Explaining Southern California's economy

Standard & Poor's says that bankruptcy is no bargain for California cities

 bankrupt pensions

Steven Cuevas / KPCC

San Bernardino City Hall. Was bankruptcy really the best move for this California municipality?

Moody's, the investment rating agency, has just released some commentary on "speculative" credit in the local-government sector. This is credit that has been downgraded to non-investment-grade status. It's basically junk — or, if you prefer, "high yield." The risk of default is higher, but the interest rate is also higher, making for a beefier return.

Moody's has been focusing for a while now on the worsening fiscal situation for the cities whose debt it rates, with special concentration on California. It recently placed a number of municipalities in the state on review. The agency says that there's a new factor it's watching carefully. From the report:

Some distressed governments have confronted the plethora of economic, financial, and managerial problems by choosing to discriminate among their outstanding obligations. Lack of willingness to pay debt service is emerging as a new theme in public finance. Although it’s not expected to become a widespread practice, even among speculative-grade issuers, there are several recent examples of this development.

The City of Stockton, CA has struggled for many years to control costs efficiently amid a severely weakened local economy, ineffective negotiations with its bargaining units, and management’s decision to take on the costs of dissolving its redevelopment agency. In June 2012, Stockton filed for Chapter 9 bankruptcy protection and adopted a budget that suspends payments on some lease and pension obligation bonds. 

Another big rating agency, Standard & Poor's, is also keeping an eye on cities in California. I recently talked with Gabriel Petek, an S&P credit analyst. He indicated that S&P is also reviewing the California cities in its ratings universe and echoed Moody's concern about the "lack of willingness to pay" matter.

But he also tackled the question of whether it makes sense for financially distressed cities to enter bankruptcy, as three California cities — Stockton, San Bernardino, and Mammoth Lakes — have this year. (More may be on the horizon: Atwater, near Stockton, has declared a fiscal emergency, and things don't look too good in Compton.)

"In a case where an entity is genuinely insolvent, there may not be a lot of options," he said. This is effectively what happened in San Bernardino, where unlike Stockton, there was no pre-bankruptcy mediation process, now mandated by state law. The fiscal crisis in San Bernardino was so dire that the city proceeded directly to Chapter 9.

But as far as Petek is concerned, that was an extreme case. "Bankruptcy should be avoided at all costs," he said. "Most bankruptcies seem to exceed long-run and near-term benefits."

Case in point? Vallejo, the Northern California city that declared bankruptcy in 2008 and emerged in 2011, racking up tens of million in bankruptcy costs along the way. The Vallejo experience led to AB 506, the mediation legislation that created the process that was first tried, but that ultimately failed, in Stockton. Vallejo's dire financial straits have been much analyzed, perhaps most prominently by Michael Lewis last year in Vanity Fair.

"Other parts of Bay Area are in recovery, but Vallejo is languishing," Petek said. "They haven't had access to capital markets. Older cities need to make investment in infrastructure, and the only way to do that is via access to capital markets. So cities that may be in Vallejo [and Stockton's] position should be forewarned. It will be a costly drawn-out process."

So if bankruptcy is a bad move for California cities under financial stress, does mediation, even though it failed in Stockton, represent a vaible option?

Not really.

"We haven't seen so far that it's functioned that way some policymakers had hoped for or envisioned," Petek said. "The problem starts with initial negotiations. Multi-year contracts with labor,  securing compensation, don't enable management to deal with changing conditions."

These labor contracts have become a sticking point for numerous older, stressed-out California municipalities. Negotiated when city budgets were flush, they've become onerous since times have changed and revenue bases have collapsed due to the housing crisis and high unemployment cutting into sales taxes. Labor costs are gobbling up 80 percent of budgets, leaving city managers with extremely limited flexibility.

"Cities are service providers, but some are operating in an environment where you can't raise revenue due to Proposition 13, and some of these are cities that also locked in multi-year labor contracts," Petek said. "They removed the part of the budget they had discretion over."

Petek calls this "fiscal handcuffs." Because Proposition 13 prevents any latitude on raising property taxes and some city workers have been inflexible in renegotiating contracts, municipalities are staring down the difficult choice of declaring bankruptcy and ending up like Vallejo or muddling through and trying to slash everything but essential or non-negotiable services, degrading quality of life in their cities.

Petek doesn't let city managers off the hook, however. He said that many made decisions prior to the end of redevelopment and the loss of $6 billion painted cities into a corner. Redevelopment wasn't intended to plug budget gaps. But in San Bernardino, redevelopment money became a "lifeline," according to city officials, enabling the municipality to maintain it aging infrastructure.

The fiscal collapse of several cities in California caught the bond markets off guard. Over the past year, Moody's, S&P and others have been taking a much closer look at why cities that didn't outwardly look like major credit risks suddenly got on fast tracks to Chapter 9. For the most part, there's no reason to expect a deluge of bankruptcies. But for Petek and others, there are good reasons to drill deeper into what's really been going on with the finances of Golden State municipalities.

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

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Cities in financial trouble: debt defaults are still rare

Stockton, CA Leads Nation In Rate Of Foreclosures

Justin Sullivan/Getty Images

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."

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San Bernardino's finances were already dire in 2010

Researchers Predict Major Earthquake To Hit California In Next 30 Year

David McNew/Getty Images

San Bernardino City Hall. In 2010, the City Council was warned that bankruptcy was on the horizon.

A former San Bernardino City Council member, Tobin Brinker, commented on my post from yesterday about the bond markets being taken by surprise by the Inland Empire municipality's vote this week to become the third California city to declare bankruptcy. The one-time representative of the city's third ward wrote about a council meeting that took place in 2010: 

[C]ity Treasurer David Kennedy spoke and explained the city had lost $40 million dollars in its investment pool in the previous three years. If major changes aren't made he will not be able to certify that the city can meet its payroll for the next six months. He was the first person to mention BANKRUPTCY. The City Finance Director Barbara Pachon spoke and shared a slide titled "Symptoms of Bankruptcy." She informed council members that we unfortunately meet all of the symptoms....

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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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A Q&A on the San Bernardino bankruptcy

berdoo bankrupt

Steven Cuevas / KPCC

San Bernardino city council caps a 3-hour budget hearing by grimly approving authorization for Chapter 9 bankruptcy protection. What would bankruptcy mean for the city of more than 200,000?

Last night, the San Bernardino City Council voted to prepare for a bankruptcy filing. If the city of 211,000 does enter Chapter 9, it would follow Stockton and Mammoth Lakes, both of which have turned over their finances to the courts in recent weeks after a new state-mandated mediation process failed to resolve heavy debt burdens and, in Mammoth Lakes' case, a legal judgment that was more than double the city's budget. San Bernardino would also be the second U.S. city of more than 200,000 to enter bankruptcy.

So what would bankruptcy mean for San Bernardino? I've created a Q&A that I'll follow up with some more in-depth reporting on San Bernardino's specific problems.

Q: Can San Bernardino declare bankruptcy right away?

A: It's unclear. A new California law requires municipalities to declare a fiscal emergency — San Bernardino says that it can't make its city payroll, which definitely qualifies — and enter a mediation period before officially filing for Chapter 9. In Stockton's case, this consumed about 90 days but was ultimately unsuccessful. In a July 26 analysis of the city's dire finances, the mediation process was referenced.

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