Editor’s Note: This is the sixth in a CalWatchDog.com Special Series of 12 in-depth articles on municipal bankruptcy.

April 12, 2012

By Tori Richards

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?”

Richards is an investigative reporter.

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Check out other articles in our Special Series on Bankruptcy.

MARCH 6, 2012

BY CHRIS REED

Overwhelmed by enormous unfunded liabilities for retired employees’ pensions and health care, local governments throughout California are increasingly contemplating what once seemed unthinkable: declaring Chapter 9 bankruptcy to hold off creditors, to buy breathing time to reorganize and to attempt to reduce costs by any legal means necessary.

This fiscal crisis is outwardly downplayed or dismissed by the state’s public employee unions, who insist that claims of strained finances at all levels of California government are either exaggerated by alarmists unfamiliar with the ebb and flow of pension investment portfolios or the fabrications of anti-government ideologues.

But that these same unions know the crisis is real is manifest in their successful push to get the Legislature to pass Assembly Bill 506, by Assemblyman Bob Wieckowski, D-Fremont. Gov. Jerry Brown signed it into law on October 9, 2011. It ends local governments’ ability to unilaterally declare bankruptcy. Instead, it requires that they first go through a mediation process or hold a public hearing at which they would declare a state of emergency and certify that they will be unable to meet their obligations within 60 days.

This obstacle may make some local officials think twice. But in an era in which San Jose Mayor Chuck Reed — a liberal Democrat — openly speculates about his city being forced to switch to a volunteer fire department, crushing financial pressures are certain to prompt many governments to consider Chapter 9. In so doing, many will look to the most famous municipal bankruptcy in U.S.history: Orange County’s Dec. 6, 1994, declaration that it could no longer pay its bills.

Does Orange County’s Chapter 9 adventure raise any red flags for local governments considering bankruptcy?

Not a one.

But is the county’s highly positive experience truly instructive for local governments in general?

That’s another matter entirely, because Orange County’s story is an unusual one.

Speculative Gambles

The bankruptcy was triggered after failed speculative gambles by county Treasurer Robert L. Citron resulted in a $1.64 billion loss in county investment pools. The immediate reaction was one of shock and dismay, with grave warnings of profound long-term damage to Orange County’s quality of life.

Transportation officials feared crucial highway projects would have to be postponed or cancelled, yielding gridlock in fast-growing south Orange County. A portfolio manager at Scudder Funds said what “the future residents face [is the] cannibalization of every county service.” The executive director of the Associated General Contractors of Southern California said the bankruptcy’s impact was “like a nine on the Richter scale.”

Instead, a mix of new and old county leaders, working with former state Treasurer Tom Hayes and a Salomon Brothers team, stabilized the county’s fiscal picture in fairly short order. They persuaded creditors to hold off a year, froze salaries, put off infrastructure projects, pared services (particularly social services) and reduced the county work force from 18,000 to 15,000, primarily through attrition and dropping vacant positions, not layoffs.

Critics of these moves said county leaders had consistently insulated the middle class and rich from the effects of the bankruptcy, showing a cruel indifference to how cuts in social services hurt the poor. But perhaps because progressives had been making this same argument long before the bankruptcy, it barely resonated beyond the pages of the alternative OC Weekly newspaper. 

No Serious Disruption

“There wasn’t any kind of serious disruption over the long term for the residents of the county,” Mark Baldassare, author of “When Government Fails: The Orange County Bankruptcy,” said in a recent interview. “It was shocking, it was surprising, it was something that caused a lot of frustration, but for the average county resident, it didn’t matter that much.”

County leaders made one misstep: asking county voters to raises the sales tax by a half-cent for 10 years to bring in $1.35 billion. Portentously described in a Los Angeles Times headline as a “Referendum on O.C.’s future,” Measure R was rejected on June 27, 1995 in a landslide — 61 percent to 39 percent — by voters incensed that county leaders expected them to pay for a mess they didn’t create. This led to stark warnings from Wall Street credit-rating firms and familiar media complaints that voters wanted services but didn’t want to pay for them.

Soon, however, voters were vindicated, as the county and local agencies that had invested heavily in the county’s investment pools — the biggest creditors — worked out a complex deal. Under the deal, transit and other funds were diverted on an emergency basis and promises were made to give to pool members initial proceeds of lawsuits against Merrill Lynch and other county investment advisers.

On May 15, 1996, a bankruptcy judge gave the go-ahead to the county’s recovery plan. On June 5, 1996, the county was able to sell $880 million in long-term bonds to cover its short-term debts. This allowed county officials to emerge from bankruptcy on June 12, 1996, prompting a jubilant celebration on the steps of a Santa  Ana courthouse. On Feb. 27, 1997 — just 814 days after the bankruptcy declaration triggered an avalanche of sky-is-falling warnings from the media, politicians and Wall Street — Fitch Investors Services gave its highest rating, AAA, to Orange County’s investment pools. And on Feb. 24, 2000 — after unexpectedly successful litigation yielded $865 million from the Wall Street firms that worked with Citron on his speculative gambles — the 200 agencies that had invested with Citron were made nearly whole, given checks or wire transfers that brought their recovery on their investments to from 94 percent to 97 percent. 

Soft Landing

In March 2011, at an American Enterprise Institute forum on municipal debt, Pat Shea, an attorney representing 175 of the cities, water, school and sewer districts with investments, reflected on the outcome: “Five years afterwards everyone, at least on my side — within government, within the family of government — every one of them would say this worked out as well as it possibly could for every member of government.”

The long-term cost to Orange County taxpayers of repaying the $880 million in bonds, of course, has been vast. But even on that front, the news has not been all bad. In June 2005, Orange County’s supervisors OK’d a plan under which the bankruptcy debt would be repaid by 2016, 10 years ahead of schedule.

Yet in reviewing Orange County’s history to determine what lessons it offers, those lessons may not be quite the tidy package that the county’s rebound would suggest.

The circumstances of how the county lost its way are nearly without precedent in U.S. history, having relatively little in common with the retirement benefits crises now bedeviling so many local governments. Citron for years managed to generate above-average returns in the county’s investment pools, with a key strategy to gamble on derivatives that would yield high returns if interest rates remained low. Even as Orange County became, by one report, Merrill Lynch’s biggest customer and its heavily leveraged investment holdings topped $20 billion, Citron continued to operate with little or no scrutiny.

A 1985 Orange County Grand Jury report warning of the risks posed by such an informal investment arrangement was ignored. In spring 1994, warnings by Newport Beach CPA John M.W. Moorlach that Citron and the county risked disaster if interest rates continued to rise were largely disregarded by the media and dismissed by county supervisors and bureaucrats. With Moorlach a candidate to replace Citron as treasurer, the assumption was that his warnings were driven politically. Moorlach’s simple explanation — that Citron’s above-average returns were driven by unusually risky investment strategies — went largely unexplored in the media, who were as shocked as county residents by the December 1994 bankruptcy.

Strong Economy

Soon after, with Citron forced out of office, Moorlach appointed to replace him, and new sobriety driving decision-making, the county began to turn the corner — but with immense help from a source unlikely to help current local governments on bankruptcy’s brink. That source: a sharply rebounding Orange County economy.

Venture capital investments tripled in the first quarter of 1995 compared to 1994, and a huge building boom quickly gathered steam. Entrepreneurial high-tech firms, especially in software, aerospace and telecommunications, helped the county move out of the shadow of Silicon Valley and sharply grow international trade. By December 1997, the county unemployment rate was down to 2.7 percent. That year, Orange County had $2.6 billion in annual exports to Japan, South Korea ,China and Taiwan alone. Tax revenue grew steadily, helping push up the county’s total budget from $3.45 billion in 1995-96 to $4.01 billion in 2000-01.

In a 2004 symposium on the 10th anniversary of the Orange County bankruptcy, Moorlach acknowledged the central role of the economic recovery in minimizing the county’s pain.

“Only a county like Orange County could have come back from such a dramatic loss,” he said. “We’re just a dynamic economic powerhouse. Some other counties — I don’t know if they would have fared as well.”

This sharp boom helped the county to escape bankruptcy with relatively modest downsizing of government. Similar bonanzas seem unlikely to come to the rescue of many ofCalifornia’s struggling government agencies.

Unique Situation

“Orange County was very unique,” said Baldassare, now president and CEO of the Public Policy Institute of California. “It doesn’t really have much to do” with the present straits facing other local governments in the state.

This doesn’t mean Chapter 9 is a bad choice for local governments overwhelmed by red ink — just that their path back to stability isn’t likely to be as clean and straightforward as Orange County’s.

But there is a powerful lesson to be learned in how Orange County’s leaders behaved after the county emerged from bankruptcy. That lesson: Even after as wrenching an event as a bankruptcy declaration, leaders can’t be counted on to be fiscally responsible. The bankruptcy fiasco was still a very fresh memory when Orange County supervisors and top bureaucrats put the county back on the path toward severe financial problems of a more conventional sort.

The bankruptcy did trigger the changes and cutbacks discussed above. But by July 1999, when I began a two-year stint covering the county government for The Orange County Register, county leaders increasingly showed the same old casual attitudes about spending and oversight — accompanied, incongruously enough, by a vast sense of accomplishment and enormous self-regard.

Bad Habits Return

County Executive Officer Jan Mittermeier, hired in 1995, was a huge improvement over the feckless executives of the pre-bankruptcy era. But the accolades coming her way — including her November 1998 selection as one of Governing Magazine’s Public Officials of the Year — as well as to county supervisors for the county’s rapid rebound produced an insufferable climate at the Hall of Administration. There was a self-congratulatory subtext to interviews, events and board hearings that was impossible to miss. And it continued even as supervisors made decision after decision that treated taxpayer funds cavalierly.

In 1998, the Performance Incentive Program (PIP) was initiated for county workers, billed as an easy, smart way to incentivize superior performance. But an Orange County Grand Jury report in 2003 detailed how PIP amounted to disguised bonus program in which at least 95 percent of employees were being given annual 2 percent raises.

In June 2000, county supervisors voted unanimously to give themselves a 6 percent raise for a third straight year. They also gave nine senior county administrators a 14 percent raise.

But the most devastating decisions involved pensions.

Pension Spiking

In December 2001, supervisors Jim Silva, Todd Spitzer, Tom Wilson, Cynthia Coad and Chuck Smith — all Republicans who claimed to be fiscal conservatives — approved a 50 percent retroactive increase in the pension formulas for 2,000 sheriff’s deputies, allowing them to earn up to 90 percent of final pay in retirement.

“It’s a mind-blower,” Moorlach said in a recent telephone interview. “Not one of those supervisors called me up [in his role as a member of the county retirement board and as county treasurer] to ask if it was a good idea.”

The pension boost was passed so quickly and with so little fanfare that it didn’t even make the pages of The Orange County Register or The Los Angeles Times. The Nexis news archive shows no contemporaneous media coverage of any kind.

A subsequent pension proposal — to provide a 62 percent retroactive increase in the pension formulas for more than 14,000 county workers — drew far more advance attention. But it was nonetheless enacted in August 2004 on a 3-2 board vote, with the support of self-styled Republican fiscal conservatives Silva, Wilson and Bill Campbell. Their fig leaf: a requirement that affected county employees had to pay more toward pension costs when funding lagged.

Even with that concession, however, the unfunded liability for the Orange County Employees Retirement System soared from $85 million in 1999 to $3.7 billion on Dec. 31, 2009, the most recent figures available on the OCERS website. In the process, the pension system went from being 98 percent funded to 69 percent funded.

‘Funny Money’

Moorlach, who left the county treasurer job in 2006 to replace the Assembly-bound Silva on the county board, expresses amazement at how quickly Orange County’s rebound went sour.

Supervisors didn’t “seem to treat money like it’s real. It’s all funny money, and it will keep coming” was their attitude, he told me.

Moorlach believes the county is now well-managed, with appropriate safeguards and smart long-term planning. But he described how difficult it was for county leaders to replace $48 million in vehicle license fees taken by the state government in June 2011. And he noted that, in the next fiscal year, additional pension costs alone will be $53 million.

As in 1994, he said, “We are dependent on what the investment markets will do.” That year, when Citron’s offbeat investments tanked, bankruptcy became inevitable. “Now, we have to place all our bets on the stock market [portion of the county’s investment portfolio] doing 12 percent a year” — for the indefinite future.

Moorlach’s conclusion: By themselves, board members Silva and Wilson “caused more financial havoc” than the county boards which failed to oversee Citron.

And so in short order, Orange County went from being a nationally recognized model of smart governance to just another California government in which elected officials and top bureaucrats blithely showered taxpayer funds on public employees.

Spending Every Tax Dollar

Chriss Street is an Orange County investment banker who succeeded Moorlach as county treasurer from 2006-2010 and who also voiced alarms about Citron’s strategy before it went haywire. Street has a particularly astringent view of the relevance of Orange County’s second self-created fiscal debacle.

Even in a county buffeted by a recent bankruptcy, “Governments and politicians by their nature will try to find a way to spend every dollar possible and push the liability for that spending into the future, either through borrowing or creative accounting,” Street said in a phone interview.

Far from acting prudently with taxpayer funds, Street said, government officials instead work overtime to enable their spending schemes by crafting narratives that depend on “false impressions of spendable cash flow.”

In other words, they lie now and let the public pay later.

Orange County’s experience in the 1990s does show a Chapter 9 municipal bankruptcy filing can help local governments when it comes to the “pay later” part of this disastrous public policy one-two punch. But the blithe way the county government created a fresh fiasco illustrates a larger truth about the need for citizens to show perpetual and eternal vigilance in monitoring their leaders.

“One of the common failings among honorable people is a failure to appreciate how thoroughly dishonorable some other people can be, and how dangerous it is to trust them,” Thomas Sowell once observed. In less than 20 years, Orange County’s citizens learned this painful lesson twice.

Reed is an editorial writer for The San Diego Union-Tribune, former KOGO talk-show host and editor of Calwhine.com.

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CalWatchDog.com’s Special Series on Municipal Bankruptcy:

Broke Municipalities Look to Bankruptcy Option

Bankruptcy Didn’t Make the Sky Fall In Orange County

Local Governments Face Bankruptcy Quandary

Bond Holders Seek Governmental Transparency