Special Series: The pros and cons of municipal bankruptcy

April 12, 2012 - By CalWatchdog Staff

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

April 12, 2012

By Tori Richards

What’s better for a cash-strapped municipality: filing for bankruptcy or struggling to survive without any clear solution to a massive deficit?

In an era of runaway pensions and multimillion-dollar — and sometimes billion-dollar — budget shortfalls, it seems as if no other option exists. Surely filing for bankruptcy is the Holy Grail for municipalities that have wormed their way into a hole covered by massive debt brought on by generous labor contracts, mismanagement of investments or lackluster tax revenue. Or is it?

“It’s not a solution — it’s so rare that the case law isn’t even that deep,” said one of the nation’s foremost experts, Chicago attorney James Spiotto, author of several manuals on municipal bankruptcy. “You don’t know what you are going to get, it’s expensive and drawn out.”

Like any court action, there are pluses and minuses to consider. Lately it seems that public opinion is siding more with the “plus” column as taxpayers are fed up with skyrocketing costs and unsustainable government salaries. Cases in point: the cities of Vallejo, Calif.and Central Falls, R.I., both of which filed for bankruptcy as a way out of excessive pension obligations that dwarf their annual budgets. Jefferson County, Ala. followed suit. So did Harrisburg, Pa., in October 2011, although a federal judge denied the bankruptcy petition because the city council “was not authorized” to file it. On Dec. 11, the city indicated it would appeal the ruling. San Diego, Calif. also has been threatening to declare bankruptcy.

Municipalities have been allowed to file bankruptcy since the Great Depression, when Congress decided that counties and cities needed help from creditors when tax revenues dried up. Chapter 9 was created for this purpose in 1937 and since then, 624 municipalities have filed for relief.  About 40 percent of the filings have occurred since 1980.

Banking analyst and frequent cable news pundit Meredith Whitney became an enemy of the municipal bond market last year when she issued a doom-and-gloom report stating that perhaps 100 municipalities would start default proceedings on obligations worth hundreds of billions.

“It will be a tidal wave,” she said.

But the prediction didn’t materialize as only 24 defaults occurred through the first half of 2011, totaling some $746 million, Bond Buyer reported. And the bankruptcy trend has been shown to be more talk than action, with just five filings in 2011, a decrease from years before when there were six in 2010 and 10 in 2009.

Too Big To Fail? 

In 1994, Orange County made international headlines when its treasurer engaged in risky investment strategies that failed, leaving inadequate funds when interest rates increased. The county filed for bankruptcy on December 6 that year. Residents refused to raise taxes to cover the $1.7 billion shortfall, forcing austerities on county and local governments. At 3 million people, it is the sixth most populous county in the nation and the 38th largest economy in the world.

Orange County has nothing on Jefferson County, which filed for bankruptcy protection on Nov. 9, 2011. On Dec. 9, creditors asked U.S. Bankruptcy Judge Thomas Bennett to dismiss the case.

The largest county in Alabama may only be a third as populous as its wealthy counterpart, but its problems are deeper. A federal consent decree required sewer repairs that were paid for with bonds. When a refinancing deal collapsed in 2008, it left behind $3.1 billion in debt.

Like Orange County, Jefferson County’s finances hinged on speculation that interest rates would remain low.

But it didn’t end there. The courts have declared one of the county’s taxes unconstitutional. The loss of that revenue has left a $74 million hole. As a result, 500 government workers were laid off, road and bridge repair is sorely needed and sewer rates have skyrocketed.

While county lawmakers floated the idea of bankruptcy and even hired lawyers for that purpose, that briefly was staved off on Sept. 16 when the County Commission voted 4-1 to settle its debt. Terms include refinancing $2 billion while the creditors — led by JPMorgan Chase — dismissed approximately $1 billion in debt, the Associated Press reported. The action is tentative because it still requires assistance from the state legislature to shore up the county’s budget. One of the sticking points is a continued escalation of sewer rates for years to come.

In the months leading up to Jefferson County’s bankruptcy, pros and cons were bandied about as to why Jefferson County should or should not file for bankruptcy, issues that generally apply elsewhere.

Perhaps the most widespread factor argued against it was the domino effect. Wall Street is already nervous over sinking money into any municipality located in Alabama.

“It’s the contagion effect,” attorney Spiotto said. “If one does it [files bankruptcy], there is a view that it is spreading to other communities in the locale. That’s why you see rare use of Chapter 9. It doesn’t provide any new tax source or revenues.”

Financial advisor Tom Dalpiaz said just the mere mention of the world Alabama is enough to raise rates. As senior vice president of Advisors Asset Management in Colorado, Dalpiaz oversees $280 million in municipal bonds.

“While it may not seem entirely rational, that’s what happens,” Dalpiaz said. “People in the marketplace see a major issue such as Jefferson County having difficultly and they will look at other municipalities in Alabama and say, ‘Gee, if they run into trouble they will have same type of problem because the state didn’t help out in any way.’”

This means Alabama cities are stuck paying about 0.2 percentage points more than cities in other states with the same credit rating. If the bond issuer is in Jefferson County, that results in 0.8 percentage points more, Bloomberg reported.

For example, a Birmingham, Ala. bond maturing in 2032 traded to yield 4.61 percent on Aug. 15, compared to a similar bond in Memphis, Tenn., which had a 4.25 percent yield. Another bond in nearby Huntsville, Ala., with an AAA credit rating, was traded recently at 2.42 percent, compared to 2.07 percent elsewhere in the nation, Bloomberg reported.

But over in Rhode Island, the Legislature was a little bit smarter and saw the pending repercussions after the tiny city of Central Falls filed for Chapter 9 on Aug. 1, 2011. The first law of its kind in the nation was immediately passed, giving bondholders access to funds ahead of retirees and other creditors. Investors were paid their entire amount of $635,000 when their bonds came due in October.

Suddenly Rhode Island has become the place to invest with relative safety. It had a bond sale at the end of August and the notes were just .04 percentage points below the AA+ index. But the payment to bondholders means cutbacks elsewhere, such as the library, post office, pensions and union contracts.

This has angered unions, such as the Fraternal Order of Police, whose lawyer Jack Parlon wrote in a blog post that “someone out to go to jail” over the state receiver’s plans to chop 50 percent from pensions. Parlon vowed a legal fight, which is proceeding through the courts.

Like so many other places, Central Falls got into trouble over its excessive government contracts and pensions. The city of 19,376 owed $80 million in health benefits, but only had an annual budget of $17 million. When union reps failed to make concessions, the city filed for bankruptcy.

“Bankruptcy not only affects the workers and the unions, but all the relationships. Any creditor, every service contract, every provider of goods, every contract you feel is a good contract,” Spiotto said. “The problem with Chapter 9, rather than a rifle shot dealing with certain problems, is it throws all the creditors in the air, tips them all over, and you have to deal with a plan of adjustment.”

“Chapter 9 is time consuming, expensive and more painful than is probably realized going in,” Spiotto continued. “It is very complex because you have to examine all your relationships and work out new ones. If they can’t pay in full, will they continue to provide the service?”

Many municipalities can’t afford the legal fees associated with bankruptcy, which can be $10 million or more.

Perhaps E.J. McMahon, senior fellow of the Empire Center at the Manhattan Institute think tank, said it best: “Ultimately, bankruptcy is a result of political failure. It’s because of either an enormous bonehead play or malfeasance. But it’s a political failure.”

The Union Factor 

Before there was Central Falls, there was Vallejo. The Northern California city of 116,000 had counted on a nearby U.S. Navy and a shipyard for revenue. When they closed in 1993 and 1996, respectively, the money started drying up. A housing boom still followed, but a lack of commerce eventually won out and a budget crisis ensued. Police and fire pay and pensions were 70 percent of the city’s $83 million budget. The city’s reserves were exhausted and still the budget deficit existed.

Finally in 2008 an ultimatum to the unions was given that would be repeated three years later inCentral   Falls: make cuts or we’ll file for bankruptcy. The unions refused and the following day Vallejo filed.

“Just as many companies have been forced into bankruptcy due to labor costs and the inability to work out a tenable collective bargaining agreement with unions, Vallejo found itself in the same predicament,” according to a 2008 report by the American Bankruptcy Institute. “Municipal bankruptcy in such instances may be a necessary solution for other municipalities with similar escalating labor costs, while facing a ‘near-term liquidity crisis.’”

In 2009 a bankruptcy judge made a precedent-setting ruling. He allowed the city to void contracts with its fire and electrical unions.

“We had to do something to economically survive,” said Robert McConnell, one of Vallejo’s bankruptcy attorneys. “The first fight was whether Vallejo could even file a bankruptcy. The unions challenged this. The next step was about the contracts and the judge agreed we do have the ability to void the contracts. Some settled and we were left with two. It went up on appeal and they withdrew the appeal.”

The city emerged from bankruptcy in August 2011 with a plan that makes retirees pay more for their health plans, cuts pensions to new employees and institutes new labor contracts.

Changing pensions and contracts is certainly a benefit and there are other benefits, McConnell said. “It gets everybody off your back immediately, an automatic restraining order,” he said. “Nobody can sue you, demand things of you; everything is put on a temporary hold. A time out.”

Added attorney Klee, who represents Jefferson County, “The people who say no one should do it [declare bankruptcy] are the people who sell municipal bonds and are in charge of the business community. They very clearly would be opposed to it.”

Still, Chapter 9 remains the only viable way for municipalities to rectify any combination of following problems, Klee said: unsustainable labor costs and benefits, reduced state funding, infrastructure funding, an inability to raise taxes to cover shortfalls and increasing environmental mandates with no funding to support them.

But the euphoria of a clean slate also brings a cautionary tale. Bankruptcy does not lead to structural change.

“It’s like coming upon a yard full of weeds and mowing the weeds,” McMahon explained. “Sometimes you mow the weeds right down to the nub and you think they are gone but you haven’t uprooted any of your problems. There is case after case when bankruptcy has not done that. If you are Vallejo and not going to fundamentally change how you do business, all you’ve done is give your bondholders and employees a haircut and you still have bad habits that you are unwilling to address. And you spent millions on legal fees.”

Vallejo’s McConnell agrees and he is running for city council in order to affect change. “It does get rid of burdensome contracts, but only those that had been done in the past and doesn’t do anything to change the future and that is a political issue,” he said.

Perhaps McMahon said it best. “Vallejo went into bankruptcy because it was easier for them to cut pay and reduce the amount going to retiree health plans. It can be renegotiated back to the way it was. Deals can be worked out afterward. What is going to stop Vallejo from happening again in Vallejo?”

Richards is an investigative reporter.


Check out other articles in our Special Series on Bankruptcy.


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  1. Rex The Wonder Dog! says:

    But over in Rhode Island, the Legislature was a little bit smarter and saw the pending repercussions after the tiny city of Central Falls filed for Chapter 9 on Aug. 1, 2011. The first law of its kind in the nation was immediately passed, giving bondholders access to funds ahead of retirees and other creditors. Investors were paid their entire amount of $635,000 when their bonds came due in October. Suddenly Rhode Island has become the place to invest with relative safety……This has angered unions, such as the Fraternal Order of Police, whose lawyer Jack Parlon wrote in a blog post that “someone out to go to jail” over the state receiver’s plans to chop 50 percent from pensions. Parlon vowed a legal fight, which is proceeding through the courts.

    Yes, the GED educated cops and firedorks who scammed the pension systems are the ones who outght to go to jail,and the funniest part of this is that they are now a role model nationwide on how to cut scammed multimillion dollar pensionsby 55%.

  2. Frank says:

    It cost Vallejo $10 million in legal fees alone to take the bankrupcy route. The city’s police force operates at 38% of its peak capacity in 2004, and the fire department is at 30%. The city’s credit rating was cut to junk level during the bankruptcy, making it prohibitively expensive to borrow. Vallejo must tackle pension payouts, which it didn’t deal with during bankruptcy. The pension payouts are set to rise from roughly $13 million in the current fiscal year to about $14 million in fiscal 2013, according to bankruptcy-court filings.

    Vallejo emerged from court protection in 2011 with a skeletal workforce, about 20 new medical-marijuana dispensaries and a surge in prostitution, while forfeiting its ability to issue debt for five years.

    “We truly want to avoid that,” Stockton Mayor Ann Johnston, 69, said in a Jan. 19 interview at City Hall. “We’re not moving in that direction whatsoever. Our focus is to balance our budget, to continue to provide services, to continue laying the foundation for our future recovery.”

    Anybody who thinks US municipalities want to repeat Vallejo’s actions need their head examined.

  3. Rex The Wonder Dog! says:

    Anybody who thinks US municipalities want to repeat Vallejo’s actions need their head examined.

    Spoken like a TRUE bottom feeder public employee.

    One only needs to look at Central Falls RI and the 55% cut to scammed cop/firedork pensions and anyone who claims Chapter 9 is not a great solution needs to have THEIR head examined.

    BTW- Vallejo did not go after the pensions, they could have-and should have- gone after them because they would have taken a 60%-70% cut if they did. They were not earned, just gifted away for special interest donations…..

  4. SeeSaw says:

    Vallejo spent nearly 12 million in legal fees, and Frank is correct. Nobody wants to revisit a situation like Vallejo went through for three years:

    Title: Vallejo Exits Chapter 9 Bankruptcy (From the Vallejo Times Herald, August, 2011):

    “According to a statement released to the press Tuesday, Vallejo will begin repaying its creditors beginning Tuesday. The city has established a $6 million creditor repayment fund, Whittom said, to draw from in damages due to past and present city employees and other major creditors. The city had spent nearly $12 million in bankruptcy court-related fees, as of August, according to the city Finance Department.”

    No self-respecting person would refer to those who provide the public services that are used by the citizenry every day, as bottom feeders. Of course we know that RWD does not possess dignity.

  5. Rex The Wonder Dog! says:

    No self-respecting person would refer to those who provide the public services that are used by the citizenry every day, as bottom feeders. Of course we know that RWD does not possess dignity.

    Thank you seesaw, I will wear your comment as a badge of honor from you ;)

    And for the record, Stockton, San Jose and most likely LA, will ALL be filing BK within 2 years-Stockton within 6 months.

  6. Tough Love says:

    Vallejo’s mistake was not freezing the existing pensions (AND demanding further haircuts to accrued pensions if needed), and having all future pension accruals for CURRENT workers via 401K-style DC Plans. THAT would have put a real dent in their pension obligations.

    But alas, their Council was still co trolled by the Unions and “caved” on the best option it will ever have.

  7. john moore says:

    In fairness to the decision to forego reducing pensions, Vallejo had a medical insurance deficit that was out of control. But more importantly, it filed in 2008, a year before the massive CalPERS loss of 2009. In 2009, the official loss as verified by CalPERS was 29.2% of assets. In addition it failed to earn 7.75% on the assets needed to be fully funded for a total loss exceeding 35%. If it had known that loss was coming, I believe Vallejo would have been forced to face up to its’ pension deficit. Why didn’t it amend to include the pension issue? My understanding is that an election subsequent to the filing changed the council in favor of the employee unions. As to the cost, much of the cost was paid by skipping bond payments and payments to other creditors and using the money for the Chap 9. The whole thing was a failure and has under cut the only leverage that citizens have against the bubble pensions. Just because Vallejo screwed up in Chap 9, doesn’t mean it could not be done efficiently. Pacific Grove Taxpayers Assn’

  8. Rex The Wonder Dog! says:

    Calpers said it was going to fight Vallejo in court if they went after vested pensions, and Vallejo folded like a cheap laundry.

    What Vallejo should have done was say “Bring it ON CalTURDS” and settled the issue, just like Central Falls RI did. They wussed out.

  9. Ted Steele, Associate Prof. says:

    “folded like a cheap laundry”????

    It’s hot enuf out here to mix a metaphor on the sidewalk!

    poor poodle!

  10. SeeSaw says:

    That’s because Cali is not RI, or NJ, or ALabama, or any other state, Rex. If you think any other City who claims bankrupty is not going to be growled at by CalPRS, just like Vallejo was, you better think again. You and your cohorts cheering to see the public sector workers brought down, are sickening.

  11. Rex The Wonder Dog! says:

    You and your cohorts cheering to see the public sector workers brought down, are sickening.

    I will b throwing a partay!~

  12. queeg says:

    The Brown tax will pass and here we go again. Spend. Spend. Spend

  13. Beelzebub says:

    The large urban areas like Los Angeles, Stockton, Fresno, San Jose – that are in deep, deep financial crap (according their own city officials) – have no other choice but to drastically cut both current pensions being paid and pensions of active duty city employees – since that is where 80% of the problem originates. If they cannot come to an agreement with the unions to accomplish that – then the next step in the process is bankruptcy to force it down their throats. This is reality. Bankruptcy has already been threatened by the city officials. It is not conjecture. These are the hard, cold facts. The thing about changing the pension formulas or going to a defined contribution for new employees does not scratch the surface of the CURRENT fiscal crisis. The ones who are stomping their feet and turning blue on these boards are simply not facing reality. They are in deep denial. When it finally happens it will hit them in the face like a glass of ice water.

    You see, the revenue that the cities are relied on to finance all this excess is shrinking and IT AIN’T COMING BACK. The investments markets will be STAGNANT (in the very best scenario) and property tax revenue is on a steep decline. As interest rates climb (and they must) the cities will find it harder and harder to find buyers as risk goes substantially higher (remember: municipal bonds are supposed to be a SAFE HAVEN for conservative investors. Not a risky security to gamble with) and to service the interest on the huge debtloads.

    I am sorry to be the messenger of bad news, but you current and former government people who rely on easy pension money are about to get screwed.

    I ask you to remember this piece of wisdom going forward:


    Please write that down for future reference.

    Have a nice day.

  14. Ted Steele, Associate Prof. says:

    Beezy boob——- you alarmists have been tooting garbage for years now…..there are so many ways to work through this lawfully but your crew only advances the draconian nonsense…….dull——– have a super duper day too!

  15. SeeSaw says:

    There is no collective bargaining when it comes to current pensions. You are the one who will dissappointed, Beez–because our pensions are rock solid.

  16. john moore says:

    I suspect that CalPERS is no more effective at litigating than investing. The safety unions are heavily armed with legal and experience. No one should expect it to be easy. If I were negotiating the pre-bankruptcy mediation(per Stockton), my first offer would be that 90%+ of all 3%@50 employees would go to part time, w/o benefits. Just like a fast food franchise. There are tens of thousands of unemployed police and fire people out there who would love to make $50,000 per year. We should give them a fair chance.

  17. SeeSaw says:

    Your, “stand up” is no good Mr. Moore. Look into doing something else.

  18. john moore says:

    There is no vested right to any salary level. Nor to full time. My example may have been extreme, but valid. I take your Reply as an “I don’t understand.”

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