State Controller Betty T. Yee disclosed the 2014 payroll data from 54 counties and 468 cities, which included information on more than 600,000 employees. The disclosure is part of the controller’s latest update to the “Government Compensation in California” website.

The open government online portal allows users to map compensation levels throughout the state, assemble charts, evaluate payroll trends and export data for in-depth statistical analysis.

Vernon: Smallest City, Biggest Pay

The state controller’s public employee payroll website has become a powerful tool for journalists and citizen watchdogs to identify wasteful spending and corruption in local government.

Among the municipalities with questionable payroll data from 2014: the city of Vernon. Although it is the least populous city in California, with just 123 residents, Vernon has double number of employees. And those employees earn $103,601 per year in salary — the highest average salary in the state. Vernon employees also take home, on average, another $32,462 per year in health and retirement benefits.

Vernon’s top salary is followed by the city of Hayward with $94,041 average salary, and Palm Desert at $89,582 in average salary. The state controller’s office notes that the average wages for city governments overall fell by 3 percent to $59,614.

In 2014, the average salary for county employees increased by approximately 3 percent to $60,993. At the county level, the nearly 19,000 employees at Santa Clara County received the highest average wage, earning $78,486 per year in wages and $27,655 in retirement and health benefits.

9 Local Governments Fail to Disclose Data

The controller’s office classified six cities as non-compliant entities for having “filed a compensation report that was incomplete, was in a format different than the one requested by the Controller’s Office, or was submitted after the reporting deadline.” San Francisco, the largest non-compliant entity joined the cities of Bell, Compton, Covina, Dana Point and Santa Ana on the list of non-compliant entities.

The counties of Modoc, Monterey and Riverside were the three counties, or 5.3 percent, that failed to file.

The city and county of Los Angeles remain the largest local government agencies. Los Angeles County employs 103,338 people with a cumulative wage of $7.2 billion in annual salary and $2.76 billion in health and retirement benefits. The city of Los Angeles paid out $4.5 billion in wages and $703 million in health and retirement benefits.

Yee’s latest disclosure builds on the work of her predecessor. In 2010, following the high-profile corruption case at the city of Bell, then-Controller John Chiang didn’t wait around for local governments to clean up their act. He ordered cities, counties and special districts, under Government Code sections 12463 and 53892, to share salary and other wage information with his office. Initially, some local governments balked, then dragged their feet in disclosing the payroll data.

To access State Controller Betty Yee’s payroll database, go to publicpay.ca.gov.

Top 10 Highest County Employees in California

1. Faculty Physician-Contract: $1,360,744
Kern County

2.Faculty Physician-Contract: $1,295,929
Kern County

3.Orthopedic Surgeon-Contract: $1,092,651
Kern County

4. Chairman, Department of Surgery: $851,665
Kern County

5. Medical Director II: $775,999
Los Angeles County

6.Physician – VMC: $760,461
Santa Clara County

7. Chief Physician III Surgery-Neurological: $728,489
Los Angeles County

8. Physician: $727,864
San Joaquin County

9. Physician – VMC: $684,365
Santa Clara County

10. Physician – VMC: $658,745
Santa Clara County

Top 10 Highest City Employees in California

1. Police Sergeant: $592,652
City of Burbank

2. Fire Chief: $487,871
City of Richmond

3. Chief Of Police: $487,644
City of El Monte

4. City Manager: $470,249
City of Lincoln

5. City Manager: $419,840
City of West Covina

6. City Attorney: $412,211
City of Escondido

7. Power Engineering Manager: $403,271
City of Los Angeles

8. Assistant City Manager:
$396,548
City of Oxnard

9.City Manager: $395,501
City of Escondido

10. Police Officer (PERS): $393,573
City of Oakland

This week, Franklin Templeton filed vigorous objections to Stockton’s recovery plan, saying “no bondholder has ever received so little in the history of municipal bankruptcy.”

This is from Reuters:

The creditor, two funds managed by Franklin Templeton Investments, said Stockton’s plan to exit Chapter 9 bankruptcy was discriminatory and punitive.

Franklin said it would receive less than 1 percent of its $30.5 million unsecured claim in the case, now before the U.S. Bankruptcy Appellate Panel of the Ninth Circuit.

The brief claimed that by confirming a plan providing such a small distribution, compared with recoveries of 52 percent to 100 percent for other unsecured claims, U.S. Bankruptcy Judge Christopher Klein erred in backing Stockton’s exit plan. …

The Franklin team argued that Stockton would leave its two funds with little while leaving the city’s pension fund, the California Public Employees’ Retirement System, untouched.

CalPERS also made whole in San Bernardino

San Bernardino’s bankruptcy saga has key similarities. More from Reuters:

The bankrupt California city of San Bernardino revealed on Thursday details of its deal with the state’s public pension system CalPERS, in which the retirement fund will be paid in full under the city’s bankruptcy exit plan.

San Bernardino announced last year it intended to pay the powerful California Public Employees’ Retirement System in full under its bankruptcy plan, while cutting its bondholder debt. …

The CalPERS deal has angered other creditors, including holders of $50 million in pension obligation bonds, who face cuts to their debt. They are suing the city over the CalPERS deal. …

Luxembourg-based EEPK, holders of the pension bonds, and Ambac Assurance Corp, which insures a portion of them, sued San Bernardino in January, claiming the bonds are part of a single pension obligation, so that any payment to CalPERS requires equivalent payment to the bondholders.

Initial arguments on that lawsuit will be heard on May 11.

Bond companies likely to be wary of struggling cities

Analysts said this disparate treatment was likely to make bond companies — and Wall Street in general — wary of dealing with financially stressed cities in California.

CalPERS appears to have something of a home-court advantage in dealing with bankrupt cities. As attorneys for Franklin Templeton have laid out, bankruptcy laws generally are structured to ensure “everyone takes a haircut” in recovery plans.

That’s not happening in Stockton and San Bernardino — so far, at least.

It was 1975 and New York City was running out of cash. Its excessive spending and lack of financial oversight created a $14 billion debt, with more than half of it short-term. A request for a bailout from the federal government, headed by President Gerald Ford, didn’t happen and was memorialized with the famous New York Daily News headline, “Ford to City: Drop Dead.”

So rather than watch the Big Apple fail, the state of New York took action and helped make the city the strong metropolis it is today. That landmark process has become a primer for other entities to follow in keeping out of bankruptcy.

“It’s a well-regarded credit now,” municipal bond manager Tom Dalpiaz said of the city. “New York’s budgetary process is very strong. They keep track of it, have projections and know when they are going to run into trouble.” Dalpiaz oversees portfolios worth $280 million as senior vice president of Advisors Asset Management in Colorado.

But before arriving at a disaster point, municipalities can employ a variety of strategies to stay solvent, experts say.

“You can only do what is sustainable and affordable and if you make promises you can’t keep, then the best thing you can do is correct that mistake as soon as possible,” said Chicago bankruptcy attorney James Spiotto, considered one of the foremost experts on the topic. “You have to watch your budget.”

Before a municipality can file for Chapter 9, it has to be truly insolvent and not just looking for a way to get out of existing contracts and pensions. Cities like Vallejo, Calif.and Central Falls, R.I. had minuscule budgets compared to their looming pension payments and the contracts with city workers were excessive. Bankruptcy was the only option.

The Municipal Assistance Corporation

New York legislators knew that a bankruptcy filing for their world-class city would be disastrous for the state’s credit rating, Wall Street and the economy. So they created the Municipal Assistance Corporation  in 1975.

With members appointed by the governor, this state agency converted the city’s sales and stock transfer taxes into state taxes which were used as security for additional bond sales. It also advanced funds to keep the city running, according to a report from the California Research Bureau.

“The MAC demanded that the city institute a wage freeze, lay off employees, increase subway fares and begin charging tuition at city universities,” the report said. “Despite a summer of labor unrest, these measures stuck and MAC was able to refinance some city debt, but the market was still resistant.”

Next, the state created the Emergency Financial Control Board, which took control of the city’s finances.

“The state law creating the EFCB required the city to balance its budget within three years, change its accounting, and submit a three-year financial plan,” the report said. “The Board had the power to review and reject the city’s financial plan, operating and capital budgets, contracts negotiated with the public employees’ unions, and all municipal borrowing.”

Six years later, the city had a balanced budget and was able to sell long-term bonds. By 1985, MAC was no longer needed and New York was again a thriving city. It had overcome an operating deficit of $2.2 billion, the report said.

“MAC hasn’t issued bonds in 20 years,” Dalpiaz said. “It did the job and now the sick patient is up and healthy and on its own. That’s how the state is supposed to work with a troubled municipality.”

What New York accomplished has been emulated by other states across the nation, but not where it has been needed the most. Jefferson County, Ala. and Orange County, Calif. were both in dire straits financially, with the latter filing for bankruptcy in 1994 to close a $1.7 billion deficit. Jefferson County, Alabama’s largest and home to Birmingham, filed for bankruptcy on Nov. 8, 2011.

Neither California 16 years ago, nor Alabama today, has helped floundering counties avoid bankruptcy. California, which is also home to the bankrupt cities of Vallejo, Stockton, San Bernardino and Mammoth Lakes, passed a law last year that stops short of doling out funds. Assembly Bill 506, by Assemblyman Bob Wieckowski, D-Fremont, requires municipalities to work with a neutral evaluator under the California Debt Advisory Commission and obtain permission before filing for Chapter 9.

“This bill would NOT ban municipal bankruptcies or make them impossible,” according to a statement on the California Labor Federation’s Website. “Instead, it would simply create an oversight structure to ensure that bankruptcies are only entered into when necessary.”

What the Website doesn’t say is that a federal judge has the authority to deny a bankruptcy petition that lacks merit. For example, Bridgeport, Conn. filed in 1991, but the case was dismissed by a judge who ruled that the county was not insolvent.

Interestingly, California is in dire straits itself and some have floated the idea of amending federal bankruptcy law to allow states to reorganize their finances.

In a January 27, 2011 column, Newt Gingrich and Jeb Bush called for Congress to “allow states in default or in danger of default to reorganize their finances free from the union contractual obligations.” Gingrich is the former speaker of the U.S. House of Representatives and a was Republican candidate for president. Bush is a former governor of Florida. 

Organized Labor

Municipalities that aren’t lucky enough to have a MAC-style agency helping out have to look toward other options in preventing bankruptcy. One of the most obvious is controlling labor costs.

Worker contracts and their pensions proved to be the undoing of both Vallejo and Central Falls and have placed an untold number of other municipalities in danger, including San Diego and Los Angeles.

“To the extent that employee compensation costs are a problem, states have it within their power to change collective bargaining rules,” said E.J. McMahon, a senior fellow with the Manhattan Institute, a New York-based free-market think tank. “If you are threatened with fiscal distress because of collective bargaining rules, you can change the rules.”

In California, those rules were enacted in 1977 with what’s called the Dills Act. The bill was signed into law by none other than Jerry Brown, during his first stint as governor. The rules and can be undone by the Legislature at any time, McMahon said. He added, “California has a statutory presumption that the pensions are contractual. No one has been willing to test [in court] that it’s a benefit not yet earned by future employees.”

Another recommend overhaul in California and perhaps elsewhere is civil-service rules.

“Most of the states need to move to a new place away from old civil-service rules and there is not a move to do that,” McMahon said. “A federal judge can’t just say, ‘Let’s get rid of these civil service rules’.”

Unyielding unions, which drove Vallejo into bankruptcy, got more than they bargained for when a judge ruled that the labor contracts could be broken. That precedent-setting move is bad news for unions in future cash-strapped municipalities.

“There are painful choices that need to be made when a budget needs to be cut,” Dalpiaz said. “No one wants their ox to be gored; everyone thinks the problem is somewhere else. The fighting gets intense and. before you know. it people throw up their hands and say, ‘We have to file for bankruptcy’.”

Lessons from the Past

New York’s problems may have dated back to the 1960s, but 50 years later they seem remarkably contemporary. According to the California Research Bureau, the following “gimmicks” existed:

* Overly optimistic forecasts of revenues;

* Heavy use of revenue anticipation notes, including notes for revenues that did not materialize;

* Underfunding of pensions;

* Use of funds raised for capital expenditures for operating costs;

* Appropriation of illusory fund balances, meaning that special fund revenues were overestimated and used to balance the budget;

* Writing checks late.

Of course, any expert would advise entities to conduct affairs in the opposite manner. Bankruptcy attorney Robert McConnell, who represented Vallejo, said too few lawmakers have a working knowledge of finances.

“They get elected because they are popular, not because they are accountants or financial experts,” he said. “They leave it to their professional staff to explain it to them. When you go to a city council, board of supervisors or water district meeting, they have their accounting experts out there to explain it to them. Any legislator has to do his or her own independent research.”

Understanding finances will help lawmakers pinpoint the exact reason for fiscal trouble, which is the first thing a municipality needs to do, according to the report, “Municipal Bankruptcy: Avoiding and Using Chapter 9 in Times of Fiscal Stress.” It was written by attorneys John Knox and Marc Levinson, who also represented Vallejo in its bankruptcy.

Some financial stressors are a one-time problem — such as Jefferson County and a huge sewer repair bill. Others are systemic and flaws in the municipality’s operation.  The former may be able to be rectified by spreading payments out over a long period of time; the latter requires structural change which lawmakers may not want to tackle.

Regardless, it’s essential that officials closely monitor the operating fund so they will know when the money runs out.

Knox and Levinson wrote, “A municipal official who requires or even permits employees to come to work if the official knows that the municipality will not be able to pay them may be violating state labor laws or committing common law fraud. In some states, this may even constitute a criminal offense.”

Novel Approaches

Obviously, raising taxes could stave off some filings, although the public doesn’t appear to have an appetite for that, especially in the high-tax states such as California, where municipal bankruptcy threats are more common. But there are other things legislators can do. According to a 2008 report from the American Bankruptcy Institute, state legislators can pass a law requiring cities to set aside a certain amount of money every year as a “rainy day fund,” with a mandate that it cannot be spent until a time of need. Research showed that states with such laws weathered recessions better than others that didn’t.

Also, local tax systems can be reformed to required suburbs to share in part of a city’s expenses. This could be accomplished by the creation of special districts to levy taxes. Where citizens refuse to back tax increases, a host of fees could be tacked on to services such as trash, sewage, parking and utilities.

But above all, just have common sense, McConnell said.

“Don’t give away the bank. Our previous city council made some pretty generous agreements with our labor unions. That can only be sustained with a healthy economy.

“Bankruptcy is like a boat overloaded with people in the water when a storm comes,” McConnell continued. “It’s that one wave that sinks them and they are all done. We have to be more careful than we ever were before.”

Richards is an award-winning investigative reporter.

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

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

(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.

What happened in Harrisburg, Pa.? One day there was nothing but murmurs about Pennsylvania’s capital city being in a fiscal mess. Then, all of a sudden, Harrisburg filed for Chapter 9 Municipal Bankruptcy protection.

What made the declaration all the more significant is that it’s the state’s capital. Everyone had been talking Jefferson County, Ala. or Central Falls, R.I., which filed for Chapter 9. But few figured Harrisburg would be the next to do so. However, the signs for this abrupt, bold move were there despite the state doing its best to control the situation. which includes not only a grave municipal fiscal crisis, epitomized by a defunct public project, but a power vacuum left behind by a seven-term mayor.

In November 2011, as Reuters reported, “Pennsylvania is poised to take over its struggling capital of Harrisburg after a federal judge said the city cannot file for bankruptcy to get out of its $300 million outstanding debt.” As the Wall Street Journal explained, “Judge Mary France of the U.S. Bankruptcy Court inHarrisburg ruled that a band of city councilors lacked the authority to put the city of roughly 49,000 residents under bankruptcy protection when they filed the Chapter 9 petition on Oct. 11.” City councilors who favor bankruptcy may challenge the ruling, but however it ends up, it’s clear that Harrisburg needs to be rescued from itself.

The picturesque city along the Susquehanna River is located halfway between Philadelphia and Pittsburgh. With a population of just under 50,000 people, it seems and acts more like an oversized town than a metropolis. Its daytime commuting population doubles the total residential population, as state government workers come in from the surrounding suburbs and countryside. About 53 percent of the city’s residents are African-American; and 30 percent of the citizenry live below the poverty line. Also note that 50 percent of the city’s assessed property is tax-exempt: government buildings, hospitals, colleges and universities, churches and non-profits are concentrated there.  As the city’s financial and infrastructure problems grow, more residents who can are leaving behind the spark of renaissance the city was starting to benefit from.

Operating under a strong-mayor model, Harrisburg’s government consists of an executive branch (the mayor) and a legislative body of seven city council members. On Oct. 12, the council voted 4-3 to pass back-to-back resolutions to retain a bankruptcy attorney and file for Chapter 9. As soon as the vote was over, the council’s new attorney, Mark Schwartz of Bryn Mawr, Pa., faxed off the petition. The next morning, it was officially received by the U.S. Middle District Bankruptcy Court. 

New Mayor

Mayor Linda Thompson was near the end of her second year in office. She had overthrown the 28-year-reign of Stephen R. Reed by beating him in the primary, then winning the general election against Republican opponent Nevin Mindlin. Thompson decried council action as “a sneak attack” and defined it as “procedural defectiveness” since the process of passing the resolutions did not proceed per city rules.

The state of Pennsylvania and Dauphin County also proclaimed the move invalid. On Oct. 17, the parties met in front of Federal Bankruptcy Judge Mary France for a Scheduling Conference of the proceedings. Attorneys from high-powered New York and Philadelphia firms filled the room, representing creditors, bond insurers and trustees. The state of Pennsylvania, joined by the county, requested an expedited dismissal of the city’s bankruptcy petition, arguing it is unlawful to file for Chapter 9 without the state’s approval. The office of the mayor argued for the petition’s dismissal, claiming it is unlawful for Chapter 9 to be filed without the mayor’s involvement. The bankruptcy opponents all asked Judge France to declare the filing illegal as soon as possible so all parties could move forward with their plans for Harrisburg

It’s precisely the bankruptcy opponents’ plans that drove the city council to file for municipal bankruptcy. A year ago, the city received a $4.3 million bailout from then-Gov. Ed Rendell in order to pay a $3.3 million general-obligation bond payment. Rendell insisted it was “not a bailout.” 

Act 47

Mayor Thompson unilaterally requested admission to Pennsylvania’s Municipal Financial Recovery Program, known as Act 47. Act 47 is Pennsylvania’s statutory response to a) dealing with fiscally challenged municipalities and b) controlling municipal bankruptcy filings. Pennsylvania is one of 19 states that require state authorization of Chapter 9, and its Act 47 program is its mechanism to do so. If a municipality finds itself unable to maintain essential public services, meet debt obligations, make payroll and pay bills — or ultimately, run the ship — then it must turn to the state for help. That help includes financial and professional assistance to devise a plan of solvency, called an “Act 47 Plan.” The goal is that an Act 47 Plan will fix the impoverished place’s problems. The statute lays out a formula and path for success. If success is not able to be met, then the state will permit Chapter 9 filing.

Since 1987, when Act 47 became a law, 26 municipalities have entered the program. Only six have emerged, and those were boroughs, each with a population of less than 5,000 people.

In Pennsylvania, Third Class Cities are defined as “cities under 500,000 population that have not elected to become a city of the second class A.” No Third-Class City has ever come out of it, and the longest one in has been there since 1987.

Only one Pennsylvania municipality had ever filed for Chapter 9 before Harrisburg. Westfall Township filed for Chapter 9 in 2009 because of a $20 million judgment against it, which was 20 times its yearly operating budget. Because the township had experienced no municipal fiscal distress prior to the judgment, Westfall was not in the Act 47 program, yet was able to skip the state’s requirements and file for Chapter 9 under “emergency” conditions triggered by the ruling.

Mayor Thompson applied for Act 47 status after nine months in office in Harrisburg and failing to get a grasp on the city’s financial crisis. Although she had served on the city council for 10 years, she said she did not know just how bad things were and indicated that the complicated financial problems of Harrisburg were far greater than her skill, experience or capabilities. A polarizing personality, the mayor found it challenging to secure the internal help she required to face a city insolvency that was decades in the making. Thus, Thompson turned to the state for assistance and applied for Act 47. 

Resistance

There was substantial resistance to Harrisburg entering the program. Residents, business owners and public officials testified in front of the state that Act 47 wasn’t designed to handle Harrisburg’s complex financial problems, which centered around a trash-burning facility, dubbed The Incinerator — what the Wall Street Journal called, “The Incinerator That Kept Burning Cash.”

To say The Incinerator is a regional public project gone bad is an understatement. In 1972, The Incinerator was built as the region’s answer to its waste. Ideally, the facility would convert trash to steam and electricity, which the city would sell. Ideally, the trash would be flowing in from places local and afar. Ideally, the whole thing would run cleanly, smoothly, efficiently and profitably. That was the public message. In reality, that hasn’t happened. Never quite right since it was built, the peak of The Incinerator’s troubles came in the 1990s, when massive disrepair plagued it and the county decided it was cheaper to use a landfill for 10 years instead of the city’s facility.

In 2003, when a modernization and retrofit was getting underway, The Incinerator was $104 million in debt. Fortunately, upon completion of the construction, the county agreed it would bring all of its trash back to The Incinerator. The county committed to guaranteeing some of the retrofit bonds and even received fees for doing so. 

More Funds Needed

The construction didn’t go as planned. Barlow Projects Inc. was unable to finish what it started.  More funds needed to be taken out. In 2007, the Harrisburg Authority that owned and operated The Incinerator borrowed more money. The city and county stepped in again to provide loan guarantees, and to guarantee received fees for doing so. As with the first guarantee agreement, this one was voted on by county commissioners and the city council, brought together by then-Mayor Reed, with only one dissenting vote among 10 elected officials. Current Mayor Thompson in 2007 sat on the city council for this guarantee and voted in favor of the borrowing. By the end of 2007, The Incinerator carried $230 million in debt, with very little revenue coming in from converting the trash into steam and electricity.

Currently, Harrisburg residents pay $200 a ton to dispose of their own waste at a facility within city limits, one of the highest trash rates in the country. Harrisburg residents are also on the hook for what has become an accumulation of principle, interest, penalties, legal fees, consulting fees, advisory fees and more. Harrisburg is the first and only full guarantor of The Incinerator’s debt. As second guarantor, Dauphin County guaranteed $144 million of it, but the agreement states that any payment the county makes, the city will pay back. Neither the authority nor Harrisburg has been able to make any of  The Incinerator’s debt payments for the past two years. For that reason, both the city and the authority have suits filed against them by the county, bond insurer and trustees.

Taking what probably should have been a private business and attempted to make it something to generate revenue for the city, The Incinerator is what makes Harrisburg’s financial crisis so distinctive and serious. While several parties facilitated the debt of The Incinerator over 15 years of debacles, it is the city that’s left holding the bag. The details of The Incinerator saga tell a chronicle of political maneuvering, creative financing, cronyism, bad business and citizen apathy. 

Beyond Act 47

In the past few years, though, details of Harrisburg’s crisis have caught the attention of more people. As the public became more aware of the city’s financial woes, people argued that the convoluted conundrum surrounding The Incinerator was beyond the scope of Act 47′s structural solutions. Act 47 was designed for dying industrial towns, not small cities with more intricate issues and massive debt. By last October, when Mayor Thompson applied for Act 47, the city was estimated to owe more than $320 million in debt tied to The Incinerator, along with a budget deficit of at least $5 million a year. In December 2010, Pennsylvania declared Harrisburg “fiscally distressed.”

From then until now, the city has been presented with two Act 47 fiscal recovery plans: one by the state-appointed coordinator, Novak Consulting Group; and a second by the mayor, who was required to present her own plan after a vote by the city council rejected the state coordinator’s plan. The coordinator’s plan and the mayor’s plan were essentially the same. The main solution of both plans is to sell or lease the city’s two primary revenue-generating assets, The Incinerator and the city’s parking system. While there isn’t much dispute that those privatizations are necessary, they still don’t resolve Harrisburg’s debt. According to the Act 47 plans, projections and anticipations, those transactions would still leave behind $26 million in stranded debt the city would be responsible for. Based on other interested parties’ calculations, the stranded debt has been calculated as much higher, upwards of $60 million to $80 million.

The four city council members who voted to file for Chapter 9 protection consistently voted down the Act 47 plans put before them. To vote to pass or reject the plans is one of the only powers the legislative body has in the Act 47 process.

Said Brad Koplinski, a councilmember who voted yes to move forward with Chapter 9, “In the Act 47 Plan, the numbers just weren’t going to work. In general, the plan overestimates revenues and underestimates costs and liabilities.Harrisburg residents can’t pay for those errors. Our residents have already absorbed some significant blows including increased trash fees and decreased services. Based on the Act 47 Plans, taxpayers will see a 30, 40, even 50 percent increases in taxes. There’s got to be shared pain among the parties. There’s no way the Act 47 suggestions can succeed in solving Harrisburg’s massive and unique financial problem.”

Both the state and the mayor have admitted the plan has errors, but contend, “It is a living, breathing document.” What worries the city council members is if Harrisburg passes an Act 47 plan and it becomes an ordinance. Then the city must follow the ordinance, or risk Act 47 consequences, which now include brand new legislation for a state-appointed receiver to manage the city’s financial recovery. “The State changed the rules on us,” Koplinski said. “And it’s the city that has the most at stake.”

The city council members in favor of Chapter 9 say the city has been bankrupt for years. They maintain now is the time to use the official tool of bankruptcy to get everyone to the table to work out a fair and equitable plan. The previous mayor, Reed, was efficient at moving money around without many checks and balances. Up until this point, the city was able to avoid what the city council sees as this inevitability of a bankruptcy filing. Through a series of municipal authority transfers and borrowing, Reed was able to bury the city’s deficits all the while hoping to reach the tipping point into legitimate solvency. 

Unsustainable Policy

Nevin Mindlin, the Republican who lost the 2009 mayor’s race to Democrat Linda Thompson, also criticized her predecessor, former Mayor Reed. Mindlin said Reed’s policy on The Incinerator was unsustainable, referring to it as a classic tale of robbing Peter to pay Paul. “Steve Reed kept moving money around, kicking the can down the road, and ended up having to cut the things that make a good community function,” Mindlin said. “When his gambles failed, it was the taxpayers that had to pay. That’s where we are now.”

While there is dispute about the best way to confront the city of Harrisburg’s fiscal quagmire, some taxpayers looked to municipal bankruptcy protection to help Harrisburg with the massive pubic debt it guaranteed.  However, on November 23, Judge France dismissed the Chapter 9 petition, declaring that the city council did not have the authority to make such a filing without the mayor’s or the state’s approval.

A week later, a state-appointed receiver was confirmed, bond attorney David Unkovic.  Unkovic had been outspoken that creditors will have to pay a fair share in Harrisburg’s debt solution – especially in light of what he testified as the “uncommon” Incinerator debt structure. Whether he will be able to negotiate “fair share” results is yet to be seen.

But on March 30, 2012, Unkovic resigned in the midst of receiving bids for The Incinerator and the parking system. Reported Reuters, Unkovic, “said in his resignation letter that he was no longer in a position to find a solution to the city’s financial crisis.” But Steven Kratz, spokesman for the Pennsylvania Department of Community and Economic Development, said, “The process is going to continue to move forward.”

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?”

There are many California cities likely to be facing future stress to their operating fund budgets because of rising public pension obligations. But even more so county governments are staring down the unthinkable: bankruptcy.

This is mainly because counties overlap in providing public services with the state. Under what is called “realignment,” the state is dumping prisoners, Medi-Cal patients and social welfare recipients on California’s counties without deregulating such programs.  This is a fiscal perfect storm waiting to happen.

The local level is where the action will be with the public pension system crisis and the associated prospect of municipal bankruptcy. It will take a vigilant and informed local citizenry to bird dog the process of renegotiating public pensions, reworking local government budgets and understanding the associated risks to taxpayers of pension reforms. The action will be in city halls, county halls of administration and county superior courtrooms across the state.

Let’s first take a look at the basics of municipal finance.

1.      The General Fund is a Common Pot of Funds

Local government budgets are called “general fund budgets” because they are a large common pot of revenues that funds a whole range of basic services: fire, police, parks, streets, water systems, sewer systems, the city manager, etc.  Typically, 70 to 80 percent of a city’s budget goes for personnel expenses: salaries, pensions and health benefits.

Pensions presently consume from about 4 percent to 9 percent of city and county budgets, although this is increasing and could balloon to 15 to 20 percent or higher.  As that percentage increases, other services provided by local governments are likely to get crowded out of the budget unless pensions are renegotiated, a court forces a reorganization “cram down” or taxes are increased to cover the mounting pension debt.

2.      Revenue Sources

The main sources of revenues for local government in California are sales taxes, property taxes, business taxes, utility users’ taxes (on electricity, water and telephones), federal block grants and fines and revenue sharing from state government. The revenue sharing can include a portion of sales taxes, gasoline taxes and vehicle license registration fees.  The state also collects a corporate tax, a capital gains tax and a gasoline tax.

3.      Pay-Go or Bonds 

Local governments typically have two ways to finance their obligations: 1) pay cash, called pay-as-you-go or “pay-go”; or 2) bond financing. Large or long-term projects of a local government are typically funded by municipal bonds, just as homeowners finance their homes with mortgages.  Bonds are like mortgages that are promises to pay a long-term debt and are backed by the “full faith and credit” of a municipality.

There are two types of bonds: 1) general obligation bonds; and 2) revenue bonds.

Investors find general obligation bonds or GO bonds attractive because they obligate everyone in the municipality to pay them off even if there is a shortfall in revenues.

This is all-important for understanding bankruptcy because a general obligation bond can require a tax levy at a rate for whatever level is needed — up to 100 percent — to recover a shortfall in taxpayer delinquencies.  In California under Proposition 13, a general obligation bond must be authorized by a supermajority — two thirds — of voters.  Voter rejection for raising taxes to pay a bond means that the local government will need to make space in its existing operating budget to make the debt payments.

General obligation bonds typically pay for general municipal improvements such as streets, sewers and water systems.  Revenue bonds typically pay for special revenue-producing facilities such as a convention center, a stadium or a redevelopment project. The money comes only from the revenues of that project.

The difference between the two types of municipal bonds is the type of security for the bonds.  General obligation bonds obligate all the taxpayers within the respective city, county or special taxing district.  Revenue bonds are secured only by the cash flow from a specific project and not from the taxpayers.

4.      Bonds Cost More

No matter what type of bond, local government typically ends up paying one third or more higher than the face amount of the bond because of compound interest that needs to be paid to bond investors, typically over a 20 to 25 year life of the bonds.  Government bonds are typically tax-exempt and thus offer local government a sort of low-interest credit card.

As David Crane, advisor to former Gov. Arnold Schwarzenegger, testified:

“For example, an annual obligation of $30,000 for 25 years for a government employee’s pension is projected to cost the government $320,000, while the same $30,000/year, 25-year obligation in the form of a bond is projected to be $425,000….

“Two identical and unconditional obligations owed by the same government are valued at different amounts. The answer lies in the Alice in Wonderland world of government pension accounting that allows governments to hide liabilities…. The government and the taxpayer stay on the hook” for pension promises. “To put this in perspective, consider this: If Alice’s accounting could be applied to your mortgage obligation, then just setting up a trust account and projecting that account to earn a high rate of return on any deposit you make to that account would allow you to reduce the reported size of your mortgage. Now wouldn’t that be nice — at least until you had to make the payments on that mortgage.”

5.      Funding Pensions with Bonds is Risky

Bonds are not typically used to pay for city or county services, public pensions or health benefits.  The most famous case of a large municipality nearly going into bankruptcy was New York City during the stagflation of the 1970s. The Big Apple only averted insolvency by being bailed out by a federal loan.  Part of the problem in New York City was that bonds were being used to fund soft costs — social services, salaries and pensions — not hard costs such as capital improvement projects.

Imagine taking out a mortgage on your home to provide a pension for you to live on. Then what would you pay back the mortgage payment with?  Despite the risk of funding pensions with bonds, the wealthy city of Pasadena recently funded its unmet pension obligation with a general obligation bond.

Up until now, most municipal bond defaults have been concentrated in the category of redevelopment revenue bonds backed by stadiums, hotels, casinos and infrastructure for large residential subdivisions.

But what’s new is municipal defaults in which legally committed expenses exceed the available revenues of a municipal operating budget — called a “general fund” budget.  This can occur if a public-employee union labor contract obligates a city or county to pay pensions based on a lucrative formula, but revenues decline to the point that they are insufficient to cover expenses obligated under the contract.

6.      Bankruptcy

One way to invalidate or have a court adjudicate such a pension contract would be to seek a Chapter 9 bankruptcy — which refers to Chapter 9 of the U.S. Bankruptcy Code for cities, counties, towns, special taxing or assessment districts, municipal utilities and school districts.  The first municipal bankruptcy law was enacted during the Great Depression of the 1930s.

Another way is for local governments to put pension reform before the voters.  This might be called “proxy bankruptcy” because it effectively does much of the same thing as bankruptcy.  On Dec. 6, 2011, the San Jose city council voted to put a pension reform measure on the June 2012 ballot. The constitutionality of that measure has been challenged in court and could eventually set a precedent for what is going to happen all over the state.

“What the ballot initiative does is it looks to challenge laws as they exist today, which is probably going to mean years of litigation before anything gets settled, if anything at all gets settled,” said Robert Sapien, the president of the San Jose Fire Fighters union.

If the courts rule that existing pension plans are constitutionally protected and unchangeable, then we are likely looking at formal bankruptcy for many local governments.

With the basics of municipal finance explained, let’s look at the fiscal — or budgetary — situation that California cities and counties find themselves in today.

City and County Budgets on the Verge of Upset

Many California cities are under fiscal stress due to the protracted contraction of the economy. Many of those cities will be staring down bankruptcy waves as public pension obligations start kicking in during the coming years.

One of the largest prospects for bankruptcy is that of the City of Los Angeles. Former Mayor Richard Riordan wrote an article in the May 5, 2010 issue of the Wall Street Journal, “Los Angeles on the Brink of Bankruptcy.” He warned, “Between now and 2014 the city will likely declare bankruptcy.”

According to Riordan, even if the city were to enact drastic pension reforms today, it wouldn’t be enough to meet the $2.5 billion in increased pension obligations the city faces.

Riordan blames the city’s budgetary crisis on two numbers: 8 percent and 5,000.

8 Percent Returns in a Zero Interest Rate Environment

For Los Angeles’ pension funds, 8 percent is the projected annual rate of return.  But Riordan warned, “Over the last decade, the two main pension funds in Los  Angeles have seen their assets grow at just 3.5 percent and 2.8 percent annually.” The two funds are the Los Angeles City Employees’ Retirement System and the Water and Power Employees’ Retirement Plan.

And investment rates of return are likely to decline now that the U.S. Federal Reserve Board has lowered the long-term Treasury Bill borrowing rate effectively to zero percent.  Much of the high annual returns advertised by the CalPERS state pension fund in the past two decades have been earned because growth has been financed with debt and leveraging, which neither the state nor local governments can continue to count on.

Adding Government Employees Erodes Legitimacy for Any Tax Increase

Riordan’s other number is 5,000.

Despite the recession, from  2005 to 2010 the city of Los Angeles added 5,000 new employees added to its payroll.  Cities like Los Angeles, which added employees during the recession, are particularly vulnerable not only fiscally. They also raise the ire of the voters who may be asked to approve any renegotiated pension plans.  Many cities and counties have padded their employee rolls during the recession. Such cities and counties are likely to lose legitimacy before the voters for any kind of tax increase to fund lucrative pensions.

Los Angeles officials have dismissed Riordan’s forecast of a looming fiscal crisis by using accounting gimmicks to wish the problem away, and by sticking to the 8 percent annual rate of return on retirement funds.

Los Angeles Mayor Antonio Villaraigosa continues to assert that bankruptcy is not an option for the city. He has proposed a pension reform deal that would require approval by the city council and the voters.  But the problem with Villaraigosa’s pension deal may be the sheer mathematics of overly optimistic pension fund investment returns that got the city into its impending budget mess in the first place. So the city ofLos Angeles may be going in circles with pension reform.

On April 6, 2012, Miguel Santana, chief administrative officer of Los Angeles, warned that the city faced bankruptcy unless it raised taxes and laid off personnel. The Los Angeles Times reported that, according to Santana, “[R]ising employee costs combined with flat-lining revenues have left the city in a precarious position. Even after reducing its workforce by 4,900 positions in recent years, the city faces a $222-million budget shortfall, he said, a figure that is expected to rise to $427 million by 2014-15.”

Multiply the fiscal problems of Angeles times the number of cities and counties in California, and you have a statewide fiscal crisis affecting hundreds of municipalities.

Pensions are ‘Eventually Unsustainable’

Howard Cure is the director of Municipal Bond Credit for Evercore Financial Management in New York. He stated in an interview that the current pension commitments in California are “eventually unsustainable.”  He believes that local governments cannot look to the growth of equity or fixed income financial markets to close the funding gap in the underfunded public pension programs.  Cure added, “If nothing is done, the costs get more onerous and you can’t continue to defer it.”

There are several changes that could be made to pensions for future public employees: extend the retirement age, disallow pension spiking and gaming the system, and increase the percentage of pension contributions by new employees.  But Cure said this takes a long time to work through the system and is not likely to solely represent a quick fix to the ailing public pension systems.

Changes are needed to the pension formulas for existing public employees and retirees.  But once again, merely lowering the cost-of-living adjustments for existing pensioners may not do the trick fast enough or deep enough to avoid a fiscal crisis.  Retirees will have to be asked either to increase contributions to the pension system or increase taxes to plug the pension gap.

Alternatively, pension benefits could end up facing the risk of a court a “cram down” reorganization either in bankruptcy court or in the superior and appellate courts.

Raising Taxes Out of the Question

But Cure is not optimistic that taxes can be raised. Public unions do not have the muscle they once had. And the public is not going to vote for a tax increase for lucrative public pensions when their 401(k) private pension funds dropped sharply in the financial crash of 2008.

Bankruptcy is not a solution, according to Cure, if it means repudiating debt, which would result in local governments being denied future access to the debt markets.  Nonetheless, it is likely that existing pension formulas and benefits will end up in court to determine to what extent public pensions are constitutionally guaranteed, or if they can constitutionally be unwound.

Cure is optimistic that the pension system can be reformed based on efforts by such cities as San   Jose. As mentioned, the city is putting pension reform on the ballot in June 2012.  He says the current situation is fluid and not static.  But it will take hundreds of such local efforts to reform each pension plan instead of merely systemic reforms at the state level.

Municipal Bond Insurance Has Declined

There isn’t much municipal bond insurance coverage any more to backstop fiscal crises. According to the Municipal Securities Rulemaking Board, fewer than 10 percent of all new municipal bond issues are insured. That’s a drop from 50 percent as recently as 2008. The municipal bond industry may be less worried about municipal fiscal defaults than the average citizen. But the insurance industry has vastly reduced its exposure in the municipal bond market.

Perhaps bond insurers are fearful of being a “deep pocket” stuck with paying out liabilities in a bankruptcy court order.

Pension Studies are all based on Assumptions

A key to understanding pension-fund obligations is to look at the assumptions of some of the studies that have been conducted on California’s public pension system:

1.      Northwestern Pension Study — A Disaster Scenario of Closed Pension Plans

In 2010, the Kellogg School of Business at Northwestern University released a study, “The Crisis in Local Government Pensions in the United States.” It indicated a dire scenario mainly for counties in California.

Pension Legislative Representative Eraina Ortega of the California State Association of Counties said the Northwestern study is based on an assumption of a closed pension system that would no longer be funded.  A closed pension system would be one that accepted no new retirees.  She said that, even if a pension system were closed, it would still be funded and would not necessarily run out of money.

However, she added that the assumption that public pension funds will continue to earn around 8 percent returns on their funds is a legitimate issue of concern.

2.      Boston College Retirement Study — Moderate Scenario but New Taxes Unrealistic

The Boston College Center for Retirement Research conducted a study in 2010, “The Funding of State and Local Pensions: 2009-2013.” It is based on perhaps a more reasonable assumption that employer contributions of public pension systems would continue. According to Howard Cure, the Boston College study is also based on more reasonable expected rates of return of around 6 percent, rather than the nearly 8 percent used by CalPERS, or the risk-free 4.14 percent rate of return on T-bills used in a 2010 Stanford University study (see below).

Even though the Boston College study indicated that funding ratios for public pension funds would likely drop from about 85 percent to 72 percent by 2013, it nonetheless concluded that “a major increase in contributions is not realistic at this time.”  The Boston College study did not recommend raising taxes to plug the pension gap. But it did recommend that local governments at least fund the Annual Required Contribution, which is the annual amount the government would have to pay to fund its liabilities over time.

3.      Stanford Pension Study — Financial Train Wreck Scenario Based on Low Return Rate

Also in 2010, graduate students at the Stanford University Institute for Economic Policy Research completed a study, “Going for Broke: Reforming California’s Public Employee Pension Systems.”  It was based on conservative safe rate of returns to the pension funds of 4.14 percent, instead of the 7.75 percent assumed by CalPERS. It estimated as much as a $425.2 billion funding gap as of 2009.  The Stanford study recommended reforms such as the implementation of a hybrid public pension plan and a 401(k) private pension plan.  The Stanford study did financial modeling of the future and did not assume that the pension systems would be closed off, as did the Northwestern study.

According to Eraina Ortega of the State Association of Counties, Gov. Jerry Brown has questioned whether the hybrid pension plan being proposed by the Stanford study could be a “Ponzi scheme.”  CalPERS actuaries have reportedly pointed out that, even if its pension fund were to be capped and closed, it would still be able to service pensioners and not leave them wiped out.

The Stanford study was updated in December 2011 in “Pension Math: How California’s Pension Spending is Squeezing the State Budget.” It used more conservative investment assumptions of a 6.2 percent annual investment rate of return. Yet it found the funding shortfall had climbed by 17 percent, to $498 billion.

Instead of experiencing “number shock” of all the different calculations in each pension study, it is better to focus on the assumptions undergirding each study.

Comparison of Assumptions in State Pension System Studies

It is important to understand that the higher the rate of return the pension fund earns, the lower the present value of the benefit cash flows.

Pension Liabilities Could Be Made to Disappear by Assumed Return Rate

If a high enough rate of return is used, assuming risky investments with high-average rates of return, it could make local government pension liabilities hypothetically vanish.  So beware of the trick of using high rates of return as well as unreal low rates of return that would make the pension liabilities look smaller or larger.  It is possible that most pension systems in California use a return rate around 8 percent purely as a device to minimize the perceived expected exposure to the taxpayers.

No one knows what rates of return pension funds will yield in the future. Past return rates were inflated by incurring debt and leverage that is unlikely to continue in the future.  There seems to be a tentative consensus that an 8 percent rate of return is too high. But a safe rate of, say, 2.5 percent is too low.

Not All Cities Are in Distress Scenario

Not all cities in California are under such financial distress. The city of Laguna Niguel in Orange County would likely be untouched by the wave of pension obligations.  Its pension debt is less than 20 percent of its annual operating budget and it has $40 million in financial reserves for a city of about 65,000 people. The city is known for its political conservatism and has only 17 retirees and 59 current full-time employees, as it contracts out most of its services. This shows that the current mess could have been avoided if officials took a more fiscally prudent approach to their budgets.

California Counties in Double Jeopardy

Howard Cure said it is not California’s cities, but counties, that face the greatest threat of fiscal crisis in the near future.  As mentioned at the beginning of this chapter, a major culprit is “realignment” that sends functions from the state to the counties, but with inadequate financing.

Although the Northwestern University pension study is based on arguable assumptions leading to a pessimistic set of scenarios, it nonetheless highlights that 18 of the 50 municipalities, or 36 percent, expected to be bearing the most fiscal stress are located in California.  And of the 18 California local government pension systems surveyed, 15 are counties.  Whether one agrees with the assumptions of the Northwestern study or not, it nonetheless calls to our attention that the greatest municipal fiscal stress in the U.S. may occur in California’s counties.

Below is a table from the Northwestern study indicating the estimated proportion of annual general fund revenues for each municipality in California that would be consumed by pensions.

Percent Municipal Revenues Consumed by Pensions

It will be county supervisors and their constituents that will be in the vortex of the public pension perfect storm scenario in California.  Political parties, think tanks and emerging movements such as the Tea Party would best be advised to focus on the county level of government, where the prospect of a fiscal meltdown is going to be greater and the stakes much higher.

Will counties merely replicate the state’s prison, medical and social welfare systems at the local level under “realignment,” thus putting the state right back where it started from with programs it can’t pay for?

For example, Sheriff Lee Baca in Los Angeles County is proposing that the county supervisors float a $1.4 billion general obligation bond to fund the renovation and expansion of two existing jails to accommodate the transfer of offenders from the state prison system.  No public policy discussion has taken place of any alternatives such as privatizing lesser-offender prisons, transferring misdemeanor offenders to prisons in other states or decriminalizing some misdemeanor offenses to save costs.

No Cost Savings

With all the ballot initiatives being floated for the November 2012 election, none so far exists to establish lesser-offender prisons.  The local bureaucracies have taken the early lead in trying to shape public policy by merely shifting the political locus of the problem from the state to the counties without any real cost-saving reforms.

There is no guarantee that delegating prisons, medical and social service programs to the counties will result in any real reforms, or that unions won’t be able to capture local policy makers just as they have state lawmakers.  Indeed, the unions already exert heavy influence over many cities and counties.

But if the state’s structural $20 billion annual budget deficits are any indication, costs must be reduced by counties. Otherwise, realignment will be an exercise in futility ending right back in bankruptcy court.

Once upon a time buying a municipal bond was considered a safe bet. A decent rate of return with little risk ­– just the thing for junior’s college fund and grandma’s retirement account. But that was before Standard & Poor’s downgraded the U.S. government’s credit-worthiness, sending shock waves through the bond markets. And before governmental agencies increasingly defaulted on loans and threatened or declared bankruptcy, converting safe securities into junk.

That’s potentially a lot of junk. Investors hold nearly $3 trillion of municipal debt in the United States.

Municipal bond holders have become concerned that they can’t get access to adequate financial information from governmental agencies about their credit-worthiness. Many are senior citizens who may know members of their city council or water board. In the past, the citizens blindly trusted in the fiscal soundness of government, considering it a safe place to park their money without having to worry about pouring through bond offering reports, prospectuses and audits.

One of those investors receiving a wake-up call is Irv Siminoff, a World War II veteran who served in the Pacific Theater and began investing in municipal bonds in the early 1980s to provide a stable income for his son’s tuition at Stanford.

“I started out investing in Wall Street right out of college, and in those days things were pretty calm,” he told the Securities and Exchange Commission at a hearing last year in San Francisco. “One could get 5 to 6 percent in dividends and could reasonably expect maybe a 5 to 10 percent annual return from the underlying corporation. In addition to income from my equity portfolio and my growing business, muni bonds seemed like an ideal, good security, a given income and investment return at some time in the future at a scheduled date. Boy, was I naive.”

‘Looked Really Safe’

His first municipal bond investment was in the Washington Public Power Supply System. It was not insured, but, he said, it “looked really safe. What could be better than revenue from power?” He wound up losing half of his money after delays, cost overruns, mismanagement and political opposition to nuclear power resulted in WPPSS defaulting on $2.25 billion in construction bonds. Investors and the public were largely kept in the dark about the problems. Siminoff was luckier than some investors who only received 10 cents on the dollar.

He then shifted his account to Drexel Burnham Lambert and bought bonds that turned out to be secured by nothing more than raw land and an Oklahoma hospital center that was on the fast track to bankruptcy. Bankruptcy is also where Drexel wound up after its illegal activities in the junk bond market were discovered. “Looking back, these deals were sold on projections, not on established facts,” said Siminoff. He got similarly burned on Mello-Roos bonds that were based on pie-in-the-sky projections.

While Siminoff was naive at the outset, even sophisticated investors can suffer from insufficient knowledge about the risks in these supposedly safe investments. Peter Kuhn, a former accountant for Price Waterhouse whose wife calls him a “municipal bond geek,” bought from a professional trader a general obligation bond issued by the Hayward School District, getting a very good yield. “However, Hayward is having some financial challenges, and their certificates of participation were just downgraded to nearly junk, if not junk status,” he said.

Lack of Information

A lack of up-to-date governmental financial information was a common complaint at the SEC hearing by both individual and institutional investors.

“The municipal securities market lacks many of the basic investor protections that exist in most other sectors of our capital markets,” said Andy Gill, senior vice president at Charles Schwab. “It is time for this circumstance to change, beginning with an improved disclosure regime that will boost investor confidence and improve access to information about the municipal securities market. Financial reporting by municipal issuers can take up to 270 days to reach an investor.

“This information lag is particularly worrisome because, for many investors, bond assets provide stability and income generation, the most critical portion of an individual investor’s assets.”

Institutional investors have an advantage because they are exclusively treated to investor road shows in which bond issuers may provide financial information that never appears in financial statements, according to Mary Colby, representing the National Federation of Municipal Analysts. But they share the complaint about being kept in the dark.

“Given that most issuers only undergo audits annually with a substantial lag after the end of the fiscal year, this often results in fairly stale financial information being included in offering documents,” said Colby. “While this situation has improved in the last few years, perhaps in response to the financial crisis, it is still fairly common to see an official statement that only includes audited financials that are six to nine months old.”

The situation is even worse in the secondary market in which bonds are resold; for example, Chicago takes 13 months to file its financial information. A lot can go wrong financially for a government agency in the meantime.

“During the current recession, many state and local governments experienced double-digit declines in revenues, including sales taxes, personal income taxes, property taxes and mortgage recording taxes, among others, all of which separately or jointly secure tax exempt debt,” Colby said. “Investors during the period were often left relying on financial information gleaned from newspaper articles, because secondary market disclosure lagged so substantially and was so infrequent. The municipal market contrasts very poorly with the corporate sector where quarterly disclosure is the norm.”

Incomplete Information

In addition to late filings, many small-to-medium sized government agencies provide incomplete information when they do file.

“Often after a few years, the filings may shrink to only the audited financials ­– and the additional items of information disappear,” said Colby. “These items may range from annual updates for assessed valuation, property tax delinquencies and tax appeals — all of which are critical for assessing a general obligation bond — to operating information for a water and sewer system or sales tax collections, all of which are vital to a thorough analysis of associated bonds. There are numerous issuers currently under financial stress about whom newspaper articles frequently appear, but who have not released any updated financial information.

“While some might argue that the filings are an unnecessary burden, given their low rate of default among municipal general government issuers, we feel strongly that the issuers have availed themselves of the benefits provided by issuing debt in the public market and must be prepared to follow through with the promises they have made to investors to provide complete and timely information.”

A lack of transparency and deceptive practices were unveiled in the Los Angeles Community College District’s $140 million bond construction program. An audit by state Controller John Chiang released in August 2011 concluded that the district “could not produce complete and timely records, spent funds outside voter-approved guidelines, ignored its own procurement rules, failed to plan effectively, and provided poor oversight of bond funding. Shoddy fiscal management and sub-par oversight of a project of this magnitude will undermine the public’s trust and threaten billions of public dollars.” 

Problem? What Problem?

But to listen to the government representatives at the SEC hearing, you would not think there was any problem. They argued that, as public entities, they are even more transparent than private corporations.

Said California Treasurer Bill Lockyer, who manages a $67 billion investment pool of state and local funds and annually issues more than $30 billion worth of debt, “As both investor and issuer, we’re responsible for protecting the public trust and adhere to the highest standards of transparency.”

Lockyer had a complaint of his own about the ratings provided by S&P, Moody’s and Fitch, which have pegged California’s general obligation bonds in the A-minus to A1 range. The A-minus score ranks California tied for last with Illinois, or second worst behind it, among the states in credit worthiness — and that rankles Lockyer.

“There’s been historic discrimination in public issues compared to corporate issues,” he said. “Municipal bonds rarely default. A study by S&P revealed that 0.33 percent of municipal bond issues rated A-minus defaulted during the last 15 years, while corporate issuers rated A-minus had an average default of 3.16 percent. So, 100 times more likelihood of default, but same rating.

“That discrimination costs taxpayers a lot of money because our cost of issuance goes up, and it’s unfair to investors to not be able to accurately compare the choices that they would be making.”

Fair or not, the credit agencies’ ratings can negatively affect the municipal bond market, particularly the sector tied to federal debt. Moody’s recently warned 177 municipal issuers with high exposure to federal funding about possible downgrades, including 162 local governments in 31 states, 14 housing finance programs and one university, according to Wells Fargo Wealth Management. The company advises investors to be wary of these issuers, particularly bonds issued by Virginia, Tennessee, South Carolina, Maryland and New Mexico. 

Under-Reporting

But as bad as that seems, the problem actually may be much worse, given the under-reporting of unfunded pension and retirement health care liabilities for state employees. Taxpayers may be on the hook nationwide for more than $2.5 trillion in pensions, according to David Crane, a registered Democrat who has been an economic advisor to former Republican Gov. Arnold Schwarzenegger, with perhaps $500 billion of that in alifornia alone.

“State and local governments utilize a misleading method for reporting the size of public pension obligations,” said Crane, calling it “the Alice in Wonderland world of government pension accounting that allows governments to hide liabilities.”

The California Public Employees Retirement System, the largest pension fund in the nation, voted in March 2011 to keep its discount rate at 7.75 percent, despite a recommendation from its actuary to lower it to 7.5 percent. The rate reflects what the fund expects to earn on its investments over 20 years, allowing it to reduce what it owes by what it expects to bring in. In the past 20 years, CalPERS has earned an average 7.9 percent rate of return, despite the Great Recession.

“According to our actuaries, maintaining our discount rate at its current level is prudent and reasonable,” said CalPERS Board President Rob Feckner. “Given the current economic environment, we believe keeping our discount rate unchanged is in the best interest of our members, employers and taxpayers.” Despite his recommendation to lower it, Chief Actuary Alan Milligan went along with the status quo, saying, “The discount rate adopted is reasonable and achievable, and appropriate for funding the promised benefits.”

Market Crash

CalPERS was especially hurt by the market crash of the summer of 2011. CalPERS, which has 49 percent of its investments in the market, lost $17.5 billion in just five weeks, representing 7.4 percent of the $237.5 billion balance it reported on June 30, as reported by Calwatchdog Managing Editor John Seiler on August 9, 2011. Some of that has been restored. But as of December 12, 2011, the fund’s value stood at $238.3 billion, up not even a billion dollars from the June 30 amount.

Crane considers a 7.75 percent discount rate a misrepresentation of reality, and provides the following example:

“Suppose an individual wears two hats. One is a just-retired government employee entitled to pension payments from the state government, and the other is an investor in a general obligation bond issued by that very same government. Assume the pension payments and the bond payments are unconditionally owed by and fully recoursed to the government. 

“Suppose further that the pension payments and the bond payments have identical profiles. For example, suppose that both require a payment of $30,000 per year for 25 years. Also with respect to the bond, assume that, at the interest rate at which it was issued to the retiree, the government would record a present value obligation of $425,000. With respect to the pension payments, that very same government would record an obligation of only $320,000. Now how can that be? Two identical, fully recoursed and unconditional obligations owed by the same government are valued at different amounts.” 

In March 2012, CalPERS bowed slightly to reality and dropped its discount rate to 7.5 percent from 7.75 percent.

Expensive Mistakes

Overstating the pension fund’s ability to cover its liabilities can lead to expensive mistakes. Such as what occurred in 1999 when CalPERS reported that its fund assets equaled 128 percent of liabilities, when a more realistic discount rate would have put assets at only 88 percent of liabilities, according to Crane. That imaginary surplus led the legislature to increase employee pension promises, which could result in an additional $150 billion hit to the state budget, he said.

“California wasn’t alone in this regard,” Crane told the SEC. “Unrealistic reporting of pension promises is a systemic problem. That’s why the SEC must require realistic accounting of public pension promises. For that to happen it must insist upon a realistic discount rate when reporting pension liabilities.”

A month later Crane took his case to the Governmental Accounting Standards Board, which is considering revising the accounting rules for pension funds. A decision could be made sometime in 2012. It remains to be seen whether the SEC will revise pension reporting rules, but there’s a chance it will seek more openness in governmental financial reporting.

“There seems to be a disparity between the level of information that institutional investors in this market are able to obtain compared to what a typical retail investor can access, and that’s a serious concern for all of us, particularly for me,” said SEC Commissioner Elisse Walter, who chaired the hearing. “And while I would not want to see a door shut on institutional investors obtaining the information they need to make sound decisions, we can’t close our eyes to the fact that retail investors are really in need of the same types of information. As in so many areas, improving investor education and financial literacy about issues of risk, whether it’s credit risk, default risk, interest rate risk, always has to be a high priority.”

Walter also acknowledged Crane’s concerns, saying, “Disclosure of accounting for pension and other post-employment liabilities is quite complex and implicates serious public policy issues.”

In late July 2011 the SEC wrapped up its field hearings around the country on the municipal securities market. It is preparing a report with recommendations for further action, which may include changes in rules and industry best practices as well as legislation by Congress.

Roberts is a contributing editor to Calwatchdog and a long-time Bay Area newspaper reporter.

Bankruptcy is the boogeyman haunting governments across America. It’s not a question of if more cities will file for bankruptcy, but how many.

The culprit is a decade of over-spending by governments, especially on pension guarantees, and an economic slowdown that refused to flip into a robust recovery. The money just isn’t there. And it’s not going to be there even if local governments raise taxes while cutting employees and services to the bone.

Chriss Street was the treasurer of Orange County, Calif., from 2006-2010. And back in 1994, he warned that Orange County was headed for what would become, in November that year, America’s worst municipal bankruptcy. People didn’t listen then. They’re not listening now.

He told me that, today, things are just going to get worse for municipal finance. “State and local government revenues are taxes and fees on the private sector and housing,” he said. “The bulk of this tax collection is subject by law to an approximately 18-month lag in collection. The recovery in real estate peaked out in November 2010 and economic activity peaked around April 2011. Both real estate and the economy are in substantial decline.” Therefore, tax collection will be falling all through the first half of 2013.

“Most states, counties, cities and school districts have spent their cash reserves down to the legal minimum,” Street said. “When I speak at national conferences on municipal finance, I ask the question: ‘How many of you have made contingency plans for another 15 percent decline in revenue in the next year?’ I have never gotten a hand raised. Consequently, it is my belief that there is the potential for thousands of defaults in the 50,000 municipal bond issuers in the United States.  Most cities can cut spending, but they cannot cut principal and interest payments without default and bankruptcy.”

The Way to San Jose Bankruptcy

An example of where so many cities are going is San Jose, Calif. Unlike some small cities facing bankruptcy, such as Central Falls in Rhode Island, San Jose remains highly prosperous. It’s not a dead-end rust-belt town. San Jose enjoyed the dot-com prosperity of the late 1990s, then the real-estate boom of the mid-2000s. The ensuing real-estate bust was milder there than in most places. It still prospers from being part of Silicon Valley, the epicenter of the world computer revolution that’s booming again, despite the global economic slowdown. Apple’s HQ is a stone’s throw away in Cupertino. Facebook is just a little further north in Palo Alto.

But San Jose officials have discussed bankruptcy as a possible option.

Its prosperity turned out to be its undoing. In the November 2011Vanity Fair, financial writer Michael Lewis wrote, “[T]he city owes so much more money to its employees than it can afford to pay that it could cut its debts in half and still wind up broke.”

The problem for America’s 10th-largest city, population 1 million: “The Internet boom created both great expectations for public employees and tax revenues to meet them….  Over the past dec­ade the city of San Jose had repeatedly caved to the demands of its public-safety unions. In practice this meant that when the police or fire department of any neighboring city struck a better deal for itself, it became a fresh argument for improving the pay of San Jose police and fire. The effect was to make the sweetest deal cut by public-safety workers with any city in Northern California the starting point for the next round of negotiations for every other city.”

This ratchet effect also struck areas throughout the rest of California and the United States.

According to Mayor Chuck Reed, a Democrat, “Our police and firefighters will earn more in retirement than they did when they were working. There used to be an argument that you have to give us money or we can’t afford to live in the city. Now the more you pay them the less likely they are to live in the city, because they can afford to leave. It’s staggering. When did we go from giving people sick leave to letting them accumulate it and cash it in for hundreds of thousands of dollars when they are done working? There’s a corruption here. It’s not just a financial corruption. It’s a corruption of the attitude of public service.”

And it’s a corruption that could lead to bankruptcy.

While costs have been ratcheting up for San Jose, city staff levels have been ratcheting down. City staff has been cut from 7,450 to 5,400. The number of staff is the same as that of 1988, before the city added another 250,000 residents. By 2014, the number of city staff could be as low as 1,600. Reed warned, “There is no way to run a city with that level of staffing.”

San Jose’s fate could rest on the decision of voters. As Ed Mendel of CalPensions wrote in December 2011, “The San Jose City Council voted 6-to-5 … to place a pension reform measure on the June ballot that takes on what the Little Hoover Commission called ‘the elephant in the room,’ a way to reduce the cost of pensions promised current workers. As state and local governments face rising pension costs while a weak economy forces deep budget cuts, the San Jose council’s plan is the biggest and boldest proposal yet by elected officials to reduce pension costs widely believed to be legally untouchable. Mayor Chuck Reed had talked about declaring a fiscal emergency to reduce pensions earned by current workers in the future. Now he is talking about the city charter specifying minimum benefits provided by the city’s two independent pension systems.”

Vallejo

One city that did declare bankruptcy was Vallejo, Calif., back in 2008. Unfortunately, the city missed a grand opportunity to pull itself from fiscal disaster. Government-worker unions made some concessions, such as higher payments for retirees for their health-care insurance. However, Jonathan Weber wrote in the  Bay Citizen, “But pension plans for retirees and current city employees, including one that allows police officers to retire at 50 with as much as 90 percent of their pay, remain untouched. The city chose not to test whether messing with pensions would be allowed even in bankruptcy, and so remains on the hook for some $195 million in unfinanced pension liabilities.”

Vallejo is a city of 116,000. So, each resident remains on the hook for paying $1,681 in pensions to city workers who no longer even are on the job.

The city is surviving — sort of — by cutting the police force from 155 to 90, or 42 percent; and slashing firefighters from 122 to 70, a 43 percent cut.

Weber described the city: “Vallejo stumbles forward: with minimal public safety services, a skeleton crew for road repairs, deferred maintenance on everything, and no money for ‘extras’ like parks, libraries and senior centers.”

As Calwatchdog Contributing Editor Steven Greenhut wrote in the Wall Street Journal, “Over the past five years, Vallejo has slashed spending where it could, mostly by cutting personnel and services. As a recent San Francisco Chronicle editorial pointed out, the city cut its police force to about 100 officers from nearly 160 and warned residents to use the 911 system judiciously, even while it experienced crime rates higher than other comparable cities in California. The city has also cut funding for a senior center, youth groups, and arts organizations and has done little to restore an increasingly decrepit downtown, develop waterfront properties, or attract new businesses.

“To permanently bring its spending in line with its tax base, however, at some point Vallejo will have to do something about its pensions. U.S. bankruptcy judge Michael McManus, as the National law Journal reported last March, ‘held the city of Vallejo, Calif., has the authority to void its existing union contracts in its effort to reorganize.’ … But when it came to voiding those contracts on pensions — a major driver of public expenses — the city blinked. The “workout plan” the city approved in December calls for cuts in services, staff and even some benefits, such as health benefits for retirees. However, it does not touch public-employee pensions. Indeed, it increases the pension contributions the city pays.”

San Diego

San Diego still bills itself as “America’s Finest City.” They’re talking about the balmy weather, the beaches and the famous San Diego Zoo, not the city’s finances.

The city’s pension payments are skyrocketing, from $229 million in 2010, to $318 million in 2015 – 40 percent in just five years. By 2025, the number will be $512 million, a whopping 124 percent increase in 15 years.

No wonder City Councilman Carl DeMaio in September 2011 turned in 145,000 signatures to put a pension-reform measure on the ballot in 2012. Instead of pensions, it would enroll mostnew city employees in 401(k) programs for retirement. It would save the city $1.2 billion through 2040. DeMaio also is running for mayor in 2012.

“Sadly, San Diego’s pension/budget debacle is hardly unique,” Richard Rider told me; he’s chairman of San Diego Tax Fighters, which has been warning of the pension crisis for many years. “Like most cities and counties in the state, the politicians gave away benefits today that had to be paid for years later.  Everyone in the city’s decision-making process — the city managers, politicians from both parties, pension oversight committee, actuaries, attorneys, staff and the unions — profited from the giveaway of both pensions and free retiree health care. No one represented the taxpayers.  Indeed, we have had city council critters retiring in their 30s with pensions.”

Central Falls, R.I. Files for Bankruptcy

The small city of Central   Falls, R.I., filed for bankruptcy on August 1, 2011 because it couldn’t pay its pensions. In an action heard around the country, it also claimed it did not have to pay full pension benefits to retirees. The city’s population is 19,376 and its annual city budget, $17 million. But its total pension obligations are $80 million. It’s like a family having $17,000 in income but owing $80,000 on credit cards. The numbers don’t work.

Eight public employee unions insisted that the city must pay its pension obligations in full and filed suit. On Sept. 13, Superior Court Judge Sarah Taft-Carter ruled in favor of the unions. According to the Providence Journal, “Taft-Carter says that there is an implied contractual relationship between the Employees Retirement System of Rhode Island and participating employees.”

“The benefits provided … are not gratuities that may be taken away at the whim of the State,” the judge wrote. However, reforming municipal bankruptcy — especially in 2011 and 2012 — isn’t exactly a whim.

On Oct. 5, Rhode Island Gov. Lincoln D. Chafee and state Treasurer Gina M. Raimondo, reported the Providence Journal, “asked the Supreme Court to use its discretion because of the ‘extreme public importance’ of the case and because Taft-Carter erred in ruling that state pension law is an ‘implied contract,’ rather than an evolving public policy statement enacted by the General Assembly that has been and will continue to be subject to change.’

“ ‘Immediate review of the decision is necessary and warranted so that the State, the Governor and the General Assembly will have clear guidance on the law in Rhode Island as they endeavor to resolve the State’s $9.4 billion unfunded-pension liability’,” lawyers for the state argue in their court filing.”

On November 22, the Rhode Island Supreme Court ruled that the unions’ lawsuit could proceed.

Meanwhile, Central   Falls’ case was moving through federal bankruptcy court. In late November, reported WPRI.com on Nov. 29, “the bankrupt city signed new agreements with its unions to cut costs and stabilize its budget. A tentative agreement on pension cuts has been reached with its retirees. And Tuesday [Nov. 29], its Adams Memorial Library said the city will rejoin the state lending system on Dec. 1 thanks to a flood of donations from celebrities and others.” The celebrities included actor Alec Baldwin and Tony Award-winning actress Viola Davis.

Retired Supreme Court Justice Robert Flanders, whom the state appointed Central Falls’ receiver, told WPRI.com, “This is all good news for the city and its taxpayers. It definitely is a new beginning for the city.”

At the state level, Rhode   Island is leading the way for the type of far-reaching reform that can keep states from reaching dire financial situations. As the Bond Buyer reported in November 2011, “Gov. Lincoln Chafee … signed the [pension-reform] bill, which he and General Treasurer Gina Raimondo had championed. … It creates a hybrid plan that merges conventional public defined-benefit pension plans with 401(k)-style plans. While some other states have implemented hybrid plans,Rhode Island’s would be the first to affect current employees, according to the Pew Center on the States.”

At this point, in Rhode Island, California and the rest of America, municipal bankruptcy law is up for grabs. But officials in Democratic Rhode Island, unlike Democratic California, appear more likely to take the steps necessary to fix the problem without reaching the point where bankruptcy is the most feasible option.

Does Bankruptcy Work?

As the case of Vallejo shows, bankruptcy is not a cure-all for a city’s problems. In Vallejo, bankruptcy led to a hollowed-out government. But the alternative isn’t all that attractive, either.

The dilemma was described by Jonathan Henes, a municipal bankruptcy expert: “Today, municipalities are facing an unfunded pension obligation problem. Chapter 9 [bankruptcy] was not set up specifically to address this problem, although certain sections of the Bankruptcy Code (sections 365, 1113 and 1114) may provide municipalities with the tools to address it. Based on the initial reports about the Central Falls bankruptcy, it appears that we will find out if Chapter 9 can help a municipality fix its unfunded public pension problems. If it doesn’t, it may be time for Congress to amend Chapter 9 to address today’s problems.”

However, with Democrats still controlling the White House and the U.S. Senate, reform is unlikely because their major constituency is public-sector employees. Republicans, should they control the White House and both houses of Congress beginning in 2013, may be reluctant to act in state matters if only because national economic problems will be more pressing.

Moreover, reforming municipal and state pension obligations also could affect federal pensions, including the pensions of congressmen themselves.

Reform a Must

With the economy still underperforming, there will be no rescue for public budgets. There’s no dot-com boom or real-estate bubble on the horizon. As we have seen, those booms were unsustainable anyway, and just encouraged unrealistic expectations about municipal revenues and portfolios.

What has happened is that at least 12 years of delusions finally are wearing off, and everyone is being forced to meet reality. For most governments, the easy fix, if one could do it, would be just to switch all future pensions for current employees to 401(k) plans. And for those facing bankruptcy, the additional fix would be to cut payouts to existing retirees, as Central Falls is trying to do. But employee unions, not surprisingly, are resisting any changes to current benefits.

“As budget realities have started to hit home, most cities now realize that just making tweaks in pension formulas for future hires won’t solve their problems — the mushrooming retirement obligations are just too large,” Jack Dean told me; he publishes the indispensable PensionTsunami.com news site, which collects stories on the national pension crisis. “Modifications in agreements with current employees will have to be made. And if the unions won’t cooperate, then municipal bankruptcies could become more commonplace.Vallejo in California and more recently Central Falls in Rhode Island have provided us with a glimpse of what may be in store for us on a larger scale without major pension reforms.”

Public employee unions complain that their members should not be subject to the ups and downs of 401(k)s invested stock markets. But that’s what most people have in the private sector that pays for the public sector.

The longer true reform is delayed, the worse matters will become.

Economist Allan Meltzer once quipped that “Capitalism without failure is like religion without sin. It doesn’t work.” Americans have been witnessing this axiom on a broad scale, as government efforts to prop up industries, bail out the financial sector and protect select private businesses from failure have only caused a prolonged financial crisis. Without failure, there is no day of reckoning and no effort by the failed party to make the fundamental changes needed to avert future crises.

Ultimately, there’s only so much bailout money to go around, and private businesses that make bad decisions, offer uncompetitive products or services or are run inefficiently ultimately go belly up or restructure their debt. Americans accept that bankruptcy is a necessary part of the market system. We want to see those poor-performing businesses change or shutter their doors. New competitors will spring up and, in the end, the public is generally better served when companies can fail rather than get bailed out.

The problem in the public sector is that government never is allowed to fail. There never is a day of reckoning no matter how poorly a government agency may provide its so-called services. Because there are no real customers in the government world, there’s never any hell to pay when the public is mistreated, when resources are wasted and when incompetents enrich themselves in the name of serving the public. Often, the worst agencies are rewarded for their failure by being granted additional public dollars. There never is actual failure.

Reform Plans

For decades, I’ve been hearing about reform plans for any number of government agencies. Think of the Los Angeles Unified School District, the poster child for mis-educating students and squandering public resources. Nothing ever changes there because the system cannot fail. It is propped up by government funding.

Our federal government does many things, almost all of them poorly and wastefully, yet our government prints as much money as it needs to pay for this. There is no failure, no day of reckoning. The federal government’s debt has soared above $15 trillion, but there is no chance of capitalist-like failure for the national government.

But it’s a different story at the state and municipal level. State governments and localities cannot print money. They must, at least theoretically, balance their books. Yet many state governments such asC alifornia struggle with endless budget deficits. Unfunded liabilities to pay for pension promises for state and local public employees hit an estimated $3 trillion nationwide. Then there are the debts for the health-care promises that municipalities have made to their employees. Much of this is not honestly accounted for, so the real numbers are worse than the official ones.

De Facto Bankruptcy

As Orange County, Calif., Supervisor and former Treasurer John Moorlach has pointed out, California is in de facto bankruptcy. States are not allowed technically to go bankrupt under current federal law, but some of them – California most notably – are basically insolvent. They spend more money than they take in. California’s officials play games with the budget every year to mask that debt, but it is there no matter how artfully legislators and governors shift around funds and paper over their ongoing debt spending.

Municipalities can go bankrupt and some of them — Harrisburg,Pa., Central Falls, R.I., Vallejo, Calif. — have actually gone bankrupt or tried to do so. In the San Francisco Bay Area,Vallejois a union-dominated city that ended up spending 80 percent of its budget on pay and benefit packages for city workers, primarily police and firefighters. In Vallejo, one police captain earned a compensation package of $300,000 and average firefighter compensation is in the $175,000 a year range. At a certain point, cities that spend that way end up insolvent and bankruptcy becomes one of the few options available.

It’s one of the only ways to impose failure on a public entity. Governments are the ultimate example of Meltzer’s maxim. They spend. They make foolhardy decisions. They make outrageous promises to the public employee unions that have so much political power in state capitols and city halls. When there’s no money left, officials play games with the numbers or — as California Gov. Jerry Brown continues to do — make their main objective raising taxes. Of course, raising taxes is only a temporary fix. Short of the threat of failure, the same politicians who created the current mess will continue to spend money in the same old ways. They only buy themselves time and tax hikes can actually reduce tax revenues, as the supply side economists have shown.

Union Critics

The main critics of the bankruptcy option are the unions. They know that bankruptcy would enable cities and possibly states to abrogate these unaffordable contracts. I saw it many times while covering local government. Unions would promise that the new pension formula — usually granted retroactively — would not cost city governments anything. But their economic projections were always overly rosy, and before long the unfunded liabilities would soar.

But the courts in California have ruled repeatedly that once an elected body grants a pension increase, there is no reducing the benefit for the 30-year life of the contract. The California Supreme Court ruled in November 2011 that not only are vested benefits such as pensions, which were granted contractually, off-limits from any tinkering, but non-contractual and non-vested benefits such as retiree health care also can carry the weight of a contract. By unanimous vote, the court found an implied contract and made it that much more difficult for localities in this state to address budgetary problems. There are fewer and fewer options.

The public-employee unions championed a bill, signed into law by Gov. Jerry Brown in October 2011, that makes municipal bankruptcy more cumbersome by forcing localities to get approval for such actions by additional committees. It’s not a ban on such bankruptcies, but it makes it harder for cities to use this option. But it’s not just the unions that are opposed to the concept of government bankruptcy.

Bond Markets

Some conservative intellectuals, concerned about the impact of bankruptcy on bond markets, have been campaigning against this idea. This debate started in January after former Florida Gov. Jeb Bush and former U.S. House Speaker Newt Gingrich made this argument in a Los Angeles Times op-ed titled, “Better Off Bankrupt”:

“The figures for next year’s budgets are staggering. California, which faces a $25.4-billion budget shortfall, will pay $100,000-plus pensions to more than 12,000 state and municipal retirees this year. A Stanford study puts the state’s unfunded pension obligations at more than half a trillion dollars.Illinoishas a $15-billion budget deficit, prompting its governor and lame-duck Legislature to hike its personal income tax rate by 66 percent.New York, where 73 percent of the government workforce is unionized, is staring at a $10-billion deficit.

“There has been an organized federal bankruptcy process for municipalities since the 1930s, and a handful of cities, towns and counties – most notably California’s Orange County in 1994 – have gone through municipal bankruptcy and gotten their fiscal houses back in working order. A bankruptcy option for the states would look very similar to Chapter 9 municipal bankruptcy, with some necessary modifications.”

The Manhattan Institute’s E.J. McMahon disagreed. He argued in the Wall Street Journal that, “Such an option would certainly rattle the bond market — which bankruptcy proponents see as a good thing. Yet this ignores the potential for collateral damage and disruption. While bond spreads might get wider for the most troubled states, the enactment of a state bankruptcy law is likely to raise the cost of borrowing for all municipal issuers.”

Granted, McMahon is dealing here with the prospect of state bankruptcy, rather than the municipal bankruptcies that are the subject of this series. As such, he is right to point out that most of the state spending problems come from educational spending and Medicaid transfer payments, not pension obligations, which are local obligations. But many of his points are meant to apply to municipal bankruptcy as well. He argues that “officials committed to cutting costs already have options for putting the squeeze on their unions.”

Unused Tools

Unfortunately, while officials indeed have those tools, they generally are unwilling to use them. Expecting state and local officials, who in California and other states with the biggest problems tend to be union-supporting Democrats, to take on the unions that elected them to office is unrealistic. It’s not going to happen easily and the threat of bankruptcy at the very least could force these unions and officials to embrace the needed tough medicine.

Critics of bankruptcy like to point to the results of the Vallejobankruptcy as an example of why municipal bankruptcy is no panacea. I wrote in March 2010 in City Journal, “Though the city eventually voted to reduce firefighter pensions for new hires and to require a larger pension contribution by firefighters, it did not touch existing pensions or pensions for police officers.Vallejo’s avoidance of the pension issue makes it less likely that other cities could declare bankruptcy and then easily dispose of their burdensome pension promises.” Since then, the city has emerged from bankruptcy and has cut benefits mostly moving forward. The city did cut back salaries and slash its retiree health-care debt, but it fell far short of ditching its enormous benefit obligations.

Bondholders’ Losses

Wrote Nicole Gelinas in City Journal:

“Bondholders should realize, then, that they are vulnerable to real losses as cities, towns, and states move to escape massive health-care obligations to their retirees. At best, they’ll suffer theVallejo bondholders’ fate – though a three-year deferral of payment is no small matter to an investor. At worst, they’ll take bigger losses as obligations pile up. It’s easy to imagine some future mayor convincing a bankruptcy judge that it’s only fair for bondholders, along with union members, to take big cuts in a restructuring. Indeed, heavily indebted governments’ willingness to repay crippling municipal debt will depend on what’s politically expedient. Today, politicians still see the advantages of borrowing more. Ten years from now, it may be more practical for a governor to tell the public: we’ve borrowed too much, we did so because clever Wall Street investors convinced our predecessors that it was a good idea, and we shouldn’t have to pay those investors back.”

So Vallejo was not a panacea, but it did help the city and, as Gelinas points out, might set the stage for much more far-reaching results from future municipal bankruptcies. That’s what has many bankruptcy critics concerned. Granted, bond holders might have reason to fear that result, but that should give taxpayers hope that bankruptcy could provide the pressure needed to force officials to get out from under these unsustainable costs for public employees. Cities are running out of money and something has to be done.

Sure, it would be better if elected officials used other options such as those detailed by McMahon before relying on bankruptcy. But that’s wishful thinking. Officials would rather play financial games and seek new tax revenues or leave the mess for future politicians. Yes, as other critics note, municipal or state bankruptcy is just a reflection of failure. But that’s exactly what governments need — some level of failure to force them to act responsibly. As Meltzer understood, failure — or the threat of it — is the only thing that works.