Bankruptcy choices highlight fiscal pain of cities nationwide


The decision by three California cities to seek bankruptcy protection in the space of two weeks is unlikely to presage a wave of copycat filings. But it does underscore the mounting financial pressure facing local governments around the country.

Collapsing property values and entrenched unemployment have pushed cities and counties to the economic brink. Tax receipts in some locales have shrunk more than 20% over the last three years, and soaring pension costs exceed funding levels by as much as $3 trillion nationwide.

As the California cities of Stockton, Mammoth Lakes and, most recently, San Bernardino show, the temptation to flee to Bankruptcy Court is growing. Last year, four municipalities nationwide also applied for so-called Chapter 9 protection, including Jefferson County, Ala., which eclipsed Orange County as the largest such filing in U.S. history. Meanwhile, the Bay Area city of Vallejo emerged from its own reorganization.

PHOTOS: California cities in bankruptcy

All that has fed fears that American cities are lined up to fall like so many dominoes. But municipal bankruptcy filings are likely to remain rare for a variety of legal and political reasons.

What’s clear is that the fiscal pain experienced by U.S. cities is widespread and shows no sign of easing.

“It does not look pretty. It’s not going to look pretty over the next three or four years,” said Michael Pagano, dean of the College of Urban Planning and Public Affairs at the University of Illinois at Chicago. “It’s a long-term structural problem, and cities need to think of new ways to collect resources to fuel their services, or they are only going to be in worse trouble.”

Like hundreds of other cities around the country, Stockton, San Bernardino and Vallejo share a number of fundamental problems that drove their finances into the ground. Blue-collar cities with aging infrastructure, they have relatively poor populations. And they’re saddled with ballooning pension and healthcare obligations for civic employees and retirees.

Then came the recession, and with it foreclosures, crashing property values and the disappearance of retailers that were vital to sales-tax revenue. Cities that had been scraping by suddenly found their bank accounts depleted and their budgets in a death spiral.

When San Bernardino’s council voted to authorize a Chapter 9 filing last week, it said the city had just $150,000 in the bank and couldn’t make the next payroll. If it ends up filing, the city of 213,000 will be the second-largest in the U.S. ever to seek bankruptcy protection, after Stockton.

“Up to this point, we’ve seen idiosyncratic situations where there was exposure to one of a kind risk,” such as a court judgment or natural disaster, said Anne Van Praagh, a managing director in the public finance division at bond rating company Moody’s.

“With Stockton and San Bernardino, we’re seeing something potentially different. They’ve taken all the measures they can,” she said. “The question is, where do they go next? What can they do at this point?”

Unlike Orange County — whose infamous 1994 bankruptcy was caused by a massive $1.6 billion in losses on risky investments — San Bernardino, Vallejo and Stockton pulled the trigger because, simply put, revenues didn’t match their obligations.

Mammoth Lakes, meanwhile, filed for court protection to escape a multimillion-dollar court judgment that it didn’t have the money to pay.

In Michigan, four cities and three school districts are currently operating under emergency management by the state, which means the local officials have effectively lost their administrative power. Three other cities in the state, including Detroit, are operating under consent agreements that may end in having their finances taken over as well.

For some municipalities with financial woes, bankruptcy might provide a shortcut to better fiscal health by forcing bondholders, unions and creditors to come to the table and negotiate meaningful change.

But as Harrisburg, Pa., found out last year, not every city is eligible to file. A costly incinerator project left it deep in the hole and unable to pay its bills. But its Chapter 9 filing was dismissed by a federal judge who ruled that Harrisburg was in a class of smaller cities prohibited from filing in that state. Today the city of 50,000 is operating under a receiver.

Directly up Interstate 81, the city of Scranton this month took the dramatic step of cutting all municipal pay to just $7.25 — minimum wage. The mayor has proposed an 80% increase in property taxes to help close a nearly $17-million budget deficit, a move that could help Scranton stave off bankruptcy.

Experts expect Chapter 9 filings to remain rare. From 1980 through the first quarter of this year, there were just 254 Chapter 9 filings, according to the American Bankruptcy Institute. And only about one-fifth of those were filed by cities, towns or counties. The bulk were by school districts, hospital districts and similar entities.

In part that’s because roughly half the states make it difficult if not impossible for municipalities to file. It’s also because historically, bankruptcy reorganizations have not always eliminated the underlying financial problems. Pensions and bond debt, for example, often remain untouched by the process. And the city is left with downgraded credit and a besmirched reputation.

Still, Robert Flanders — former receiver for Central Falls, one of the poorest and smallest cities in Rhode Island — has become something of a bankruptcy advocate.

Central Falls, population 19,000, long ago lost its textile manufacturing base and the tax revenue that went with it. But the city continued to provide generous pension and healthcare benefits to its employees. That, Flanders said, led to an unfunded liability that climbed to $80 million last year and cost the city $6 million more a year than it was collecting in taxes. Unable to renegotiate with unions, the city went bankrupt last August.

Many states grant constitutional protection to pension benefits, but Rhode Island does not. Central Falls used bankruptcy to win 55% cuts in pensions that weren’t all that fat to begin with. That, Flanders said, will save it $30 million over five years.

Chapter 9 “is a golden opportunity to restructure unsustainable health care and pension obligations,” Flanders said.

Municipal bankruptcy lawyers have been anticipating increased interest in Chapter 9 for some time — even practicing for it with role-play.

Last year, investment bank Houlihan Lokey organized a three-city tour of a dramatic presentation depicting scenes from a municipal bankruptcy, with lawyers and bankers playing the parts of city officials.

“Restructuring the Troubled Municipality — A Case Study” was warmly received in its one-day run at the Beverly Wilshire Hotel in Beverly Hills, particularly the soliloquy by the mayor character (in real life a partner at an investment bank): “We’ve fired people. We’ve raised taxes.... How the hell did we get here?”

John Knox, a lawyer who worked on the Vallejo bankruptcy, was there. Now he’s advising Stockton on its filing, and he suspects more bankruptcies could be coming.

“Cities in many states, not just California, are under tremendous fiscal strain because of fixed, locked-in expenses and reduced revenue,” Knox said. “The math of that is pretty simple.”

Because cities and counties rely so heavily on property taxes, the brutal decline in real estate values in most areas of the country has hit them particularly hard. And sales taxes have fallen as a slow economy forces retailers out of business. San Bernardino, for example, lost seven of 12 new-car dealers in the recent recession.

“Some parts of this country are in very bad shape. Foreclosures are up again. Demand for social services is up. People need food. People need hospitalization and indigent care,” said Jackie Byers, director of research at the National Assn. of Counties. “The cities and counties just don’t have the money they need to pay for all that.”

California’s local governments may be particularly vulnerable.

On top of high unemployment and still-depressed real estate values, California municipalities lost about $5 billion in funding when the Legislature abolished redevelopment agencies last year. That money was earmarked for economic development, but over the years many cities had come to rely on it as an emergency ATM to pay for essential services such as police, fire and code enforcement.

In many cases, cities have already made deep cuts, reducing wages, installing two-tiered benefits plans for employees and laying off as much as 20% of their workforces. Those unavoidable choices often lead to further declines in property values and more store closures, a vicious cycle.

Officials in some cities, including Grand Terrace, have raised the specter of disincorporating entirely, a step that could drop its financial obligations in the lap of San Bernardino County. Last week the mayor of Gold Bar, a small town in Washington state, said he would consider asking residents to take the same step.

In the city of Huron in the Central Valley, Finance Director Jack Castro said officials have made deep cuts over the last two years, laying off more than half the police. The agricultural city, whose population swells during harvest season, fears that it may not get money it believes it should get from the state.

“If that happens, the city will be insolvent,” Castro said. Still, he added, “I can’t talk about bankruptcy. I don’t want to say that word. That is not our goal, to file bankruptcy. Our goal is to be as responsible as we can and save the city.”