Bankruptcy Series: Cities on a future spending spree

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

Nov. 9, 2012

By Wayne Lusvardi

Are the staggering forecasted public pension obligations facing state and local governments in California the result of overspending or under-taxation?

The technical answer to this politically contentious question is: neither.  This is because most cities and counties have deferred both spending and any tax increases for pensions to the future. But starting around 2015 or sooner, bubble pension obligations are going to start showing up with dire consequences to city and county budgets.

What About Vallejo and Stockton?

Sure, cities such as Vallejo and Stockton went on wild spending sprees to build residential subdivisions during the real estate bubble of the mid-2000s.  Such cities hired too many permanent employees. They gave out overly generous salaries and pension benefits.  They expanded the division of labor and created superfluous job positions with lavish compensation packages.  Overreliance on development fees, property taxes and sales taxes from new commercial developments fueled this spending binge. It appeared it would continue forever. But as the saying goes, “If it looks too good to be true, it probably is.”

In 2008, Vallejo’s City Council voted to file for Chapter 9 bankruptcy.  It became the largest California city to ever do so.  Reportedly, the salaries and pension benefits exceeded 80 percent of the city’s operating budget.

The city of Stockton additionally built a new marina, baseball park and sports arena.  None of these projects broke even. Stockton declared bankruptcy last summer.

What mostly threatens future city budgets are the labor contracts that obligate each city to pay out future pension benefits.  Typically such lucrative pensions have been based on unrealistic pension fund investment returns during the real estate bubble. Nonetheless, the California Constitution guarantees such “bubble” pension benefits.  Without legal relief from these constitutional mandates, many cities may be facing:

* Court approval for any pension reductions;

* Employee layoffs;

* Having to roll existing, approved pensions benefits into risky taxable pension obligation bonds that end up costing double due to paying interest on the bonds plus taxes;

* Ultimately bankruptcy.

Why Spending Was Invisible During the Bubble

About 80 percent of a city’s general fund budget goes to salaries, based on data from the California League of Cities.  Pensions only encumber roughly 5 percent to 10 percent of most city or county operating budgets today, according to Howard Cure, director of Municipal Bond Credit for Evercore Financial Management in New York.  Payment of long-term debt for capital projects — bonds — typically takes up another 5 percent to 10 percent of a city’s budget.  Cities usually set aside 10 percent of gross revenues for reserves. Future pension liabilities don’t usually show up in a city’s operating budget until the benefits need to be paid out.

But if pensions grow to 20 percent or higher, then there is a fiscal — or budget — insolvency crisis at hand, as shown in the simplified table below.

How Pension Bubble Causes City Budget to go Upside Down

BUDGET CATEGORY	BUBBLE ECONOMY	POST-BUBBLE ECONOMY
Public salaries	80 percent	80 percent
Debt, bond payments	5 to 10 percent	5 to 10 percent
Pensions	5 to 10 percent	20 percent or higher
Reserves	10 percent	0 percent
Total	100 percent	105 to 110 percent or higher – insolvency

As you can plainly see in the above table, the cost of the pension bubble does not show up on a city budget until after the real estate bubble. This is because pension spending is in the future. So it gives an illusion that increased hiring levels and lavish pension benefits are sustainable. Current pension benefit obligations in California are “eventually unsustainable,” according to Cure.

Alternatives to Bankruptcy Aren’t Much Easier 

The city of Costa Mesa is an example of what happens in a post-bubble economy.  In 2011 it had to lay off 50 percent of its employees because pensions were going to rise to 20 percent of the city budget by 2014.

The city of San Jose has chosen a different route than layoffs. On Dec. 6, 2011, the city council voted to put a pension-reduction measure on the June 2012 ballot. Part of the proposed San Jose deal would reduce pension levels in return for job security.

The constitutionality of such measures is likely to end up in court and would eventually set a precedent for what is going to happen all over the state.  If the courts uphold existing, guaranteed pension levels, then there is a much greater prospect that cities would end up seeking Chapter 9 bankruptcy as their only way out of unsustainable pension obligations.

The city of Pasadena has decided to refinance its existing police and firefighter pension plan and roll it into a $65 million pension obligation bond.  Because it is an existing pension plan, the refinancing doesn’t require voter approval. The city must also make a balloon payment of $81 million in 2015 to keep the pension plan afloat.

Pasadena is a wealthy city. It had nearly two-thirds of a billion dollars — $666,000,000 — in budget reserves, investments and cash in early 2008.  But now it is running a $20 million deficit in its special revenue fund to renovate the Rose Bowl.  This could end up tapping the city’s general fund. Pasadena now wants to at least temporarily bring a National Football League team into the Rose Bowl to bail itself out. As real estate developers often say when the economy turns down, “The only way out of a hole is to build out of it.”  But should government be in the “spec” real estate business?

Some cities have had to turn to speculative recreational development to hopefully generate a tax base to bail themselves out of their self-created pension crisis.  For example, Stockton is stuck with a bunch of revenue-generating recreational projects with a negative cash flow. The proverbial rule, “If you have dug yourself into a hole, stopping digging,” seems to apply here.

Playing the Rate Spread With Pension Obligation Bonds

Much as sports betting plays the point spread between football teams, cities have gambled the interest rate spread to pay off unfunded pension liabilities.

According to the State Legislative Analyst, since 1963 more than two-dozen cities and counties in California have issued taxable pension obligation bonds to pay off their unfunded liabilities in a lump sum. Payments to the bondholders substitute for payments into the pension fund.

The difference in interest charges between the pension system’s higher assumed rate of return — say, 8 percent — and the interest rate on the bonds — say, 5 percent — supposedly generates savings for the city.  Thus, a city with a pension obligation bond does not have to generate around an 8 percent average rate of return.  It only has to pay off a bond at, say, 2 to 5 percent interest, plus taxes.

This is also called arbitrage and typically is forbidden with the use of tax-exempt bonds.  But pension obligation bonds are taxable, which adds to their cost to the taxpayers.

Courts have upheld that pension obligation bonds do not require voter approval.  This is because they reflect the replacement of an existing debt with another debt.  This is also called refinancing. The State Legislative Analyst’s Office states, “Incurring debt for operating costs is ill advised.”

California Pension Obligation Bonds –POB’s

Sale Date	Issuer	Type	Amount ($ million)
7/28/1995	Santa Rosa	POB	$8.67
10/25/1995	City of Long Beach	POB	$108.64
2/14/1997	City of Oakland	POB	$436.29
5/19/1998	City of Berkeley	Pension Obligation Refunding Bonds	$12.42
7/29/1999	City of Pasadena	POB	$101.94
11/3/1999	City of Richmond	POB	$36.28
7/11/2000	City of Fresno	POB	$211.30
6/13/2001	City of South Gate	Taxable Certificates of Participation	$8.50
10/3/2001	City of Oakland	POB	$195.64
1/23/2002	City of Fresno	POB	$205.34
8/9/2002	City of Long Beach	POB	$87.34
7/9/2003	City of Santa Rosa	POB	$50.67
6/17/2004	Union City	POB	$23.00
6/29/2004	City of Pomona	POB	$38.00
1/20/2005	City of Fairfield	POB	$29.92
3/1/2005	City of South Gate	POB	$24.40
4/13/2005	City of Fairfield	POB	$11.83
6/13/2005	City Huntington Pk.	POB	$23.05
8/2011	City of Pasadena	POB Refinancing	$74.00

(Source: Hewitt Associates, the Segal Company, Deloitte Consulting, 2009.)

One of the problems with municipalities playing the interest rate spread is that the expected rate of return on pension fund investments — historically around 8 percent — is risky. The 8 percent is a rate before monetary inflation. The goal is to generate a net rate of return after inflation of around 5 percent. But today the U.S. Federal Reserve Board has lowered effective interest rates on Treasury Bills to near zero. T-Bills set the benchmark for interest rates on municipal bonds and other investments.

In a near-zero interest rate environment, the 8 percent target interest rate of pension investments is unrealistic. During the real estate bubble, 8 percent was considered a typical average return rate partly because most investments were puffed up by debt and high leverage (little or no down payment). But leveraging is also a thing of the past.

A recent bond issue of a taxable state bond provides an example. On Dec. 16, 2011, the state issued a $4.4 million “California State Taxable Bond — Variable Purpose.” It yielded 5.68 percent and matured in 2036 — a 25-year bond.  The 5.68 percent indicates a 2.32 percent spread from the 8 percent benchmark rate.

But inflation is running 3.5 percent.  So is there really an advantageous spread between a taxable pension bond and an estimated 8 percent return from a pension investment fund?  Has the interest rate spread gone poof? A report issued Dec. 9, 2009 by Hewitt Associates, the Segal Company, and Deloitte Consulting, “Perspectives on Pension and Retiree Health Obligation Bonds,” questioned the advantageousness of the spreads on this type of bond.

Perhaps this is why the quoted return rate on CalPERS and other pension fund investments is asserted to be 7.5 percent.  If it were lower, it would indicate little or no advantage to issuing taxable pension obligation bonds. Thus, the only apparent advantage to a pension bond is that it is exempt from voter approval.

All of this may explain why Moody’s bond rating service is starting to treat pension liabilities like bonds. Previously, pension liabilities only influenced the yield rate on bonds.

So we may see many cities turn to high-risk pension obligation bonds to bail themselves out of their pension obligations. However, it should be understood that pension obligation bonds are for municipal “high rollers.”

How Did California Get Into This Mess?

So, how did California local governments over-commit future revenues?  The suspects as to what is causing the emerging municipal budget crisis are:

* SB 400. Senate Bill 400 passed the Legislature in 1999 and was sponsored by then-Assemblywoman Deborah Ortiz, D-Sacramento. It retroactively increased the formula for government workers’ benefits based on the “superior return on system assets” of the California Public Employees’ Retirement System — CalPERS. SB 400 was initially passed in the California Legislature by an overwhelming majority of both parties.

* According to the Reason Foundation, the extra benefits provided by SB 400 will add $3.5 billion in pension costs in 2011, or about one-sixth of the $20 billion structural state budget deficit.

* Boom in Public Employment. Costs of government have soared in many ways. Since 1998, California’s government work force has grown by 31 percent, to 356,000 workers.  The state population grew by about 12 percent over that same time.

* Boom in Public Employee Compensation. The cost to the state general fund for California’s government pension and retiree health and dental care costs have increased five-fold, from about $1 billion in the 1998-99 fiscal year to $5 billion in 2010. According to the Reason Foundation, state retirement spending is expected to triple, to $15 billion, within the next decade. That tripling will crowd out funding for other public services in the state budget, some of which flow to local government programs.  The future $10 billion increase in pension costs would increase the structural state budget deficit to $30 billion.

One third of San Francisco city workers have salaries at $100,000 or higher. At the Metropolitan Water District of Southern California, 69 percent of the workers make $100,000 per year or higher; 89 percent make $75,000 a year or higher.

The salary abuses at the city of Bell are now legendary, where the city manager earned a compensation package in excess of $1 million.  Public compensation has grown out of control in most municipalities.

* Puffed Pension Benefit Packages. In 1960, 5 percent of government employees received “public safety” pensions funded at 90 percent of their ending salary rather than the typical 60 percent funding. Today, 33 percent of employees receive the premium public-safety benefits originally intended only for firefighters and police officers.

California is the sole state that uses a pension benefit formula based on the last year of service, while most states use three-year or five-year averaging formulas that limit pension spiking. The one-year final salary rule was implemented in 1990 in California under Senate Bill 2465, by state Sen. Cecil Green, D-Norwalk.

* Move To Providing Luxury Public Services. While the real-estate bubble was inflating, cities went wild with spending on all kinds of inflationary luxury goods: open space acquisitions that inflated the market price of housing; luxury affordable housing projects in upscale locations near light-rail stations; malls that replaced mom-and-pop businesses with upscale chain stories and with markets with unionized employees; public subsidized urgent care centers to relieve congested hospital emergency rooms;  subsidized restaurant business incubators, etc. You name it; cities funded it.

But these luxury public goods are often empty jobs programs. As William Voegeli writes in an article in City Journal, “The Big Spending, High Taxing, Lousy Services Paradigm,” “Whatever theoretical claims are made for imposing high taxes to provide generous government benefits, the practical reality is that these public goods are, increasingly, neither public nor good: their beneficiaries are mostly the service providers themselves, and their quality is poor….

“It’s true that many people are less sensitive to taxes and more concerned about public goods, and these consumer-voters will congregate in places with extensive services. But it’s also true, all things being equal, that everyone would rather pay lower than higher taxes. The high-benefit, high-tax model can work, but only if the high taxes actually purchase high benefits – that is, public goods that far surpass the quality of those available to people who pay low taxes.”

State and local government got into the business of providing luxury public goods to replace the loss of industrial jobs due to de-industrialization. Without the real estate bubble, which brought in record tax revenues, the wild spending spree by local government would have been more apparent. Instead, at the time, it was seen as just another California gold rush that would go on forever.

Not to be outdone by the cities and counties, the state of California also rushed into providing luxury affordable housing; duplicative stem cell research bond financing; five water bonds totaling $18.7 billion that mostly went for open-space acquisitions; and landscaping and aesthetic water habitats around upscale residential communities. California got few new water resources added to its water supply for that $18.7 billion. The voters bought into the social marketing of these programs by voting for bonds at the ballot box to fund them, without concern about the ability to pay them off in the coming economic downturn.

The Bottom Line

California cities, technically, didn’t tax and spend themselves into the pension ditch they find themselves in.  They kicked the can down the road to the future. The future is now.

Lusvardi writes for CalWatchDog.com