California counties are more at risk of going belly up

April 11, 2012 - By Wayne Lusvardi

Editor’s Note: This is the fifth in a CalWatchDog.com Special Series of 12 in-depth articles on municipal bankruptcy.

There are many California cities likely to be facing future stress to their operating fund budgets because of rising public pension obligations. But even more so county governments are staring down the unthinkable: bankruptcy.

This is mainly because counties overlap in providing public services with the state. Under what is called “realignment,” the state is dumping prisoners, Medi-Cal patients and social welfare recipients on California’s counties without deregulating such programs.  This is a fiscal perfect storm waiting to happen.

The local level is where the action will be with the public pension system crisis and the associated prospect of municipal bankruptcy. It will take a vigilant and informed local citizenry to bird dog the process of renegotiating public pensions, reworking local government budgets and understanding the associated risks to taxpayers of pension reforms. The action will be in city halls, county halls of administration and county superior courtrooms across the state.

Let’s first take a look at the basics of municipal finance.

1.      The General Fund is a Common Pot of Funds

Local government budgets are called “general fund budgets” because they are a large common pot of revenues that funds a whole range of basic services: fire, police, parks, streets, water systems, sewer systems, the city manager, etc.  Typically, 70 to 80 percent of a city’s budget goes for personnel expenses: salaries, pensions and health benefits.

Pensions presently consume from about 4 percent to 9 percent of city and county budgets, although this is increasing and could balloon to 15 to 20 percent or higher.  As that percentage increases, other services provided by local governments are likely to get crowded out of the budget unless pensions are renegotiated, a court forces a reorganization “cram down” or taxes are increased to cover the mounting pension debt.

2.      Revenue Sources

The main sources of revenues for local government in California are sales taxes, property taxes, business taxes, utility users’ taxes (on electricity, water and telephones), federal block grants and fines and revenue sharing from state government. The revenue sharing can include a portion of sales taxes, gasoline taxes and vehicle license registration fees.  The state also collects a corporate tax, a capital gains tax and a gasoline tax.

3.      Pay-Go or Bonds 

Local governments typically have two ways to finance their obligations: 1) pay cash, called pay-as-you-go or “pay-go”; or 2) bond financing. Large or long-term projects of a local government are typically funded by municipal bonds, just as homeowners finance their homes with mortgages.  Bonds are like mortgages that are promises to pay a long-term debt and are backed by the “full faith and credit” of a municipality.

There are two types of bonds: 1) general obligation bonds; and 2) revenue bonds.

Investors find general obligation bonds or GO bonds attractive because they obligate everyone in the municipality to pay them off even if there is a shortfall in revenues.

This is all-important for understanding bankruptcy because a general obligation bond can require a tax levy at a rate for whatever level is needed — up to 100 percent — to recover a shortfall in taxpayer delinquencies.  In California under Proposition 13, a general obligation bond must be authorized by a supermajority — two thirds — of voters.  Voter rejection for raising taxes to pay a bond means that the local government will need to make space in its existing operating budget to make the debt payments.

General obligation bonds typically pay for general municipal improvements such as streets, sewers and water systems.  Revenue bonds typically pay for special revenue-producing facilities such as a convention center, a stadium or a redevelopment project. The money comes only from the revenues of that project.

The difference between the two types of municipal bonds is the type of security for the bonds.  General obligation bonds obligate all the taxpayers within the respective city, county or special taxing district.  Revenue bonds are secured only by the cash flow from a specific project and not from the taxpayers.

4.      Bonds Cost More

No matter what type of bond, local government typically ends up paying one third or more higher than the face amount of the bond because of compound interest that needs to be paid to bond investors, typically over a 20 to 25 year life of the bonds.  Government bonds are typically tax-exempt and thus offer local government a sort of low-interest credit card.

As David Crane, advisor to former Gov. Arnold Schwarzenegger, testified:

“For example, an annual obligation of $30,000 for 25 years for a government employee’s pension is projected to cost the government $320,000, while the same $30,000/year, 25-year obligation in the form of a bond is projected to be $425,000….

“Two identical and unconditional obligations owed by the same government are valued at different amounts. The answer lies in the Alice in Wonderland world of government pension accounting that allows governments to hide liabilities…. The government and the taxpayer stay on the hook” for pension promises. “To put this in perspective, consider this: If Alice’s accounting could be applied to your mortgage obligation, then just setting up a trust account and projecting that account to earn a high rate of return on any deposit you make to that account would allow you to reduce the reported size of your mortgage. Now wouldn’t that be nice — at least until you had to make the payments on that mortgage.”

5.      Funding Pensions with Bonds is Risky

Bonds are not typically used to pay for city or county services, public pensions or health benefits.  The most famous case of a large municipality nearly going into bankruptcy was New York City during the stagflation of the 1970s. The Big Apple only averted insolvency by being bailed out by a federal loan.  Part of the problem in New York City was that bonds were being used to fund soft costs — social services, salaries and pensions — not hard costs such as capital improvement projects.

Imagine taking out a mortgage on your home to provide a pension for you to live on. Then what would you pay back the mortgage payment with?  Despite the risk of funding pensions with bonds, the wealthy city of Pasadena recently funded its unmet pension obligation with a general obligation bond.

Up until now, most municipal bond defaults have been concentrated in the category of redevelopment revenue bonds backed by stadiums, hotels, casinos and infrastructure for large residential subdivisions.

But what’s new is municipal defaults in which legally committed expenses exceed the available revenues of a municipal operating budget — called a “general fund” budget.  This can occur if a public-employee union labor contract obligates a city or county to pay pensions based on a lucrative formula, but revenues decline to the point that they are insufficient to cover expenses obligated under the contract.

6.      Bankruptcy

One way to invalidate or have a court adjudicate such a pension contract would be to seek a Chapter 9 bankruptcy — which refers to Chapter 9 of the U.S. Bankruptcy Code for cities, counties, towns, special taxing or assessment districts, municipal utilities and school districts.  The first municipal bankruptcy law was enacted during the Great Depression of the 1930s.

Another way is for local governments to put pension reform before the voters.  This might be called “proxy bankruptcy” because it effectively does much of the same thing as bankruptcy.  On Dec. 6, 2011, the San Jose city council voted to put a pension reform measure on the June 2012 ballot. The constitutionality of that measure has been challenged in court and could eventually set a precedent for what is going to happen all over the state.

“What the ballot initiative does is it looks to challenge laws as they exist today, which is probably going to mean years of litigation before anything gets settled, if anything at all gets settled,” said Robert Sapien, the president of the San Jose Fire Fighters union.

If the courts rule that existing pension plans are constitutionally protected and unchangeable, then we are likely looking at formal bankruptcy for many local governments.

With the basics of municipal finance explained, let’s look at the fiscal — or budgetary — situation that California cities and counties find themselves in today.

City and County Budgets on the Verge of Upset

Many California cities are under fiscal stress due to the protracted contraction of the economy. Many of those cities will be staring down bankruptcy waves as public pension obligations start kicking in during the coming years.

One of the largest prospects for bankruptcy is that of the City of Los Angeles. Former Mayor Richard Riordan wrote an article in the May 5, 2010 issue of the Wall Street Journal, “Los Angeles on the Brink of Bankruptcy.” He warned, “Between now and 2014 the city will likely declare bankruptcy.”

According to Riordan, even if the city were to enact drastic pension reforms today, it wouldn’t be enough to meet the $2.5 billion in increased pension obligations the city faces.

Riordan blames the city’s budgetary crisis on two numbers: 8 percent and 5,000.

8 Percent Returns in a Zero Interest Rate Environment

For Los Angeles’ pension funds, 8 percent is the projected annual rate of return.  But Riordan warned, “Over the last decade, the two main pension funds in Los  Angeles have seen their assets grow at just 3.5 percent and 2.8 percent annually.” The two funds are the Los Angeles City Employees’ Retirement System and the Water and Power Employees’ Retirement Plan.

And investment rates of return are likely to decline now that the U.S. Federal Reserve Board has lowered the long-term Treasury Bill borrowing rate effectively to zero percent.  Much of the high annual returns advertised by the CalPERS state pension fund in the past two decades have been earned because growth has been financed with debt and leveraging, which neither the state nor local governments can continue to count on.

Adding Government Employees Erodes Legitimacy for Any Tax Increase

Riordan’s other number is 5,000.

Despite the recession, from  2005 to 2010 the city of Los Angeles added 5,000 new employees added to its payroll.  Cities like Los Angeles, which added employees during the recession, are particularly vulnerable not only fiscally. They also raise the ire of the voters who may be asked to approve any renegotiated pension plans.  Many cities and counties have padded their employee rolls during the recession. Such cities and counties are likely to lose legitimacy before the voters for any kind of tax increase to fund lucrative pensions.

Los Angeles officials have dismissed Riordan’s forecast of a looming fiscal crisis by using accounting gimmicks to wish the problem away, and by sticking to the 8 percent annual rate of return on retirement funds.

Los Angeles Mayor Antonio Villaraigosa continues to assert that bankruptcy is not an option for the city. He has proposed a pension reform deal that would require approval by the city council and the voters.  But the problem with Villaraigosa’s pension deal may be the sheer mathematics of overly optimistic pension fund investment returns that got the city into its impending budget mess in the first place. So the city ofLos Angeles may be going in circles with pension reform.

On April 6, 2012, Miguel Santana, chief administrative officer of Los Angeles, warned that the city faced bankruptcy unless it raised taxes and laid off personnel. The Los Angeles Times reported that, according to Santana, “[R]ising employee costs combined with flat-lining revenues have left the city in a precarious position. Even after reducing its workforce by 4,900 positions in recent years, the city faces a $222-million budget shortfall, he said, a figure that is expected to rise to $427 million by 2014-15.”

Multiply the fiscal problems of Angeles times the number of cities and counties in California, and you have a statewide fiscal crisis affecting hundreds of municipalities.

Pensions are ‘Eventually Unsustainable’

Howard Cure is the director of Municipal Bond Credit for Evercore Financial Management in New York. He stated in an interview that the current pension commitments in California are “eventually unsustainable.”  He believes that local governments cannot look to the growth of equity or fixed income financial markets to close the funding gap in the underfunded public pension programs.  Cure added, “If nothing is done, the costs get more onerous and you can’t continue to defer it.”

There are several changes that could be made to pensions for future public employees: extend the retirement age, disallow pension spiking and gaming the system, and increase the percentage of pension contributions by new employees.  But Cure said this takes a long time to work through the system and is not likely to solely represent a quick fix to the ailing public pension systems.

Changes are needed to the pension formulas for existing public employees and retirees.  But once again, merely lowering the cost-of-living adjustments for existing pensioners may not do the trick fast enough or deep enough to avoid a fiscal crisis.  Retirees will have to be asked either to increase contributions to the pension system or increase taxes to plug the pension gap.

Alternatively, pension benefits could end up facing the risk of a court a “cram down” reorganization either in bankruptcy court or in the superior and appellate courts.

Raising Taxes Out of the Question

But Cure is not optimistic that taxes can be raised. Public unions do not have the muscle they once had. And the public is not going to vote for a tax increase for lucrative public pensions when their 401(k) private pension funds dropped sharply in the financial crash of 2008.

Bankruptcy is not a solution, according to Cure, if it means repudiating debt, which would result in local governments being denied future access to the debt markets.  Nonetheless, it is likely that existing pension formulas and benefits will end up in court to determine to what extent public pensions are constitutionally guaranteed, or if they can constitutionally be unwound.

Cure is optimistic that the pension system can be reformed based on efforts by such cities as San   Jose. As mentioned, the city is putting pension reform on the ballot in June 2012.  He says the current situation is fluid and not static.  But it will take hundreds of such local efforts to reform each pension plan instead of merely systemic reforms at the state level.

Municipal Bond Insurance Has Declined

There isn’t much municipal bond insurance coverage any more to backstop fiscal crises. According to the Municipal Securities Rulemaking Board, fewer than 10 percent of all new municipal bond issues are insured. That’s a drop from 50 percent as recently as 2008. The municipal bond industry may be less worried about municipal fiscal defaults than the average citizen. But the insurance industry has vastly reduced its exposure in the municipal bond market.

Perhaps bond insurers are fearful of being a “deep pocket” stuck with paying out liabilities in a bankruptcy court order.

Pension Studies are all based on Assumptions

A key to understanding pension-fund obligations is to look at the assumptions of some of the studies that have been conducted on California’s public pension system:

1.      Northwestern Pension Study — A Disaster Scenario of Closed Pension Plans

In 2010, the Kellogg School of Business at Northwestern University released a study, “The Crisis in Local Government Pensions in the United States.” It indicated a dire scenario mainly for counties in California.

Pension Legislative Representative Eraina Ortega of the California State Association of Counties said the Northwestern study is based on an assumption of a closed pension system that would no longer be funded.  A closed pension system would be one that accepted no new retirees.  She said that, even if a pension system were closed, it would still be funded and would not necessarily run out of money.

However, she added that the assumption that public pension funds will continue to earn around 8 percent returns on their funds is a legitimate issue of concern.

2.      Boston College Retirement Study — Moderate Scenario but New Taxes Unrealistic

The Boston College Center for Retirement Research conducted a study in 2010, “The Funding of State and Local Pensions: 2009-2013.” It is based on perhaps a more reasonable assumption that employer contributions of public pension systems would continue. According to Howard Cure, the Boston College study is also based on more reasonable expected rates of return of around 6 percent, rather than the nearly 8 percent used by CalPERS, or the risk-free 4.14 percent rate of return on T-bills used in a 2010 Stanford University study (see below).

Even though the Boston College study indicated that funding ratios for public pension funds would likely drop from about 85 percent to 72 percent by 2013, it nonetheless concluded that “a major increase in contributions is not realistic at this time.”  The Boston College study did not recommend raising taxes to plug the pension gap. But it did recommend that local governments at least fund the Annual Required Contribution, which is the annual amount the government would have to pay to fund its liabilities over time.

3.      Stanford Pension Study — Financial Train Wreck Scenario Based on Low Return Rate

Also in 2010, graduate students at the Stanford University Institute for Economic Policy Research completed a study, “Going for Broke: Reforming California’s Public Employee Pension Systems.”  It was based on conservative safe rate of returns to the pension funds of 4.14 percent, instead of the 7.75 percent assumed by CalPERS. It estimated as much as a $425.2 billion funding gap as of 2009.  The Stanford study recommended reforms such as the implementation of a hybrid public pension plan and a 401(k) private pension plan.  The Stanford study did financial modeling of the future and did not assume that the pension systems would be closed off, as did the Northwestern study.

According to Eraina Ortega of the State Association of Counties, Gov. Jerry Brown has questioned whether the hybrid pension plan being proposed by the Stanford study could be a “Ponzi scheme.”  CalPERS actuaries have reportedly pointed out that, even if its pension fund were to be capped and closed, it would still be able to service pensioners and not leave them wiped out.

The Stanford study was updated in December 2011 in “Pension Math: How California’s Pension Spending is Squeezing the State Budget.” It used more conservative investment assumptions of a 6.2 percent annual investment rate of return. Yet it found the funding shortfall had climbed by 17 percent, to $498 billion.

Instead of experiencing “number shock” of all the different calculations in each pension study, it is better to focus on the assumptions undergirding each study.

Comparison of Assumptions in State Pension System Studies

College   Study   Title – Year Assumptions Rate   of Return
BostonCollege The Funding of State and Local Government Pensions: 2009-2013   (2010) Open pension system with continuing contributions 6-to-8 percent
Northwestern College The Crisis in Local Government Pensions in the U.S.(2010) Closed pension system with no more contributions; assume 3   percent revenue growth Treasury bill rateSafe rate of return
Stanford Institute for Economic Policy Pension Math (2011) Open pension system with continuing contributions 6.2 percent

It is important to understand that the higher the rate of return the pension fund earns, the lower the present value of the benefit cash flows.

Pension Liabilities Could Be Made to Disappear by Assumed Return Rate

If a high enough rate of return is used, assuming risky investments with high-average rates of return, it could make local government pension liabilities hypothetically vanish.  So beware of the trick of using high rates of return as well as unreal low rates of return that would make the pension liabilities look smaller or larger.  It is possible that most pension systems in California use a return rate around 8 percent purely as a device to minimize the perceived expected exposure to the taxpayers.

No one knows what rates of return pension funds will yield in the future. Past return rates were inflated by incurring debt and leverage that is unlikely to continue in the future.  There seems to be a tentative consensus that an 8 percent rate of return is too high. But a safe rate of, say, 2.5 percent is too low.

Not All Cities Are in Distress Scenario

Not all cities in California are under such financial distress. The city of Laguna Niguel in Orange County would likely be untouched by the wave of pension obligations.  Its pension debt is less than 20 percent of its annual operating budget and it has $40 million in financial reserves for a city of about 65,000 people. The city is known for its political conservatism and has only 17 retirees and 59 current full-time employees, as it contracts out most of its services. This shows that the current mess could have been avoided if officials took a more fiscally prudent approach to their budgets.

California Counties in Double Jeopardy

Howard Cure said it is not California’s cities, but counties, that face the greatest threat of fiscal crisis in the near future.  As mentioned at the beginning of this chapter, a major culprit is “realignment” that sends functions from the state to the counties, but with inadequate financing.

Although the Northwestern University pension study is based on arguable assumptions leading to a pessimistic set of scenarios, it nonetheless highlights that 18 of the 50 municipalities, or 36 percent, expected to be bearing the most fiscal stress are located in California.  And of the 18 California local government pension systems surveyed, 15 are counties.  Whether one agrees with the assumptions of the Northwestern study or not, it nonetheless calls to our attention that the greatest municipal fiscal stress in the U.S. may occur in California’s counties.

Below is a table from the Northwestern study indicating the estimated proportion of annual general fund revenues for each municipality in California that would be consumed by pensions.

Percent Municipal Revenues Consumed by Pensions

County Best Case(2019)3% Growth Worst Case(2015)No Growth Year No Longer Able To Pay
Larger Cities   & Counties
FresnoCounty 78% 142% 2026
San Diego Co. 62% 119% 2028
SacramentoCounty 54% 110% 2030
L.A.County 41% 91% 2033
San BernardinoCounty 45% 90% 2029
KernCounty 51% 82% 2022
VenturaCounty 38% 76% 2029
San FranciscoCity& County 34% 74% 2032
AlamedaCounty 36% 69% 2028
City ofSan Jose 33% 61% 2027
Smaller Cites   & Counties
SonomaCounty 51% 82% 2022
San JoaquinCounty 46% 78% 2024
San MateoCounty 35% 59% 2024
ContraCosta  County 39% 68% 2025
Santa Barbara 32% 59% 2027
StanislausCounty 47% 90% 2028
TulareCounty 41% 93% 2034
City ofLaguna Niguel 19.85% 19.85% Never

It will be county supervisors and their constituents that will be in the vortex of the public pension perfect storm scenario in California.  Political parties, think tanks and emerging movements such as the Tea Party would best be advised to focus on the county level of government, where the prospect of a fiscal meltdown is going to be greater and the stakes much higher.

Will counties merely replicate the state’s prison, medical and social welfare systems at the local level under “realignment,” thus putting the state right back where it started from with programs it can’t pay for?

For example, Sheriff Lee Baca in Los Angeles County is proposing that the county supervisors float a $1.4 billion general obligation bond to fund the renovation and expansion of two existing jails to accommodate the transfer of offenders from the state prison system.  No public policy discussion has taken place of any alternatives such as privatizing lesser-offender prisons, transferring misdemeanor offenders to prisons in other states or decriminalizing some misdemeanor offenses to save costs.

No Cost Savings

With all the ballot initiatives being floated for the November 2012 election, none so far exists to establish lesser-offender prisons.  The local bureaucracies have taken the early lead in trying to shape public policy by merely shifting the political locus of the problem from the state to the counties without any real cost-saving reforms.

There is no guarantee that delegating prisons, medical and social service programs to the counties will result in any real reforms, or that unions won’t be able to capture local policy makers just as they have state lawmakers.  Indeed, the unions already exert heavy influence over many cities and counties.

But if the state’s structural $20 billion annual budget deficits are any indication, costs must be reduced by counties. Otherwise, realignment will be an exercise in futility ending right back in bankruptcy court.

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