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?
"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.
EMMANUEL DUNAND/AFP/Getty Images
The ratings agency announced that it's reviewing more than 30 California cities for bond-rating downgrades. However, Los Angeles could get an upgrade.
Moody's, the big ratings agency, announced last night that it's reviewing the bond ratings of 32 California cities including Santa Monica, Glendale, Huntington Beach, and Long Beach. The reviews are for downgrades, mostly, but two of California's biggest cities - Los Angeles and San Francisco - are under review for bond-rating upgrades. This is particularly good news in L.A.'s case, given the city's looming $200 million budget deficit.
This action didn't come out of nowhere. Back in August, Moody's emphasized that although municipal debt defaults are exceptionally rare, bankruptcies in Stockton, San Bernardino, and Mammoth Lakes — along with the general fiscal stress that California cities are under — compel the agency to review the 95 Golden State municipalities whose debts it rates.
Tuesday's announcement is the culmination of that exercise. All the cities Moody's is reviewing may not be downgraded, but the agency's examining one-third (the review process will take about 90 days). The pension-obligation bonds of eight cities were downgrades. That indicates how serious a problem funding legacy pensions has become for some cities in the state.
Frederic J. Brown/AFP/Getty Images
San Bernardino is the latest California city to declare bankruptcy. Is this the beginning of the end of the once-sleepy, rock-solid municipal bond market?
It's hard to tell if this is just general nervousness after a rally or a legitimate reason to worry about an impending wave of defaults on municipal bond debt — something that has basically never happened. But in the span of a few days, billionaire investor Warren Buffett has unloaded $8.25-billion in credit default swaps on muni debt.
Buffett's Berkshire Hathaway sold the CDS to Lehman Brothers prior to the investment bank's epic bankruptcy four years ago, a Chapter 11 for the ages considered by many to be the thing that kicked off the Great Recession. Buffett's CDS amounted to a bet that cities wouldn't default on their debts — a prediction that for the most part has turned out the be true.
However, over the past few months, three California cities — Stockton, Mammoth Lakes, and San Bernardino — have declared bankruptcy. The ratings agency Moody's has stressed that muni defaults are exceptionally rare (as long as the bonds are rated; the Federal Reserve Bank of New York recently noted that unrated defaults happen more frequently, although they're far from common). But Moody's has also announced that it's conducting a review of the debt of cities in California, in light of recent events.
Federal Reserve Bank of New York
Last month, I wrote about Moody's, one of the big ratings agencies, and its view that the municipal bond market was getting a bit riskier than everyone has conventionally thought, in the aftermath of the bankruptcies of Stockton and San Bernardino and other U.S. cities.
At the time, I noted that between 1970 and 2011, Moody's could find only one city — Cicero, New York — "electing to default on debt not out of ability to pay but willingness to pay."
What that implies is that the now $3.7-trillion muni bond market has been a safe investment for decades. As long as you're investing in rated bonds. (And even if you haven't, but more on that in a sec.)
Now the Federal Reserve Bank of New York has offered its own take, at its Liberty Street Economics blog. It differs from Moody's in terms of the looking at the entire muni market, not just the part that's rated by Moody's and others. The conclusion is represented in the graphic above. Moody's found 71 defaults between 1970 and 2011 — and that's total defaults in its rating universe, so presumably 70 we due to inability to pay while only Cicero strategically defaulted due to an unwillingness to pay.
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."