Local Governments Face Bankruptcy Quandary

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

Bankruptcy is the boogeyman haunting governments across America. It’s not a question of if more cities will file for bankruptcy, but how many.

The culprit is a decade of over-spending by governments, especially on pension guarantees, and an economic slowdown that refused to flip into a robust recovery. The money just isn’t there. And it’s not going to be there even if local governments raise taxes while cutting employees and services to the bone.

Chriss Street was the treasurer of Orange County, Calif., from 2006-2010. And back in 1994, he warned that Orange County was headed for what would become, in November that year, America’s worst municipal bankruptcy. People didn’t listen then. They’re not listening now.

He told me that, today, things are just going to get worse for municipal finance. “State and local government revenues are taxes and fees on the private sector and housing,” he said. “The bulk of this tax collection is subject by law to an approximately 18-month lag in collection. The recovery in real estate peaked out in November 2010 and economic activity peaked around April 2011. Both real estate and the economy are in substantial decline.” Therefore, tax collection will be falling all through the first half of 2013.

“Most states, counties, cities and school districts have spent their cash reserves down to the legal minimum,” Street said. “When I speak at national conferences on municipal finance, I ask the question: ‘How many of you have made contingency plans for another 15 percent decline in revenue in the next year?’ I have never gotten a hand raised. Consequently, it is my belief that there is the potential for thousands of defaults in the 50,000 municipal bond issuers in the United States.  Most cities can cut spending, but they cannot cut principal and interest payments without default and bankruptcy.”

The Way to San Jose Bankruptcy

An example of where so many cities are going is San Jose, Calif. Unlike some small cities facing bankruptcy, such as Central Falls in Rhode Island, San Jose remains highly prosperous. It’s not a dead-end rust-belt town. San Jose enjoyed the dot-com prosperity of the late 1990s, then the real-estate boom of the mid-2000s. The ensuing real-estate bust was milder there than in most places. It still prospers from being part of Silicon Valley, the epicenter of the world computer revolution that’s booming again, despite the global economic slowdown. Apple’s HQ is a stone’s throw away in Cupertino. Facebook is just a little further north in Palo Alto.

But San Jose officials have discussed bankruptcy as a possible option.

Its prosperity turned out to be its undoing. In the November 2011Vanity Fair, financial writer Michael Lewis wrote, “[T]he city owes so much more money to its employees than it can afford to pay that it could cut its debts in half and still wind up broke.”

The problem for America’s 10th-largest city, population 1 million: “The Internet boom created both great expectations for public employees and tax revenues to meet them….  Over the past dec­ade the city of San Jose had repeatedly caved to the demands of its public-safety unions. In practice this meant that when the police or fire department of any neighboring city struck a better deal for itself, it became a fresh argument for improving the pay of San Jose police and fire. The effect was to make the sweetest deal cut by public-safety workers with any city in Northern California the starting point for the next round of negotiations for every other city.”

This ratchet effect also struck areas throughout the rest of California and the United States.

According to Mayor Chuck Reed, a Democrat, “Our police and firefighters will earn more in retirement than they did when they were working. There used to be an argument that you have to give us money or we can’t afford to live in the city. Now the more you pay them the less likely they are to live in the city, because they can afford to leave. It’s staggering. When did we go from giving people sick leave to letting them accumulate it and cash it in for hundreds of thousands of dollars when they are done working? There’s a corruption here. It’s not just a financial corruption. It’s a corruption of the attitude of public service.”

And it’s a corruption that could lead to bankruptcy.

While costs have been ratcheting up for San Jose, city staff levels have been ratcheting down. City staff has been cut from 7,450 to 5,400. The number of staff is the same as that of 1988, before the city added another 250,000 residents. By 2014, the number of city staff could be as low as 1,600. Reed warned, “There is no way to run a city with that level of staffing.”

San Jose’s fate could rest on the decision of voters. As Ed Mendel of CalPensions wrote in December 2011, “The San Jose City Council voted 6-to-5 … to place a pension reform measure on the June ballot that takes on what the Little Hoover Commission called ‘the elephant in the room,’ a way to reduce the cost of pensions promised current workers. As state and local governments face rising pension costs while a weak economy forces deep budget cuts, the San Jose council’s plan is the biggest and boldest proposal yet by elected officials to reduce pension costs widely believed to be legally untouchable. Mayor Chuck Reed had talked about declaring a fiscal emergency to reduce pensions earned by current workers in the future. Now he is talking about the city charter specifying minimum benefits provided by the city’s two independent pension systems.”


One city that did declare bankruptcy was Vallejo, Calif., back in 2008. Unfortunately, the city missed a grand opportunity to pull itself from fiscal disaster. Government-worker unions made some concessions, such as higher payments for retirees for their health-care insurance. However, Jonathan Weber wrote in the  Bay Citizen, “But pension plans for retirees and current city employees, including one that allows police officers to retire at 50 with as much as 90 percent of their pay, remain untouched. The city chose not to test whether messing with pensions would be allowed even in bankruptcy, and so remains on the hook for some $195 million in unfinanced pension liabilities.”

Vallejo is a city of 116,000. So, each resident remains on the hook for paying $1,681 in pensions to city workers who no longer even are on the job.

The city is surviving — sort of — by cutting the police force from 155 to 90, or 42 percent; and slashing firefighters from 122 to 70, a 43 percent cut.

Weber described the city: “Vallejo stumbles forward: with minimal public safety services, a skeleton crew for road repairs, deferred maintenance on everything, and no money for ‘extras’ like parks, libraries and senior centers.”

As Calwatchdog Contributing Editor Steven Greenhut wrote in the Wall Street Journal, “Over the past five years, Vallejo has slashed spending where it could, mostly by cutting personnel and services. As a recent San Francisco Chronicle editorial pointed out, the city cut its police force to about 100 officers from nearly 160 and warned residents to use the 911 system judiciously, even while it experienced crime rates higher than other comparable cities in California. The city has also cut funding for a senior center, youth groups, and arts organizations and has done little to restore an increasingly decrepit downtown, develop waterfront properties, or attract new businesses.

“To permanently bring its spending in line with its tax base, however, at some point Vallejo will have to do something about its pensions. U.S. bankruptcy judge Michael McManus, as the National law Journal reported last March, ‘held the city of Vallejo, Calif., has the authority to void its existing union contracts in its effort to reorganize.’ … But when it came to voiding those contracts on pensions — a major driver of public expenses — the city blinked. The “workout plan” the city approved in December calls for cuts in services, staff and even some benefits, such as health benefits for retirees. However, it does not touch public-employee pensions. Indeed, it increases the pension contributions the city pays.”

San Diego

San Diego still bills itself as “America’s Finest City.” They’re talking about the balmy weather, the beaches and the famous San Diego Zoo, not the city’s finances.

The city’s pension payments are skyrocketing, from $229 million in 2010, to $318 million in 2015 – 40 percent in just five years. By 2025, the number will be $512 million, a whopping 124 percent increase in 15 years.

No wonder City Councilman Carl DeMaio in September 2011 turned in 145,000 signatures to put a pension-reform measure on the ballot in 2012. Instead of pensions, it would enroll mostnew city employees in 401(k) programs for retirement. It would save the city $1.2 billion through 2040. DeMaio also is running for mayor in 2012.

“Sadly, San Diego’s pension/budget debacle is hardly unique,” Richard Rider told me; he’s chairman of San Diego Tax Fighters, which has been warning of the pension crisis for many years. “Like most cities and counties in the state, the politicians gave away benefits today that had to be paid for years later.  Everyone in the city’s decision-making process — the city managers, politicians from both parties, pension oversight committee, actuaries, attorneys, staff and the unions — profited from the giveaway of both pensions and free retiree health care. No one represented the taxpayers.  Indeed, we have had city council critters retiring in their 30s with pensions.”

Central Falls, R.I. Files for Bankruptcy

The small city of Central   Falls, R.I., filed for bankruptcy on August 1, 2011 because it couldn’t pay its pensions. In an action heard around the country, it also claimed it did not have to pay full pension benefits to retirees. The city’s population is 19,376 and its annual city budget, $17 million. But its total pension obligations are $80 million. It’s like a family having $17,000 in income but owing $80,000 on credit cards. The numbers don’t work.

Eight public employee unions insisted that the city must pay its pension obligations in full and filed suit. On Sept. 13, Superior Court Judge Sarah Taft-Carter ruled in favor of the unions. According to the Providence Journal, “Taft-Carter says that there is an implied contractual relationship between the Employees Retirement System of Rhode Island and participating employees.”

“The benefits provided … are not gratuities that may be taken away at the whim of the State,” the judge wrote. However, reforming municipal bankruptcy — especially in 2011 and 2012 — isn’t exactly a whim.

On Oct. 5, Rhode Island Gov. Lincoln D. Chafee and state Treasurer Gina M. Raimondo, reported the Providence Journal, “asked the Supreme Court to use its discretion because of the ‘extreme public importance’ of the case and because Taft-Carter erred in ruling that state pension law is an ‘implied contract,’ rather than an evolving public policy statement enacted by the General Assembly that has been and will continue to be subject to change.’

“ ‘Immediate review of the decision is necessary and warranted so that the State, the Governor and the General Assembly will have clear guidance on the law in Rhode Island as they endeavor to resolve the State’s $9.4 billion unfunded-pension liability’,” lawyers for the state argue in their court filing.”

On November 22, the Rhode Island Supreme Court ruled that the unions’ lawsuit could proceed.

Meanwhile, Central   Falls’ case was moving through federal bankruptcy court. In late November, reported WPRI.com on Nov. 29, “the bankrupt city signed new agreements with its unions to cut costs and stabilize its budget. A tentative agreement on pension cuts has been reached with its retirees. And Tuesday [Nov. 29], its Adams Memorial Library said the city will rejoin the state lending system on Dec. 1 thanks to a flood of donations from celebrities and others.” The celebrities included actor Alec Baldwin and Tony Award-winning actress Viola Davis.

Retired Supreme Court Justice Robert Flanders, whom the state appointed Central Falls’ receiver, told WPRI.com, “This is all good news for the city and its taxpayers. It definitely is a new beginning for the city.”

At the state level, Rhode   Island is leading the way for the type of far-reaching reform that can keep states from reaching dire financial situations. As the Bond Buyer reported in November 2011, “Gov. Lincoln Chafee … signed the [pension-reform] bill, which he and General Treasurer Gina Raimondo had championed. … It creates a hybrid plan that merges conventional public defined-benefit pension plans with 401(k)-style plans. While some other states have implemented hybrid plans,Rhode Island’s would be the first to affect current employees, according to the Pew Center on the States.”

At this point, in Rhode Island, California and the rest of America, municipal bankruptcy law is up for grabs. But officials in Democratic Rhode Island, unlike Democratic California, appear more likely to take the steps necessary to fix the problem without reaching the point where bankruptcy is the most feasible option.

Does Bankruptcy Work?

As the case of Vallejo shows, bankruptcy is not a cure-all for a city’s problems. In Vallejo, bankruptcy led to a hollowed-out government. But the alternative isn’t all that attractive, either.

The dilemma was described by Jonathan Henes, a municipal bankruptcy expert: “Today, municipalities are facing an unfunded pension obligation problem. Chapter 9 [bankruptcy] was not set up specifically to address this problem, although certain sections of the Bankruptcy Code (sections 365, 1113 and 1114) may provide municipalities with the tools to address it. Based on the initial reports about the Central Falls bankruptcy, it appears that we will find out if Chapter 9 can help a municipality fix its unfunded public pension problems. If it doesn’t, it may be time for Congress to amend Chapter 9 to address today’s problems.”

However, with Democrats still controlling the White House and the U.S. Senate, reform is unlikely because their major constituency is public-sector employees. Republicans, should they control the White House and both houses of Congress beginning in 2013, may be reluctant to act in state matters if only because national economic problems will be more pressing.

Moreover, reforming municipal and state pension obligations also could affect federal pensions, including the pensions of congressmen themselves.

Reform a Must

With the economy still underperforming, there will be no rescue for public budgets. There’s no dot-com boom or real-estate bubble on the horizon. As we have seen, those booms were unsustainable anyway, and just encouraged unrealistic expectations about municipal revenues and portfolios.

What has happened is that at least 12 years of delusions finally are wearing off, and everyone is being forced to meet reality. For most governments, the easy fix, if one could do it, would be just to switch all future pensions for current employees to 401(k) plans. And for those facing bankruptcy, the additional fix would be to cut payouts to existing retirees, as Central Falls is trying to do. But employee unions, not surprisingly, are resisting any changes to current benefits.

“As budget realities have started to hit home, most cities now realize that just making tweaks in pension formulas for future hires won’t solve their problems — the mushrooming retirement obligations are just too large,” Jack Dean told me; he publishes the indispensable PensionTsunami.com news site, which collects stories on the national pension crisis. “Modifications in agreements with current employees will have to be made. And if the unions won’t cooperate, then municipal bankruptcies could become more commonplace.Vallejo in California and more recently Central Falls in Rhode Island have provided us with a glimpse of what may be in store for us on a larger scale without major pension reforms.”

Public employee unions complain that their members should not be subject to the ups and downs of 401(k)s invested stock markets. But that’s what most people have in the private sector that pays for the public sector.

The longer true reform is delayed, the worse matters will become.

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