Explaining Southern California's economy

San Bernardino bankruptcy caught the bond market by surprise

Berdoo Bankrupt

Steven Cuevas / KPCC

San Bernardino city council voted to prepare a bankruptcy late Tuesday. The bind market was completely shocked.

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.

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San Bernardino bankruptcy: Much worse than Stockton

Researchers Predict Major Earthquake To Hit California In Next 30 Year

David McNew/Getty Images

San Bernardino City Hall. The city's fiscal crisis could make its possible bankruptcy far worse than Stockton's.

The San Bernardino City Council voted last night to prepare to file bankruptcy. If the Inland Empire city does enter Chapter 9, it would be the third California municipality to do so this year, following Stockton and Mammoth Lakes.

But according to the bankruptcy lawyer who helped draft AB 506, the new California law that compels cities considering bankruptcy to first submit to a "neutral evaluation" process, and an economist who studies the Inland Empire, San Bernardino could look a lot worse than either of the cities that have already filed for Chapter 9.

"The San Bernardino situation is extremely challenging," said Karol Denniston of Schiff Hardin in San Francisco. "They don't seem to have considered the 506 process." 

A call to an aide to Mayor Patrick Morris to determine whether San Bernardino had considered going through mediation was not returned. [UPDATE: The mayor's Chief of Staff, Jim Morris, got back to me late Wednesday to explain that the city had considered the mediation requirement and is working with bankruptcy attorneys to ensure that the city is complying with state law. He also said that a fiscal emergency hasn't yet been declared but that it could soon be, in reponse to what he described as San Bernardino's cashflow crisis.]

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Moody's called bankrupt Stockton's debt 'low' last year

Stockton, CA Leads Nation In Rate Of Foreclosures

Justin Sullivan/Getty Images

A sign is seen in a deserted section of downtown Stockton. The city will declare bankruptcy, becoming the largest U.S. city ever to do so.

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.

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Let's hope Stockton can use mediation to avoid bankruptcy

Justin Sullivan/Getty Images

STOCKTON, CA - APRIL 29: Cars drive through downtown Stockton April 29, 2008 in Stockton, California. As the nation continues to see widespread home loan foreclosures, Stockton, .California led the nation with the highest foreclosure rate. One out of every 30 homes in Stockton is in foreclosure, close to seven times the national average for a metro area in the U.S. (Photo by Justin Sullivan/Getty Images)

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.

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