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A deserted section of downtown Stockton. The bankrupt California city has shown a willingness to default on its debt, according to Moody's.
With four California cities in the past two months either declaring bankruptcy (Stockton, Mammoth Lakes, and for all practical purposes San Bernardino) or making noises about declaring bankruptcy (Compton), it's easy to conclude that we're on the leading edge of a wave of Chapter 9s that will sweep across the state.
But the fact is that municipal bankruptcies are exceptionally rare. This is one of the attractions of the $3.7-trillion municipal bond market, which hasn't been signaling a wave of cities going bust, nor steeply discounting the debts of cities that are broke (cities in bankruptcy don't have to default on their debts — they can keep right on paying as they move through Chapter 9).
However, Moody's, one of the big U.S. rating agencies. put out a report yesterday titled "Recent Local Government Defaults and Bankruptcies May Indicate A Shift in Willingness to Pay Debt." In it, the Moody's analysts write that they "expect the vast majority of rated municipalities" — and for Moody's that's 8,500 cities — to "muddle through and pay their debts."
[U]nrelenting pressures on municipal finances have forced a few severely distressed localgovernments to make tradeoffs that ultimately resulted in default. While negative credit pressure is widespread, the most severely distressed speculative grade-rated municipalities face pressure emanating from a combination of factors, notably multi-year declines in housing prices, high foreclosure rates, weak underlying demographics, recurring operating deficits and in some cases management missteps including fraudulent financial reporting.
In the current environment, as more municipalities approach the economic or political limit to raising taxes or adjusting spending, we could see an increase in defaults and bankruptcies over the next few years. We continue to watch closely the events in Stockton, San Bernardino, Scranton and elsewhere for a potentially more widespread trend of defaults.
I called up David Jacobson, a Moody's spokesperson, for some additional insight.
"Even distressed cities are still trying to make every effort to pay debt obligations," he said. "Detroit, a city that's on the edge, is making all sorts of accommodations to ensure they can pay their debts."
But then he explained why Moody's generated the report: "What it gets into is that we're starting to notice some fiscally distressed municipalities become more willing to stop paying their debt obligations. It's their willingness to pay, not their ability to pay, that's notable. That's what we're seeing in Stockton."
Stockton stopped paying some of its debt prior to entering a state-mandated 60-day mediation period before declaring bankruptcy. And the bankruptcy budget it created last month contains no provision for debt service, so Moody's anticipates a default by September 1.
The distinction between willingness to pay and ability to pay is important because the assumption on the part of the bond markets is that cities want to protect their access to credit and don't want to have their bonds rated lower than investment-grade by Moody's or other rating agencies. Investment grade bonds can be bought by big institutional investors and the likes of university endowments; sub-investment grade, or "junk," bonds generally can't.
Once bond buyers realize that the issuers of debt aren't putting them at the front of the payment line, they can retaliate by forcing munis to offer higher rates to borrow money. This is how the risk-compensation game is played, and it explains why cities prioritize their debt payments.
In fact, cities almost never bail out on their debts. The Moody's report cites exactly one example in its ratings universe between 1970 and 2011 — Cicero, New York — electing to default on debt not out of ability to pay but willingness to pay.
But the times, the may be a-changin'. Cities may figure that bankruptcy is a good strategic option, enabling them to get rid of debts and obligations much as corporations learned to in the 1980s — and like American Airlines, continue to today.
However, there's still something grimly special about the California cities that are in or headed to bankruptcy. For one thing, according to Moody's, they don't have the usual risk factors.
"What cities in the Unites States have in common is what we call 'enterprise risk,'" Jacobson said. "They decided to fiscally get involved in something that put them in competition with the private sector." He cited real-estate development as a common temptation on this front. For Cicero, it was an ice rink.
"But what we're seeing with Stockton and San Bernardino is that it's not enterprise risk. Rather, there's some economic reason." Such economic reasons would include the now familiar housing market meltdown or spike in unemployment. But there's often something else going on.
"There are other Inland Empire and Central Valley cities in California that have had the same economic problems as Stockton and San Bernardino, but they're dealing with nowhere near the same issues."
In both Stockton, San Bernardino, and potentially now Compton, the thing that pushes cities over the edge into bankruptcy and that might compromise their willingness to pay their debts is a combination of political and economic shocks. In San Bernardino's case, as I've reported, the firefighters union refused to negotiate with the city on reduced wages and benefits. There have also been allegations of fraud in the budgeting process. Stockton confessed to accounting irregularities in its 2010 budget, which added to its deficit for 2011 and 2012, according to Moody's.
Jacobson said that this recent uptick in the unwillingness of a very small number of cities to pay debts isn't really significant enough to be called a trend. But it might indicate a marginally changing view of how debts are handled by financially troubled municipalities. In California, that financial trouble needs to by immense, involving major macroeconomic factors, such as the housing bubble bursting, and long-term issues, including the fiscal demands that older charter cities are dealing with. Throw in ever-rising pension and benefit obligations for city workers and you can see how California's recent experience, while important, may be distorting what actually happening in the municipal bond world.