San Bernardino may have to pay pensions before police protection

Dec. 26, 2012

By Wayne Lusvardi

Do pension payments have the first claim to a bankrupt city’s revenues, even over providing essential police and fire protection?  This is the half-trillion-dollar question currently before a Federal bankruptcy court concerning the insolvency of the city of San Bernardino.

The California Public Employee Retirement System petitioned the court that:

1. The City of San Bernardino is not eligible to file for bankruptcy;

2. CalPERS has sovereign police powers exceeding that of the bankruptcy court, which allow it to seize city funds even over paying the salaries for police and fire protection or making municipal bond payments; and

3. Bankruptcy only applies to unpaid claims before a bankruptcy action was filed, not the city’s failure to make pension payments to CalPERS after the bankruptcy filing.

The early news report of a preliminary decision by federal Judge Meredith Jury was that CalPERS may have to get in line with other creditors in the bankruptcy.  Municipal bankruptcy case law has always made the first obligation of a city to provide essential police and fire protection and all other obligations came after that.

But this may be about to change. The judge may have rejected CalPERS’s assertion that it had the right to seize revenues from San Bernardino for $8 million in unpaid pension bills.  But the judge indicated that the bill must be paid up before the bankruptcy court case is over.

Pensions Over Police?

If the bill must be paid, that could place pensions in a priority or equal position to providing essential police and fire protection.

CalPERS asserts that San Bernardino has a $14.7 million cash surplus that could be used to pay its pension bills.  The city counters that it has already borrowed from “special funds” (affordable housing, water, utility funds) and has a $19 million budget deficit.

Jury ruled on Dec. 21 that CalPERS cannot go around the bankruptcy court and collect past due pension payments from San Bernardino. CalPERS asserted that it had police powers that were superior to the bankruptcy courts powers.  It claimed its police powers were like garnishing wages for unpaid taxes or unpaid child support.  Police powers are the right of governments to enforce laws and regulations to protect public safety, health and welfare.

However, in this case the protection of the public’s safety would have been jeopardized. That is because CalPERS could have left San Bernardino without enough funds for adequate police and fire protection. The judge ruled that the bankruptcy court had superior jurisdiction over any implied police powers of CalPERS.  But the judge did not rule yet on CalPERS’ claim that San Bernardino should not have been permitted to file bankruptcy in the first place.  Nor did the judge rule that unpaid pension bills had less priority than paying for essential public services or making bond payments.

What’s At Stake?

There is plenty at stake on the outcome of this case.

Nothing will be able to stop a wave of pension write-downs and write-offs by other cash strapped cities in California if the court rules that pension payments are less of a priority than paying for essential services or bond debts.  About 10 percent of California’s 482 incorporated cities have declared fiscal distress, according to Moody’s bond rating firm. What ultimately would be on the horizon for CalPERS pensioners and future retirees is a day of reckoning for California’s unsustainable public pension levels in at least 50 cities, assuming that economic recovery continues; more than that if a new recession hits..

On the other hand, if CalPERS wins its claim for first priority for pension payments, the bond market may react negatively with much higher interest rates for borrowing or refusal to issue any more bonds to financially distressed cities. Bonds allow cities to stretch their tax dollars further. Bonds are like a home mortgage that allows a family to afford to own a home without having to save to purchase it in cash.  But perhaps the end game for both CalPERs and insolvent cities would be determined by municipal bond issuers who would simply require that it be written in bond documents that bond payments take priority over pension claims.  The municipal bond industry already believes it has priority over pension-system payments.

Fiscal emergency

The way this case is headed appears to be that the city will be ordered to pay up its past due pension obligations.  This would leave the city without adequate protective services and force a fiscal emergency.  The city’s only recourse, other than pension reform, might be to place an emergency measure on the ballot for voter approval of, say, a 100 percent increase in property taxes.

San Bernardino has a CalPERS annual payment of about $28.8 million and collects about $29.5 million in property taxes and $16.3 million in sales taxes.  But even if voters were extorted to vote for a large increase in property taxes to maintain protective services, it would likely be met by a substantial devaluation in home values (bringing in less revenue on the devalued properties) that would offset the tax increase higher bond interest rates.

The judge in the San Bernardino bankruptcy case has urged the city to devise an “end game” plan.  That may mean bringing pension reform before the voters. Or it could mean gambling on the CalPERS-backed plan to condemn “underwater mortgages” to generate more property taxes from a revival of the San Bernardino County housing market. But once again, condemning mortgages would only mean shifting upside down mortgage debts onto all property owners in the county, resulting in a countywide decline in home values.

CalPERS may win in bankruptcy court through extorting a property tax increase to pay for police protection, or through upside down mortgage eminent domain.  But the real estate and bond markets are waiting to have their say in the matter. And there will be no appeals court.