Moody's: Stockton, San Bernardino Bankruptcies May Signal Shift in Willingness to Pay

Municipal defaults and bankruptcy actions similar to those recently taken by the cities of Stockton and San Bernardino in California are likely to remain few in number but may indicate a new trend in fiscally troubled cities unwilling to pay their debt obligations, says Moody's Investors Service in a report.

"The looming defaults by Stockton and San Bernardino raise the possibility that distressed municipalities -- in California and, perhaps, elsewhere -- will begin to view debt service as a discretionary budget item, and that defaults will increase," said Van Praagh, author of the report, "Recent Local Government Defaults and Bankruptcies May Indicate A Shift in Willingness to Pay."

Hard-hit by the housing crisis, Stockton became the largest U.S. city to file for bankruptcy since the Great Depression on June 28 following a failed mediation process with creditors that began in March. The San Bernardino City Council voted to file for bankruptcy on July 10 in the face of a $45.8 million budget shortfall, some 35% of its annual budget.

"Although a few issuers in California and other states have suggested an unwillingness to meet debt service, we have also seen many distressed issuers demonstrate a strong willingness to pay despite substantial budgetary pressure," said Moody's Managing Director Anne Van Praagh. "Our expectation is that unwillingness-driven defaults will rise but remain rare, particularly among Moody's-rated issuers."

Most municipal defaults and bankruptcies involved exposure to failing enterprise projects, such as convention centers, sports arena, or other endeavors backed by a government until the project and its debt are left to falter. In contrast, said Van Praagh, Stockton's and San Bernardino's bankruptcy filings are unusual in that they were not precipitated by the realization of enterprise risks but rather from stress on their core government operations, notably high pension and other employment benefits and debt service.

"A growing-but-still-small number of financially strapped governments may take a more calculated approach to weighing the costs and benefits of default or bankruptcy in the face of current conditions," said Van Praagh. "Even a slight increase in bankruptcy filings would mark a significant departure from the historical pattern."

The Moody's report states a reduced willingness to pay debt will likely only become apparent after a decline in ability to pay, which could be evidenced by severe declines in housing prices and property tax revenues, high foreclosure rates, and abrupt spikes in debt service costs. Other sources of budget stress could include rising pension and other employment benefits or unexpected debt incurred from failed projects that were expected to pay for themselves.

Certain debt structures — especially those with guaranteed debt service payments rather than directly issued and those subject to appropriation without consequence for default — may be more heavily exposed to a potential erosion in willingness to pay, according to Moody's.

 

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