Facing a weakened police force and a failed experiment in citizen-driven budgeting, Vallejo’s structural challenges have persisted. In the wake of the pension crisis that helped plunge the city into bankruptcy, residents have become resistant to spending more money.

Hungry for cash, the City Council has turned its attention to a raft of proposals for big-ticket projects like large new casinos. Meanwhile, law enforcement has attempted to staff up even while suing the city for modifying proposed pension benefits during its bankruptcy proceedings.

All told, this portrait of a precarious, ailing city has cast doubt even on bankruptcy as a reliable fix for the budgetary woes imposed by public pensions — a challenge still unmet across California.

Spending confusion

Vallejo residents have recently encountered several unexpected developments in city budgeting. In a bid to avoid a second bankruptcy, they narrowly voted in a 1 percentage-point increase in the city sales tax in 2011. As CityLab reported, however, concerns mounted that the increased revenues would simply be funneled back into Vallejo’s broken budgetary system.

As a result, Councilwoman Marti Brown advanced a radical notion. Cooked up during Brazil’s 2005 World Social Forum, so-called “participatory budgeting” was designed to give residents a direct say in how budgets were allocated. Over strenuous objections, Brown worked with the Participatory Budgeting Project to squeak their approach through the Vallejo City Council with a 4-3 vote.

That’s when things took an unpredictable turn. As CityLab recounted, residents’ initial skepticism turned to curiosity, and soon citizens had produced some 800 potential budget items. By May 2013, the shortlist of expenditures was ready for a vote. And once it came time to allocate funds for the winners, city council meetings became a hotbed of civic engagement. “For the first time with participatory budgeting, you had a packed room, rooting for the budget,” city manager Dan Keen told CityLab. “They had a stake in the budget that they had imparted.”

The elation, however, was short-lived. The program’s operating costs, reaching $300,000 a year, have been tough for Vallejo to swallow at a time when basic services like law enforcement require more funds. The chunk of Vallejo’s money allocated for participatory budget spending has been cut by two-thirds, down to $1 million. Although increased citizen participation brought a brief wave of city pride, it failed to surmount Vallejo’s structural challenges.

Police drama

Vallejo’s new police chief, Andrew Bidou, came into office with a clear mission: grow. “At its lowest staffing point, the Vallejo Police Department had seen as few as 77 sworn officers on duty, for a city of about 120,000 residents,” the Times-Herald reported. “Bidou said he’s looking to get 110 officers on duty and that the department is on track to meet that number by the end of the year” — up from the current tally of 101.

Though many in Vallejo have strongly supported a return to pre-bankruptcy levels of policing, law enforcement was part of the spending problem that drove Vallejo toward insolvency. Vallejo police refused to negotiate away from their unaffordable pension agreements with the city.

As a result, Vallejo declared an impasse in contract negotiations and unilaterally included police in its $300-a-month cap on medical benefits for retired public employees. That led to a lawsuit brought by police. After a year of legal wrangling, a hearing date has been set for December.

Although the case has yet to progress, the expenses faced by the city could, once again, threaten bankruptcy.

A search for funding

Amid the uncertainty, Vallejo has lurched from budget proposal to budget proposal.

Measure E, a $239 million bond that would have renovated sites throughout the local school district, won 59 percent of the vote on Election Day, but fell short of the two-thirds of votes necessary to make it law. Now the City Council has been confronted with a series of offers for massive casino construction.

In partnership with Native American tribes, not all of which possess reservations, developers have promised thousands of jobs and millions in revenue.

Opponents, however, continued to worry that embracing casinos as a way out of Vallejo’s challenges would be more of a gamble than ever.

It’s a cautionary tale for Stockton and San Bernardino, both of which are working through bankruptcies — and for all California cities.

Here's a little more background from the study:

“Municipalities have rarely defaulted on their debt. As a consequence, municipal debt is regarded as having an extremely low risk for investors. There are disconcerting trends developing that may change this historical view. The combination of the weak U.S. economy, high municipal debt levels, and large under-funded pension liabilities coupled with unfunded retiree health benefits raises the likelihood that more municipalities will become insolvent going forward.

“Declaring bankruptcy (officially Chapter 9 bankruptcy) is an option available to a financially troubled municipality— more precisely to state leaders who must consent to a municipality’s bankruptcy filing—if they meet the eligibility conditions. A municipality can only declare bankruptcy if it is insolvent and only after the municipality has conducted good faith negotiations with its creditors to resolve its financial obligations.

“To provide greater perspective on this subject, this study overviews the purpose of Chapter 9 bankruptcy and then reviews the bankruptcy (or near-bankruptcy) of several prominent cases including: Vallejo, California; Detroit, Michigan; Stockton, California;  San Bernardino, California; San Jose, California; Jefferson County, Alabama; Harrisburg, Pennsylvania; Scranton, Pennsylvania; and New York City, New York.”

“There are important similarities across these high-profile municipal bankruptcies and near bankruptcies that provide  valuable lessons regarding how financial insolvency arises and the value and limits of bankruptcy protection.”

Here's the link.

By John Seiler

Last year, three California cities declared bankruptcy: Stockton, San Bernardino and Mammoth Lakes. Atwater nearly did. Mammoth Lakes lost a lawsuit.

But for the other cities — as well as for the Vallejo bankruptcy in 2008 — what the cities basically are saying is: “Previous city councils were bought and paid for by the public-employee unions. Those councils ripped off the taxpayer by giving wildly excessive pay, perks and pensions to city employees. We can’t afford that anymore, so we’re declaring bankruptcy. Let a federal bankruptcy court sort it out. Then we can start over.”

Peter Schiff is one of the country’s top financial gurus. His Euro Pacific Capital has an office in Newport Beach. He’s best known for predicting the 2008 financial collapse. Here’s his reasoning on why cities should declare bankruptcy:

“Stockton is like a Greece here in California. I mean, Stockton, the government there made a lot of promises to its government employees. And, when the real estate boom was going, there was plenty of revenue coming in, and they promised the moon to voters and to employees, big pensions, health care benefits. And then the bottom dropped out. You’ve got 20 percent unemployment now in Stockton. They don’t have the tax base. They can’t afford all these commitments. And what are they doing? They’re telling their bondholders, we can’t pay. You’ve got all the municipal bonds outstanding. I mean, this is going to be a major problem for those bondholders and now government workers.

“But Stockton is not going to be the last city to declare bankruptcy, not by a long shot. And I think it’s going to go up the food chain. We’re going to have state governments that are going to face these problems. We’re going to have the federal government face this problem, especially when interest rates go up….

“If interest rates go up, or rather ‘when’ interest rates go up, the debt becomes unserviceable. And the minute it becomes unserviceable, the minute our creditors worry that we can’t service the debt, then they actually want their principle back. Then it’s not about just the interest; it’s about coming up with the principle. Where are we going to get that?…

“But, you know, it is going to be problematic for a lot of people who have based their lives on assumptions of a revenue stream coming in from a government entity. And so it’s going to be very painful for the people involved. And it’s also going to be painful to people who loaned money to the city of Stockton, who hold those bonds, who thought they were going to get certain interest payments and they were going to get their principle returned. They’re going to wake up to the reality that Stockton can’t pay. So when we do have the restructuring that we need, there is going to be pain. We just have to be able to suck it up and bear that pain.

“And, of course, for some people, it’ll be relief because, you know, otherwise, in order to keep their promises, we have to increase taxes. And if you already have 20 percent of the city unemployed, how are you going to increase taxes on the few people that are still working, and will they stay in town to pay those taxes or will they leave, particularly the employers? So we have to do this.”

By John Seiler

In Forbes’ new ranking, three of the eight “most miserable” cities in the United States are in California: Modesto (No. 5 worst), Vallejo (No. 6) and Stockton (No. 8). Cities were graded on such factors as “crime rates, foreclosures, taxes, home prices, commute times, weather and decreasing populations.”

The “most miserable” city on the list, not surprisingly, is Detroit, Mich. For 50 years it’s been run by the kind of left-wing, socialist Democrats who now run the whole state of California. Before 50 years ago, Detroit was the industrial wonder of the world, the richest city on the planet because of the auto industry — the “arsenal of democracy” during World War II.

No. 2 “most misderable” is Flint, Mich., another formerly prosperous, car-industry city ruined by left-wind Democrats.

Michigan also placed Warren on the list at No. 7.

But we shouldn’t let Republicans off the hook. Michigan produced two of the worst governors of the modern era, George Romney (1963-68), father of Mitt. Gov. George more than doubled spending in just six years while imposing the state’s first income tax. Far from “helping” poor people with all his socialist programs, his policies sparked the 1967 riots that burned down a large part of Detroit, which never recovered.

His successor was Gov. Roger Milliken (1969-1982). I remember getting out of the U.S. Army in 1982 and returning to my home town of Wayne, Mich., just outside of Detroit, and unemployment was 16 percent. There were no jobs, so I left. True, the U.S. economy was suffering then. But Milliken had made everything worse.

And California, of course, was misgoverned for seven years by Republican Gov. Arnold Schwarzenegger. It’s now confirmed that he’s a cyborg sent from the future by Skynet to destroy California, and with it any hope our high-tech economy will be able to fight back.

Gov. Granholm

Back to the list:  Illinois also had two in the top eight worst: No. 3 Rockford and No. 4 Chicago.

Note that all the states with cites among the top eight “most miserable” long were run by liberal Democrats backed by powerful unions. Michigan now has a fairly conservative Republican governor and state Legislature. But for eight years (2002-2010) it was run by liberal Democrat Jennifer Granholm, who although born in Canada was raised in California’s Bay Area. She boosted Michigan taxes and increased regulations.

And she’s back here taking our money again as a “distinguished visiting professor of law and public policy” at U.C. Berkeley.

Does California really need lessons in bad governance?

For the three Golden States on the list — Modesto, Stockton and Vallejo — matters actually are worse than listed. A major factor in the list is “weather,” which is pretty good in those cities. I lived through 22 Detroit winters and there’s no way any California city is as bad. And the weather’s bad in Illinois, too.

So if weather were taken off the table, those three California cities would be pushed higher in the “most miserable” ranking.

Although at least if you’re out of work and homeless, you’re unlikely to freeze to death on the street. And your governor likes to quote classical authors and zen sayings. It’s something.

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

Nov. 12, 2012

By Tori Richards

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.

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

Nov. 9, 2012

By Wayne Lusvardi

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

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

What About Vallejo and Stockton?

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

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

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

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

* Court approval for any pension reductions;

* Employee layoffs;

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

* Ultimately bankruptcy.

Why Spending Was Invisible During the Bubble

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

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

How Pension Bubble Causes City Budget to go Upside Down

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.

Lusvardi writes for CalWatchDog.com

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.

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

MARCH 16, 2012

By JOHN SEILER

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.

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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

]]> https://calwatchdog.com/2012/03/16/special-series-local-governments-face-bankruptcy-quandary/feed/ 82 26936 https://calwatchdog.com/2012/03/09/special-series-municipalities-look-to-bankruptcy/ https://calwatchdog.com/2012/03/09/special-series-municipalities-look-to-bankruptcy/#comments Fri, 09 Mar 2012 17:27:27 +0000 http://www.calwatchdog.com/?p=26778 Editor’s Note: This is the second in a CalWatchDog.com Special Series of 12 in-depth articles on municipal bankruptcy.

MARCH 9, 2012

By STEVEN GREENHUT

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.

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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

Newsweek listed the Top 10 cities in America that are dying. No. 1 is New Orleans, in the wake of Hurricane Katrina.

No. 2 is Vallejo, which has suffered more than any other city from the Schwarzenegger Decade of misgovernment. Vallejo has suffered more even than Detroit and several other Michigan cities devastated by the decline of the auto industry.

Vallejo’s government is so badly managed that in 2008 it filed for bankruptcy, a harbinger of what’s in store for scores of cities across America’s worst-managed state, and indeed for the state itself.

Newsweek:

Vallejo, like much of California, suffered an extreme housing crunch in the lead up to the recession, and even as recently as December, one in every 113 homes was foreclosed on, one of the highest rates in the country. This has made the city a less desirable place to live and unfortunately, not much may change in the near future. One recent study found that housing markets in many of the cities in the South and the Southwest that tanked may take decades to return to pre-recession levels.

Total Population (2009): 114,622
Proportion Under 18 (2009): 24.4%
Change in Total Population (2000-2009): -1.8%
Change in Residents Under 18 (2000-2009): -3.2 percentage points

Jan. 23, 2011