The coming great California pension property tax earthquake

Aug. 16, 2012

By Wayne Lusvardi

The most widespread and persistent folktale about California is that some day the entire state will break away from the North American continent and fall off into the vastness of the Pacific Ocean.  That day may not be too far off if what is unfolding in the growing number of municipal bankruptcy court cases in California plays out to its logical consequence without massive and politically legitimate pension reform.

As reported by urban economist Steven Malanga, municipal bond insurers may lose out in court in their attempt to get bankrupt California cities to reduce pension costs.  This may lead to more than just bondholders getting wiped out and much higher borrowing rate costs across the state.

If the courts uphold pensions as a constitutional right over bondholders’ rights, municipal workers will be entitled to earn more in pensions and health benefits than cities can currently pay.  About 70 to 80 percent of municipal operating costs are allocated to salaries and benefits.  And the lion’s share of salaries and benefit costs go to police and fire protection.  There is little room for large budget cuts in most municipalities.

Some municipalities with pre-existing pension bonds may be able to refinance them without voter approval and shift the explosion in pension costs into long-term debt. Issuing brand new pension bonds would require voter approval. But such cities would have to have enough extra budget cash flow to handle the added debt.

Tax Flight: Voting With Their Feet

The only choice left would be to raise property taxes enormously.  The inevitable result would be a tax flight to other California cities or out of state. What is called Tiebout’s Law would prevail.  People would “vote with their feet” rather than at the ballot box.

As a consequence, property values would fall into a death spiral.  As cities raised taxes on ever-declining property values to try to maintain their revenue base, the great California property value earthquake would unfold.  It would be spotty at first.  Communities with huge pension-driven property tax hikes would end up with a stigma on their high property tax rates. Disinvestment would compound the problem of tax flight.

The shrinkage in property values would result in a zero sum game. The gain to municipal employees would result in a corresponding drop in property values that would only further erode the property tax base and municipal revenues.  Cities caught in this death spiral would over time end up like Detroit.

But many cities might not wakeup to this nightmare for 20 years in the case of deferred interest school district bonds such as those recently revealed by me in the Poway School District in San Diego County.  Deferred interest bonds — with sugarcoated terms such as “capital appreciation bonds” — are just a way to suck the equity out of home values twenty years from now after many public school retirees have likely expired.  It’s a time bomb with a long fuse to blow Proposition 13, the 1978 property tax limitation initiative, to smithereens.

Eroding Values Would Ruin Underwater Mortgage Buyouts

In such falling real estate markets, it won’t matter if cities or counties want to use eminent domain to socialize the cost of “underwater mortgages,” such as is being explored in San Bernardino.  Property values would likely drop further even after each city or county condemns over-mortgaged loans. For example, $1 billion in underwater mortgage liabilities may double to, say $2 billion after each city or county acquires them due to pension liabilities.

Voters who would be asked to approve issuing bonds to socialize the losses of properties with underwater mortgages would have to approve writing a “blank check” to bail out other homeowners.  Those municipalities that condemned underwater mortgages would face the problem of having to pick up the tab on property value losses that are in free fall with no certain bottom.

California Pension Programs are Illegitimate

Bond insurers National Public Finance Guarantee Corp and Assured Guaranty Ltd have challenged Stockton’s eligibility to file bankruptcy based on a lack of good faith bargaining. The case is City of Stockton, California, debtor, U.S. Bankruptcy Court, Eastern District of California, Case No. 12-32118.

Self-serving city officials cut the original pension benefit deals without protecting the interests of the bondholders or insurance companies who were not allowed at the bargaining table.  What lack of good faith bargaining means in political terms is lack of “consent of the governed” — or more precisely, the non-consent of bond investors, insurers and property taxpayers.

Another term for the non-consent of the governed is “illegitimate” political power.  The political problem of California’s one-sided public pension system is that it is illegitimate.  This problem is not isolated to public pension systems in California, but also to water rate increases, affordable housing, cap and trade emissions trading and post-redevelopment programs. The entire government apparatus has grown to be illegitimate.

Fixing Political Dysfunction Destroyed Political Legitimacy

“Consent of the governed” is the guiding principle that galvanized the founding of the American Republic against unjust tariffs and taxes from England. And in 1978, California’s Proposition 13 brought about supermajority voting requirements to pass tax increases.  Revolutions and tax revolts are formed from illegitimate taxation.

Presently, state Assembly Speaker John A. Perez, D-Los Angeles, is promising “broad-based” pension reform.  But no matter if such reforms are approved before the November 2012 election, it is unlikely they will make property tax hikes for public pensions legitimate in the eyes of the public.

Pension reform

This is why former mayor of Los Angeles Richard Riordan is urgently threatening to put pension reform on the ballot.  But that would be next March at the earliest and would only affect the city of Los Angeles.

In the new California political game of winner takes all under one-party rule, there never will be political legitimacy for those having to pay higher property taxes for lavish public pensions. The so-called political reforms of redistricting under Proposition 11 in 2008 and majority party passage of the state budget under Proposition 25 in 2010 have lessened the phony problem of “dysfunctional” government.  But these reforms have destroyed political legitimacy at the legislative level.  Such reforms have only wiped out rule by the consent of the governed and replaced it with rule by a tyranny of the majority based on force and fraud.

Political dysfunction has replaced political legitimacy as California’s central political value.  Mussolini could make the trains run on time, but his political system was illegitimate.  There is almost no political dialogue about the implications of weakened political legitimacy in California.

The “California Dream” of home ownership and property rights is on the verge of a 10.0 earthquake on the economic Richter Scale.  Broad-based pension reforms that can easily be unwound will be unlikely to cut off the negative political repercussions of such a widespread wipeout of property values.  That is because such reforms have destroyed the very framework that would have made the reforms politically legitimate.

Only enshrining pension reform in the California Constitution might work because constitutional amendments require compulsory supermajority voter approval.  But at this point, there are no political assurances of that happening. And how would an unscheduled supermajority vote on pension reform happen before the November election?

The omission of any permanent and binding pension reform on the ballot is sure to sink any tax hike propositions. The one-sided Legislature could pass pension reforms tomorrow and unwind it after the election. Voters are likely to sense that this is just one more illegitimate government move by fraud, force, and manipulation. Political illegitimacy is an issue that cuts across Red and Blue political boundaries.

The New Monkey Wrench Gang of Five

In Edward Abbey’s 1975 novel “The Monkey Wrench Gang,” a gang of saboteurs steals an earthquake-making machine on a truck from a university to run an extortion scheme.  They run around the Southwestern United States terrorizing the populace, threatening to set off earthquakes.  In the 2012 real life version of this story, the state Assembly speaker and the “Gang of Five” have hijacked the earthquake-making machine.   Hang on to your seats.  It is going to be a wild ride to the November election. And your property values may be at stake.