Stockton leads tsunami of Calif. bankruptcies

Aug. 27, 2012

By Troy Anderson

During Vallejo’s bankruptcy, which began in 2008, the city cut the number of police in half rather than deal with the “pension problem.”

Now, a somewhat similar scenario is playing out in Stockton, a city of 292,000 east of San Francisco that recently displaced Vallejo as the nation’s largest city to declare bankruptcy.

Rather than trim generous pension benefits, the city is proposing to fully fund its pension system while defaulting on $124 million in pension bonds floated in 2007.

Assured Guaranty Ltd., a Bermuda-based bond insurance company, says Chapter 9 bankruptcy is not intended to be used as a “sword to prefer one class of similarly situated creditor over another.” In a prepared statement, the company described Stockton’s attempt to default on the bonds as “unprecedented, a contortion of the bankruptcy process and will foreclose Stockton’s access to the capital markets for the foreseeable future.”

As a growing number of cities in California are contemplating or filing bankruptcy, some pension experts say they are disappointed that the cities are choosing to default on their debts and cut public services instead of dealing with the exploding costs of public pensions.

“They won’t touch pensions,” says Joe Nation, a professor of the practice of public policy at Stanford University. “In the case of Vallejo, they literally reduced the number of police officers by about one-half. It’s horrible. They don’t want to even take modest steps to deal with the pension problem.”

To be fair, Nation says Vallejo officials contemplated the possibility of attempting to scale back generous pension benefits as part of the bankruptcy, but backed off under pressure from the California Public Employee Retirement system.

“CalPERS made it clear that if they tried to reduce those pension benefits that it would litigate,” Nation says. “These cities know CalPERS has deep pockets and is politically strong. Instead of taking on CalPERS, they took on a much easier target — their own citizens.”

CalPERS spokesman Brad Pacheco says CalPERS did not make any threat to the city of Vallejo.

“We did inform the city that any attempt to reduce pension benefits in the bankruptcy case would go to the core of CalPERS’ mission and that CalPERS would respond accordingly,” Pacheco says. “However, the city of Vallejo never seriously contemplated cutting benefits and it quickly affirmed its contract with CalPERS.”

Bankrupt cities

In recent months, Stockton, San Bernardino and Mammoth Lakes have filed bankruptcy, raising questions of whether local governments can reduce pension benefits as part of the bankruptcy process. Compton could be next. City officials say they are on pace to run out of funds by the end of summer. These bankruptcies occurred just months after Vallejo completed its three-year Chapter 9 process.

The filings come as public pensions are consuming a growing proportion of public payrolls throughout the state and nation. Last year, the Little Hoover Commission called on the governor and Legislature to freeze pension benefits for current workers and enact other reforms, noting city councils, county supervisors and school boards face the prospect of increasing contributions into pension funds by “40 to 80 percent of their payroll costs for decades to come.”

These skyrocketing costs follow decades in which public officials bestowed generous pension and retiree health benefits upon public servants. As a result, taxpayers are now on the hook for trillions of dollars in unfunded liabilities.

In California alone, Nation estimates the liabilities range from $265 billion to $737 billion. In a June report, the Pew Center on the States found the shortfall has grown to at least $1.38 trillion nationwide, up 9 percent over last year.

But a July report by the American Enterprise Institute found the true state of public sector pension funding is far worse.  The so-called “fair market valuation” reveals the average public employee pension plan in the United States is only 41 percent funded and unfunded liabilities total $4.6 trillion.

National reforms

In response, elected officials throughout the nation have undertaken pension reforms to reduce the costs, though most reforms have been incremental, such as increasing contributions or retirement ages. The most significant changes have been aimed only at newly hired employees, wrote Andrew G. Biggs, a resident scholar at the AEI, in the report.

“Unfortunately, these reforms won’t come close to restoring plans to true full funding, because current accounting conventions systematically understate pensions’ benefit liabilities and thereby overstate their financial health,” Biggs wrote.

Last October, Gov. Jerry Brown unveiled a 12-point pension reform plan for state and local pension systems designed to end “system-wide abuses and reduce taxpayer costs by billions of dollars over the long term.” Voters in San Diego and San Jose recently approved ballot measures to reduce pension benefits for current employees, although public employee unions are challenging the initiatives in court.

Jon Coupal, president of the Howard Jarvis Taxpayers Association, recently wrote:

“Compounding the problem, of course, is the fact that any suggestion that government employees help out and pay their fair share toward their own guaranteed pensions is rejected out of hand by the union brass who are accustomed — because of their ability to distribute campaign cash and  deliver members’ votes to favored candidates — to being the de facto bosses of the California Democratic Party, the Legislature, and, with their chosen candidate elected governor, the entire state. 

“Now, partially to meet this mammoth pension burden, Jerry Brown wants to increase sales and income taxes. And, in an attempt to show the public that the state deserves more money, he has proposed some reforms to deal with the radically out-of-balance pension system. But proposing is one thing, actually expanding political capital to see it through is another.”          

Modify existing pensions?

As this battle intensifies, a growing number of public officials are asking whether governments can modify existing pension plans. Once a taboo topic, some legal experts say public agencies may have far more latitude to change retirement benefits than once commonly believed.

The recent spate of bankruptcies in California has only magnified this debate.

“Modifying pensions for these cities may be part of the solution,” says Lisa Hill Fenning, a Los Angeles attorney and former U.S. bankruptcy court judge. “If you look at the movable pieces in any bankruptcy case, you have to consider that from an economic standpoint.

“The problem in California is the uncertainty of the degree to which pensions can be modified. The case law has been scattered over the years. It’s most developed in state court, not bankruptcy court. We are just going to see how that body of case law is interpreted in the bankruptcy context.”

In a new report, “Local Government Bankruptcy in California: Questions and Answers,” Brian Uhler, a fiscal and policy analyst in the Legislative Analyst’s Office, addresses common questions about the Chapter 9 process for local governments, including what types of obligations can be changed or eliminated through bankruptcy.

In its case, Vallejo became the first and so far only California city to use a plan of adjustment to significantly reduce health benefits for its retirees by decreasing its payments to a flat rate of $300 per month, Uhler wrote. So far, no city has used Chapter 9 to change pension benefits for current retirees. However, pension benefits were changed in a case in Central Falls, Rhode Island.

Due to the lack of case law regarding the treatment of retiree benefits in Chapter 9, it is not clear if and under what circumstances local governments would be permitted to reduce retiree benefits in future filings, Uhler wrote.

“So, the upshot is that it’s still pretty unclear right now — especially with pensions — because no city in California has tried to modify pensions,” Uhler says. “There is only one city nationwide that has successfully modified pensions, but because of differing state laws and differing pension systems, we just don’t know how applicable that is to California.

“But, in theory, pension agreements are a contract and are just like other obligations that can be restructured or rejected through the Chapter 9 process. So, it’s fair to say that there is at least some reason to believe pensions could be considered — that they are not completely protected from the Chapter 9 process. It’s just that no city has tried it yet.”

In a prepared response to the report, Pacheco wrote CalPERS remains committed to safeguarding the constitutionally protected pension benefits of public employees and retirees.

“The obligations owed to public workers have priority over those of general unsecured creditors including bondholders,” Pacheco wrote. “We don’t agree with all of the characterizations and explanations of Chapter 9 proceedings in the LAO report.”

Taking on pensions

John Moorlach, chairman of the Orange County Board of Supervisors, says elected officials in California are waiting for a city or county “to take on pensions to find out if we can in fact make dramatic changes in pension contracts.”

“When that happens, the city councils in this state are going to have to rally around that city and give CalPERS a good punch in the nose,” Moorlach says. “We have to do something with current employees. That’s the only solution to this mess.”

Former Los Angeles Mayor Richard Riordan and Alexander Rubalcava, president of Rubalcava Capital Management, an investment advisory firm in Los Angeles, warned as early as 2006 that rising pension costs would result in government bankruptcies, massive cuts in public services and calls for a taxpayer bailout.

As a result, Stockton’s attempt to default on its pension bonds is “entirely predictable,” Rubalcava says.

“California cities have been and continue to be run for their employees, not for the people who invest in or live in them,” Rubalcava says. “Whether they can get away with that, whether they can ring-fence pensions and cut everything else to the bone, including bondholders, remains to be seen and only the courts will be able to decide that.”

If local governments won’t attempt to reduce pension benefits as part of the bankruptcy process and agencies like CalPERS maintain unrealistic discount rates, Rubalcava says this first wave of municipal bankruptcies is only the beginning.

Last month, CalPERS reported a 1 percent annual return on its $233 billion portfolio — well below the fund’s discount rate of 7.5 percent. CalPERS’ 20-year investment return is 7.7 percent.

“Some of the world’s smartest investors like Warren Buffett of Berkshire Hathaway and Larry Fink of BlackRock, which is the world’s largest asset management firm, have said they will be lucky to make 5-6 percent going forward,” Rubalcava says.

“If that’s the case, the handful of bankruptcies we’ve had in 2012 will be just a taste of what’s to come. There will be dozens or hundreds of municipalities in California filing Chapter 9 in the decades to come.”

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