The pros and cons of municipal bankruptcy

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

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?”