Most Californians live within about 50 miles of its majestic coastline — for good reason. The California coastline is blessed with arguably the most desirable climate on Earth, magnificent beaches, a backdrop of snow-capped mountains and natural harbors in San Diego, Long Beach and San Francisco. There is no mystery why California’s population and economy boomed after the Second World War.

The Golden State was aptly named. Its Gold Rush of 1849 was followed a century later by massive growth in the 1950s and 60s. Education in California became the envy of the world. Stanford became the Harvard of the West. A college education at the University of California and California State University systems was inexpensive. The Community College system that fed its universities was ostensibly free.

California’s public school system led the nation in innovation and almost all of its classrooms were new. The highway system that moved California’s automobile-driven commerce eliminated the need for public transportation systems like New York and Chicago. The fertile soil of the Central Valley became the breadbasket of the world.

The next golden wave in the 1980s grew from former orchards south of San Francisco known as Silicon Valley. Intel and other companies led the world’s computer and software revolution. In the 1990s, the dot-com revolution brought immense wealth to more Californians. Its innovators, Google, Apple and others, ushered in the Internet Era. The 2000s brought the greatest housing and mortgage boom in the nation’s history, with innovation centered in Orange County. California was truly the Golden State.

Why then would the author have the temerity to ask, “When did Californians become Stupid?” And: Is California the next Detroit?

Unique oblivion

Californians, due to their golden history, live in unique oblivion. When the Tea Party movement caused a political tsunami that swept more than 60 incumbents from political office in 2010, the wave petered out at California’s state line. There was no effect on the 2010 election that saw Democrats take every elected office in the state.

California voters rejected Meg Whitman, the billionaire founder of Ebay, in favor of Jerry Brown. Gov. Brown signed into law a “high-speed rail” bill that will spend $6 billion (the state does not have) to build a train between Fresno and Bakersfield — not Los Angeles and San Francisco, as promised. There was little outcry.

California has a $16 billion deficit that no one seems to notice. Brown’s budget “assumes” that California voters will pass massive tax increases on themselves. If they do not, the 2013 deficit becomes a mind-numbing $20 billion. The budget, mandated to balance by the Calfornia Constitution, has been billions in the red for 10 straight years. How could Californians re-elect the same politicians year after year that produce budgets with multi-billion dollar deficits?

To protect the endangered Delta Smelt, a fish known better as bait, water has been diverted from the Central Valley to the Pacific Ocean. Orchards in the Central Valley have been allowed to wither and die, resulting in unemployment in the Central Valley as high as 40 percent. Imagine Californians living in what was the breadbasket of American now living on food stamps. California voters rejected Republican Carly Fiorina for U.S. Senator in 2010. She ran Hewlett Packard. Instead, they re-elected Democratic Sen. Barbara Boxer ,who vowed to protect the Delta Smelt at the expense of the Central Valley.

California has 519 state agencies, like the state Blueberry Commission, that pay each of their commissioners more than $100,000 per year. State politicians, when asked to make cuts, fire teachers and fire fighters to inflict maximum pain on its citizens, while leaving these patronage commissions intact. State politicians have elevator operators in the state capital to push the buttons for them. Their solution for the overcrowding of the state’s prisons is to release inmates or transfer them to local facilities in already bankrupt cities. Yet, they are re-elected by California voters in numbers consistently higher than the old Soviet Politburo.

California’s public education system, once the envy of the world, now ranks 49th in the nation. Its business climate, according to 650 CEOs measured by Chief Executive Magazine, ranked dead last. Apple will take 3,600 new jobs to Austin, Tex. at its $280,000,000 new facility. Texas ranked first in the same survey.

California unemployment is consistently higher than 10 percent of its workforce, but it’s under-employed, according to a Gallup poll, is 20 percent. There are few jobs for college students who graduate with as much as $100,000 in student loans. Despite the overwhelming evidence that bad public policy is chasing away jobs, the same state politicians are sent back to Sacramento every two years.

In the last two months, three California cities have declared bankruptcy. Compton is next. More will follow. Some cities will simply cease to exist due to $500 million in unfunded pension obligations they simply cannot meet.

The unfunded pension obligations, now swamping California cities, were approved by these same politicians whose re-elections are financed by the unions they serve. Nine years ago, outraged Californians recalled Gov. Gray Davis from office for excessive spending and crony capitalism. Nothing has changed a decade later. Its residents believe the golden state will be golden forever. It may not be the case.

Detroit

History has an unpleasant precedent known as Detroit. In the 1950s, Detroit was a major American city with a dynamic labor force built on the manufacturing miracle that won World War II. Its factories quickly converted tanks, planes and artillery shells into trucks, automobiles and refrigerators that baby boom families demanded. Everyone had a good paying job. Detroit Iron had no competition. Its burgeoning middle class was the model of the world with excellent public schools and universities. It was the 4th largest city in America with 2 million inhabitants, with the world’s most dominant industry — the automobile.

Detroit in 2012 is a shadow of that once great metropolis. Its population has shrunk to 714,000. There are 200,000 abandoned buildings in the derelict city. The average price of a home has fallen to $5,700, unthinkable in California terms. Unemployment stands at 28.9 percent. It has a $300 million deficit. Its public education system, in receivership, is a disgrace, producing more inmates than graduates. The jobs have long ago abandoned Detroit for places like South Carolina and Alabama, far hungrier than Detroit’s leaders who believed the gravy train would never end.

In 2006, the teacher’s union forced the politicians to reject a $200 million offer from a Detroit philanthropist to build 15 new charter schools. The mayor has proposed razing 40 square miles of the 138 square miles of this once great American city, returning it to farmland. Even such a draconian plan may not be enough to save the city from itself.

If a hurricane hit Detroit, more of us would know of this tragedy in our midst, but this fate was man-made and not wrought by nature. Detroit has had one party rule for more than 50 years. Louis C. Miriani served from September 12, 1957 to January 2, 1962 as Detroit’s last Republican mayor. Since that time, the Democrats have ruled the Motor City.

John Dingell, Democrat congressman for the 15th District outside Detroit, has served since 1956. His father was the congressman there from 1930 to 1956. Despite the disastrous decline of their city, Detroit voters send him back to Congress every two years.

One-party rule

Similarly, California now has one-party rule. The Democrats of California did not need a single Republican vote to pass their budget. They now own the Golden State’s fate. The politicians’ plan to address the nation’s largest deficit is to raise taxes instead of cutting spending. If the Proposition 30 tax increase passes, the deficit would drop from $20 billion to a mere $12 billion.

Democrats have done nothing to cure the systemic problems of a bloated bureaucracy. Brown, referring to the state’s highway system, once said, “If we do not build it, they will not come.” Caltrans stopped building highways under Brown, but the people kept coming. Now 37 million Californians are locked in traffic jams each day.

Brown was rewarded for such prescience with re-election as Governor. California’s egotistical politicians passed AB 32, the Global Warming Solutions Act in 2006. Dan Sperling, an appointee to the California Air Resources Board, and a professor of engineering and environmental science at UC Davis, is the lead advocate on the board for a “low carbon fuel standard.” The powerful state agency charged with implementing AB 32 and other climate control measures claims the low carbon fuel standard will “only” raise gasoline prices $.30 gallon in 2013. But The California Political Review reported implementation of these the policies will raise prices by $1.00 per gallon.

Detroit was once the most prosperous manufacturing city in the world.  Will California follow Detroit down a tragic path to ruin? In 1950, no one fathomed the Detroit of 2010. In 1970, when foreign imports started to make a foothold, the unions and their bought and paid for politicians resisted any change.

In the 1990’s, as manufacturers fled to Alabama and South Carolina, the unions and their political lackeys held firm even as good jobs slipped away. No one in Detroit envisioned their future, even as schools declined, the jobs withered and the once proud city deteriorated in front of their own eyes.

No longer golden

California was once the Golden State. Today, it is no longer so golden. Its schools are in decline. Its business climate is equally dismal. Its cities are facing economic ruin, with exploding pension obligations and a declining tax base. Housing prices have fallen 30 to 60 percent across the state, evaporating trillions of dollars of equity. Unemployment remains stubbornly high and under-employment is rife. The Central Valley is in a depression, with 40 percent unemployment. Do our politicians need any more signs?

Brown’s budget will first slash money to schools and raise tuition on its students, while leaving all 519 state agencies intact. He apparently will protect political patronage at all costs. Jobs, and job creators, are fleeing the state. Intel, Apple, Google and others are expanding out of the state. The best and brightest minds are leaving for Texas and North Carolina. The signs are everywhere. State revenues are declining during many years. Meanwhile, the voters sleep and blindly send the same cast of misfits back to Sacramento each year — just as Detroit did before them.

The beaches are still beautiful. The mountains are still snow capped and the climate is still the envy of the world. Detroit never had that. But will California’s physical attributes be enough? If the people of California want to glimpse their future, they need look no farther than once proud City of Detroit. It can happen here.

Robert J Cristiano, Ph.D., is the Real Estate Professional in Residence at Chapman University in Orange, Calif.; a Senior Fellow at the Pacific Research Institute in San Francisco, Calif.; and president of the international investment firm, L88 Companies LLC in Washington, D.C., Newport Beach, Denver and Prague. He has been a successful real estate developer for more than 30 years.

By Chris Reed

As John Seiler pointed out here Tuesday, Monday’s court ruling by U.S. Bankruptcy Judge Christopher Klein isn’t seen as definitive. Yes, the city of Stockton can proceed with its bankruptcy filing. No, Klein doesn’t yet agree with the city’s plan to only short bondholders and not CalPERS, its biggest creditor, as it reorganizes under Chapter 9 of federal bankruptcy law. He explicitly said later that he will decide on its fairness later.

But did Klein make one crucial point in his ruling and comments from the bench? Maybe, and I’m not the only one who thinks so.

Consider this: Every newspaper advance story that I saw before last week’s hearings in Klein’s court spoke of the centrality of the CalPERS argument that promised pensions were protected by the state Constitution, which should take precedence over federal bankruptcy laws which allow federal courts to modify contracts that bankrupt entities have with their creditors.

Pension preservation: State law vs. federal law

So did the most sophisticated legal analysis of Stockton’s pension-protection proposal that I read before Klein’s April 1 ruling. It appeared in January on the Bankruptcy Law Insights blog and was written by bankruptcy expert Ben Feder:

“The issues at stake — whether California state laws protecting public employee pension obligations are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy, or are protected under the Tenth Amendment — implicate fundamental issues of federalism, and in all likelihood the Supreme Court will eventually need to resolve the questions being raised regarding the proper balance between state and federal power … .

“The [most] complicated question is whether priorities for unsecured claims created under state law — particularly regarding obligors that are themselves governmental units — can trump the distribution mechanisms of the U.S. Bankruptcy Code, and the Code’s underlying purpose of providing similar treatment for similarly situated creditors. Numerous states in addition to California have varying degrees of protection for public employee pension obligations. (Rhode Island, on the other hand, recently took the opposite tack and enacted a law that gave priority to bondholders in the Central Falls Chapter 9 cases.)

“Calpers will argue that the preference under California law for public employee< pension obligations is protected under the Tenth Amendment. San Bernardino’s bond investors will argue that the Bankruptcy Code expressly sets forth the priority of certain types of unsecured claims, that no other unsecured claims are entitled to more favorable treatment, and that California law regarding public employee pension obligations is pre-empted by the Supremacy Clause of the Constitution.”

‘Powers not delegated to the U.S. are reserved to the states’

What is the relevance of the Tenth Amendment? This is from CalPERS’ counsel:

“The Tenth Amendment provides that the ‘powers not delegated to the United States by the Constitution, nor prohibited by it to the states, are reserved to the states … or to the people.’ This is no minor addendum to the Bill of Rights; this amendment reflects the federal structure of our government.

“This structure allocates and ultimately provides limits on the powers of dual sovereigns — the federal government and the governments of the States. The Tenth Amendment and the principles of federalism preserve the integrity and residual sovereignty of the States, and ensure that the States function as political entities in their own right.”

But at least based on published accounts, the knotty question of deferring to the California Constitution’s pension protections or interpreting the Tenth Amendment to the U.S. Constitution as preserving the state’s decision-making authority on such matters didn’t seem knotty at all to bankruptcy Judge Klein.

Klein depicted CalPERS as a “garden-variety creditor” -– not one in a protected class.

He also said that going forward, he “is going to have a difficult time confirming a [bankruptcy reorganization plan] over the objection of unfair discrimination.” That’s a reference to Wall Street bondholders’ objecting to CalPERS being insulated from any of the pain facing other creditors. That’s another way of saying he rejects the idea that CalPERS is in a protected class.

Complex question — or not even a close call?

So instead of being a complex, challenging legal issue, Klein doesn’t appear to see this as a close call at all: Federal bankruptcy law supersedes the California Constitution, and the Tenth Amendment doesn’t shield CalPERS either.

I welcome any counter interpretation in the comments. And I acknowledge that an appeals court could completely disagree with Klein and go in another direction.

But I also think there is a chance that April 1, 2013, is remembered as a turning point in how Chapter 9 allows local governments to deal with their immense pension debts. We’ll see.

By Chris Reed

The stakes are immense in the four-day trial in Sacramento’s federal bankruptcy court this week. The New York Times frames the issue well:

“Wall Street is taking America’s biggest pension fund to court this week, for a long-awaited battle over who takes the losses when a city goes bust — workers and retirees, municipal bondholders, or both.

“Stockton, Calif., declared Chapter 9 bankruptcy last year after suffering one of the country’s sharpest riches-to-rags swings when the mortgage bubble burst. Struggling to stay afloat, Stockton has slashed tens of millions of dollars’ worth of city services — firefighters, senior centers, library programs for at-risk children — and said it would cut its municipal bond repayments to a degree never seen before in a municipal bankruptcy.

“But it has drawn the line at slowing down its current workers’ pension accrual, or cutting the benefits its retirees now receive.”

If judges pay attention to current events and tailor their opinions accordingly — as many legal scholars believe — then Judge Christopher M. Klein could strike a huge blow for pension sanity and for local and state governments avoiding catastrophe. The present status quo of services being scrapped and roads falling apart because of excessive government pension benefits isn’t just unsustainable. It’s horrible governance.

So how will Klein rule? He’s got a J.D. and M.B.A. from the University of Chicago, which is about the best possible pedigree for those hoping he strikes a blow for pension sanity. There’s no university in the nation more known for advocating economically rational, evidence-driven public policy.

And a commercial law expert’s analysis of an early Klein ruling in the Stockton case suggests he doesn’t believe municipal contracts are inviolate at all.

“Like many municipalities (and states, for that matter) Stockton owes its retired employees far more in pensions than it can hope to pay.  …  

“Stockton filed bankruptcy to avoid paying the benefits it had contracted to pay but could no longer afford. But wait, the retirees argued, Stockton is an instrumentality of the State of California and, as we have seen, the U.S. Const. Art. 1, Sec. 10 specifically prohibits the states from messing around with contracts. While admitting that the federal government’s constitutional bankruptcy power can discharge most contractual obligations, the retirees asserted that it cannot be permitted to do so in Stockton’s case without contradicting the constitutional text. The irresistible force meets the immovable object.

“An ingenious argument but Bankruptcy Judge Christopher Klein didn’t buy it. (Judge Klein’s lengthy opinion, Assoc. of Retired Employees, et al. v. City of Stockton (In re City of Stockton) can be found at 2012 WL 3193588.) First, he observed that § 904 of the Bankruptcy Code clearly prohibits the court from granting any interim relief to the retirees. Second, and much more fully reasoned (in anticipation of an appeal, one suspects), Judge Klein concluded that the Bankruptcy Clause in effect trumps the Contracts Clause, at least in this case. In short, the City of Stockton can ‘interfere’ with its ‘Obligation of Contracts'” because the State of California has permitted it to file for relief under Chapter 9 of the Bankruptcy Code.”

Pretty promising. Go, Judge Klein, go.

Editor’s Note: This is the 11th in a CalWatchDog.com Special Series of in-depth articles on municipal bankruptcy.

Nov. 14, 2012

By Chriss Street

Up through September 2011, Wall Street underwriters, bond counsels and other assorted securities industry camp followers were gloating over the supposed failure of predictions in late 2010 by Meredith Whitney and me that there would be a coming surge of state and local bond defaults.  These camp followers had been hitting the public airways to crow there were only 24 municipal defaults in the first half of 2011. That was down from 60 defaults in the first half of 2010. And it was down substantially from the 144 defaults in the first half of 2009.

But all the giddy glee state and local government were exempt from the Great Recession came crashing down on Oct. 12, 2011 when the city of Harrisburg, the state capital of Pennsylvania, filed the second largest bankruptcy in U.S. history with more than $500 million in liabilities. And on Nov. 8, 2011 when Jefferson County, Ala., filed the largest bankruptcy inU.S. history with more than $3.1 billion in liabilities.

Most Americans cannot fathom that state and local (“municipal”) governments in 2011 spent $2.89 trillion and commanded 20 percent of the American economy. To fund this muscular economic intervention, municipalities collected $2.62 trillion in revenue and borrowed hundreds of billions of dollars by selling municipal bonds to the public.  Over the last 10 years, the outstanding amount of municipal bonds more than doubled from $1.197 to $2.8 trillion.

Then there’s debt. According to a June 25, 2011 report by James E. Spiotto, “The debt of state and local governments has more than doubled in the last 10 years, from $1.197 trillion in 2000 to $2.8 trillion at the end of 2010. (Some [Citicorp] contend that the market is actually $3.7 trillion with individual holders being $1.8 trillion [rather than $1 trillion] or 50 percent of the market but hard to verify.)

“This does not include over $1 trillion of unfunded pension liabilities and in addition OPEB liabilities over $200-300 or more billion plus the needed debt financing over the next five years to bring infrastructure up to acceptable standards of $2.5 trillion.”

Add it all up, and municipalities look like subprime borrowers.

Since the Great Recession began in 2007, Americans have personally cut spending, reduced debt and increased savings, while their local governments have increased borrowing to increase spending.  With municipal government revenues now falling fast and economizing voters mostly opposed to higher taxes, thousands of over-leveraged municipalities appear doomed to default on their debt and be forced into bankruptcy.

About 71 percent of municipal bonds are purchased by wealthy individuals who often loathe the government cronyism and inefficiency, but have been willing to invest huge amounts of their net worth in “tax free” municipal bonds. Armed with a tax-advantaged ability to borrow for 20 percent to 30 percent cheaper than taxable borrowers, municipalities went on a borrowing binge and have increased their bond debt from $1.2 trillion to $2.62 trillion over the last 10 years. This red hot 8.9 percent compounded growth rate for debt far out-distanced the American economy’s annual growth rate of 4 percent.

U.S. Treasury Loses $40 Billion

According to Congressional Joint Committee on Taxation, this rapid growth of tax exempt municipal bonds now costs the U.S. Treasury $40 billion per year in lost taxes. Although the U.S. Supreme Court ruled in 1895 that there is no constitutional prohibition against taxing municipal bond interest, Congress authorized an exemption with the Revenue Act of 1913.  But with the U.S. credit rating recently downgraded, President Obama is trying to reduce or eliminate the exemption.

Unlike the U.S.equity and corporate bond markets that are tightly policed by the U.S. Securities and Exchange Commission, the municipal bond markets have been collegially self-regulated by the brokers that sit on the Securities Industry and Financial Markets Association and have dominated the Municipal Securities Rulemaking Board.  But the Dodd-Frank Wall Street Reform and Consumer Protection Act on Oct. 1, 2010 required the MSRB to be independent of SIFMA. Furthermore, MSRB was given expanded jurisdiction and enforcement authority to protect the interest of municipal entities and “obligated persons” — better known as taxpayers.

To review the potential impacts Dodd-Frank would have on investors, Bloomberg Television held a seminar in lower Manhattan in early October 2010.  As the treasurer of Orange County, Calif., and the whistleblower who helped expose the county’s $2 billion investment loss that forced the county to file for bankruptcy in 1994, I was invited as the token speaker to warn about the risks to the economy from potential municipal bond defaults.

Each panel session consisted of strident reassurances by underwriters, bond counsels and other assorted securities industry camp-followers that the municipal bond market was financially strong. Then I would reiterate why a combination of collapsing property tax collections, huge debt leverage and unfunded pension obligations would doom the muni bond market to years of defaults. After the sessions, we would gather for coffee and conversation.  The same panelists who had vociferously argued in public the muni bond markets were safe, fretted in private about their firm’s professional liability for future defaults. Several stated, “I hope it doesn’t blow up too soon. I still have to pay for kids in college.”

Two months later, the CBS “60 Minutes” television show aired a 14-minute piece about U.S. state and local finances. Correspondent Steve Kroft interviewed Wall Street banking analyst Meredith Whitney, who in 2007 correctly warned that losses from sub-prime mortgage bonds would devastate the solvency of the U.S. banking industry. Whitney pessimistically noted that state and local governments were minimally facing collective annual operating deficits of $500 billion per year and a least $1 trillion more in un-funded pension obligations. The show closed with Whitney projecting a wave of defaults by counties and cities: “You could see 50 to a hundred sizable defaults, [maybe] more.” 

A rattled Steve Kroft asked her when people should start worrying about local finances.  Whitney answered: “It’ll be something to worry about within the next 12 months.”

The next morning all hell broke loose on Wall Street as municipal bond prices plunged by 10 percent. Over the next two months, prices fell another 10 percent to 15 percent as the shock and awe of the market disruption fueled panic among bondholders and froze out all but the highest rated municipalities from borrowing money in the public markets.

Fortunately for muni bondholders, the U.S. Federal Reserve Board took action in spring 2011 to force down long-term interest rates. The higher rate of interest on depressed municipal bonds attracted high-yield investors who drove the prices of municipal bonds back to just below when prices collapsed.  But tax-exempt municipal bonds that once yielded 20 percent to 30 percent less than U.S. Treasury bonds now yield a whopping 20 percent to 30 percent more.

Threats to Bondholders

The higher yield for municipal bonds represents the level of risk bondholders are taking. If the economy improves, interest rates will rise rapidly and the price of municipal bonds will crash again.  If the economy contracts, tax collections will continue to shrink and municipal bond prices will be crushed over fears of potential defaults. Under either economic scenario of good or bad times, municipal bond prices seem precariously doomed to fall. Add in the probability that Congress takes back the $40 billion tax exemption and bondholders face huge threats.

For Harrisburg, Chapter 9 bankruptcy filing is the only strategy that might allow the city to escape from being a permanent debt slave. The city was once a mixed use community of heavy manufacturing, food processing and state government. But after the private-sector industries pulled out, the property tax base collapsed, because all the state government property is tax exempt.  To subsidize operating deficits and generate revenue, the Harrisburg city council sold $463 million in municipal bonds to invest in upgrading a huge trash incinerator, constructed parking lots and built a Wild West Museum.

For a working class city of 49,000 with a near poverty line median household income of $26,920, Harrisburg has a bloated municipal bond debt per household of $23,734.Harrisburg residents also pay some of the highest fees in the country to support what’s called The Incinerator, rather than hauling trash to a lower cost landfill. To fully service the city’s debt burden, each household would have to pay another $1,104 in taxes.  With The Incinerator running negative cash flow, parking lots featherbedded and the museum defunct, residents of Harrisburg are now debt slaves.

Given this ludicrous indebtedness, Harrisburg would have seemed an excellent candidate to file under 11 USC § 904 of the U.S. Bankruptcy Code (“Chapter 9”) when the city announced in September 2010 it would miss a payment on its general obligation bonds and incinerator bonds.  In bankruptcy, the city would have turned The Incinerator over to the bondholders, restructured city operations and negotiated down its debt burden to a manageable level.

But the Harrisburg mayor had fought against a filing for bankruptcy to protect her own political future. And the state of Pennsylvania was adamantly opposed to a Chapter 9 bankruptcy for fear of a daisy-chain of defaults across Pennsylvania as other municipalities and their taxpayers tried to escape similar debt-slavery.

Pennsylvania’s Act 47

To stave off an immediate bankruptcy in 2010, Pennsylvania’s then-Gov. Ed Rendell advanced $3.3 million in future state grants to pay bondholders. In July 2011, new Gov. Tom Corbett offered another grant advance of $3.6 million if the city would enter Pennsylvania’s Act 47 municipal recovery program by turning control of the city over to the state. Essentially, the state’s plan would have raised taxes, then sold off The Incinerator, city garages, parking meters and any other city property to pay bondholders in full.

After racking up millions of dollars in consultants and legal bills, a taxpayer-supported coalition elected to the Harrisburg city council voted 4-3 to file for bankruptcy on Oct. 12, 2011.  The state Legislature screamed foul and voted to put Harrisburg into receivership. The city remained in federal Chapter 9 bankruptcy until a bankruptcy judge on Nov. 23 voided the bankruptcy, but decided the state had the right to take over the city and appoint a receiver.

Corbett then appointed attorney David Unkovic as the city’s receiver, setting off howls that Unkovic’s former law firm, Saul Ewing, actually represents the city’s largest creditor, Assured Guarantee Municipal Corp. Harrisburg listed $458 million in creditor claims when it filed its bankruptcy petition. City council attorney Mark Schwartz said the Chapter 9 filing was aimed at giving the city “bargaining power” with creditors and the state of Pennsylvania.  In addition to its debt and state buildings not paying property taxes, the city also is also being battered by the state’s unfunded pension crisis.

Ten years ago the Pennsylvania State Employees’ Retirement System claimed its pension plan was “substantially over-funded” based on an assumption its investments would earn an 8 percent rate of return forever. State lawmakers then spiked public employee pension benefits and PSERS cut employers’ (including Harrisburg’s) contribution rate to just 5 percent of their payroll.

But with employees retiring early with lush benefits and the stock market losing 43.2 percent after inflation over the last 10 years, PSERS recently admitted it has a $30 billion unfunded liability. Today only 109,000 public sector workers are now supporting 111,000 retirees. To prevent the liability from jumping to $55 billion in six years, PSERS ordered Harrisburg to increase its employer contributions to 28.1 percent of payroll.

Muni bond advocates stress that there have only been 625 Chapter 9 municipal bankruptcies since 1937, versus 58,322 business bankruptcies in 2010 year alone. This conveniently avoids the fact that eight states and one territory defaulted in the 1840s. Thirteen states repudiated their debt entirely in the 1870s. And approximately 4,770 municipalities, or 18 percent of the entire municipal bond market, defaulted during the Great Depression.

Bankruptcy: Good or Bad?

The municipal bond industry has always screamed that a bankruptcy filing will deny municipalities any access to borrowing.  But given that over-barrowing by state and local governments is the primary risk for default, this is just seen to be the cost of tough love.

Historically, the results of Chapter 9 bankruptcy filings seem beneficial to municipalities and their taxpayers. Orange County, Calif. filed in 1994 after losing $2 billion in speculative investing.  After county supervisors tried and failed to convince voters to raise taxes, the county issued layoffs to 4,000 employees (20 percent of staff). And it collected $600 million in a legal settlements from Merrill Lynch, KPMG and others.

Surveys demonstrated that most residents could not identify any lower levels of service and today the county has a stellar AA credit rating. The city of Vallejof iled for bankruptcy after being overwhelmed by municipal bond debt, high wages and pension liabilities. After cutting police and fire by 50 percent, the city discounted $500 million in bond debt and other claims for $6 million.

Only municipalities in 11 states are specifically authorized to file for Chapter 9 bankruptcy. And another 13 states authorize Chapter  9 after approval by some state official or commission. But Harrisburg filed for bankruptcy without “permission” when it became clear the state’s plan was to take over the city, quickly sell the assets and raise taxes to pay off bondholders.

The day after Harrisburgfiled bankruptcy, the Jefferson County, Ala. sewer district board met to consider filing Chapter 9. After defaulting on $3.14 billion in municipal sewer district bonds, JP Morgan had already offered $647 million to settle bribery charges. But even after the settlement, the district would still need to permanently raise local sewer bills from $63 to $395 a month to pay off their municipal bond debt.

When the county’s bankruptcy lawyer, Ken Klee, was asked by Alabama lawmakers what would be the negative if the sewer district filed for bankruptcy, he could not see a negative for the sewer district, but he did believe it “would be like Chernobyl” for other districts’ bond ratings in Alabama. But since the bankruptcy filing, high credit quality issuers in Alabama have already sold billions of new municipal bonds to investors.

State and local governments have been living in a fantasy world where borrowing money was deemed a responsible way to operate huge organizations. Wealthy local individuals fed that fantasy by lending irresponsible amounts of money to bureaucrats. In a post-Lehman Brothers world, corporate bondholders of insolvent companies have had to suffer “cram-downs” of part of their debt to establish a more sound financial position for the company to survive.

The bottom line for over-indebted and over-taxed municipalities is they need to stop borrowing money. If they are insolvent and need to consider filing for Chapter 9 bankruptcy, the key question they ask is: “Are we better off continuing as debt slaves?” The answer will be usually be no.

Street was treasurer of Orange County, Calif. and blogs at Chriss Street And Company. His recent book is, “The Third Way: Public-Sector Excellence Through Leadership and Cooperation”