are even trading near their face value, according to a source quoted by MarketWatch. So it appears it wasn't excessive debt that pushed San Bernardino toward bankruptcy — it was as Jim Morris told me yesterday, a cash-flow crisis.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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