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A sign stands in front of California Public Employees' Retirement System building. CalPERS is trying to prevent bankrupt cities from evading pension obligations.
Last week, Moody's, the rating agency, released a note about the ongoing San Bernardino bankruptcy and the city's pension obligations to CalPERS. According to Moody's, San Bernardino's total unfunded pension liability far outstrips it other municipal debt.
San Bernardino declared bankruptcy in July, after the city council revealed that it barely had enough money to keep the lights on. A big question in the bankruptcy has been whether the city will attempt to reduce or discharge its CalPERS liabilities. As Moody's pointed out, neither Vallejo, which went into Chapter 9 in 2008 and emerged in 2011, nor Stockton, which declared bankruptcy earlier this year, sought concessions from CalPERS. In Vallejo's case, other creditors took a substantial haircut.
CalPERS maintains that pension obligations can't legally be reduced in bankruptcy. That hasn't stopped San Bernardino from ceasing payments, to the tune of $6 million. CalPERS is now disputing San Bernardino's Chapter 9 eligibility, according to Moody's, and is threatening to do away with the city's pension plan. This would expose San Bernardino to a bigger pension payment, due immediately.
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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.
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.
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A sign stands in front of California Public Employees' Retirement System building in Sacramento. The fund has shown that it won't give an inch in bankruptcy.
One of the biggest questions to be answered by the bankruptcies of two large California cities, Stockton and San Bernardino, is "How hard will CalPERS fight?" CalPERS is the gigantic pension fund for California's public workers, managing more than $230 billion. And it's now being accused by a Bermuda-based bond issuer of getting favorable treatment in Stockton's Chapter 9 proceeding.
A Stockton proposal to creditors in May, which was made before Chapter 9 proceedings began, showed the city on the far outskirts of the San Francisco Bay Area was ready to fully pay pension fund payments but largely abandon payments on $121 million of pension obligation bonds backed by Assured Guaranty.
Assured calculated that the loss on bond principal would be 83 percent. That amounts to $100 million, which Assured would have to cover.
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Cars drive through downtown Stockton. The bankrupt California city continues to have the nation's highest foreclosure rate.
According to RealtyTrac, a real-estate service that focuses on foreclosures, California continues to endure some of the highest levels of foreclosure activity nationwide, with seven cities in the top 10. Stockton, which recently declared bankruptcy, topped the list. One in 38 homes there is in foreclosure.
San Bernardino, a city that's headed toward bankruptcy, also made the list: its metropolitan area, which includes Riverside and Ontario, ranked number three. And Vallejo fell into a metro area, including Fairfield, that came in at number four. Vallejo declared bankruptcy in 2008 and emerged last year.
Detect a trend? It's worth noting that Both Stockton, San Bernardino, and Vallejo are all older charter cities, and that for these municipalities, a cratered housing market has been a major factor in their march to fiscal crisis and Chapter 9, the municipal equivalent of Chapter 11.