California cities are pressured by rising compensation costs and a housing crash-related decline in revenue exacerbated by revenue raising restrictions, according to a Fitch Ratings report.
"Even as the broader economy shows signs of stabilization, California cities face state specific uncertainties based on their diverse economic profiles, and revenue raising environment," said Karen Ribble, senior director in Fitch's Public Finance group. "California cities facing the most fiscal stress are those with limited options to address budget imbalance, reinforcing the divide between the strong and the weak."
Highly-rated cities are better able to manage labor costs and support rising benefit spending, while lower-rated credits struggle with inflexible labor costs that compound existing risks, including financial inflexibility and below average - often fragile - economies.
California cities operate in a restrictive revenue raising environment, in large part due to Proposition 13 (Prop 13). Prop 13, which limits property taxes to 1% of assessed valuation (AV) and does not allow for tax increases to offset AV declines, has been especially damaging to revenue since the housing bubble burst, in some cases reversing gains in AV since fiscal 2002.
The state's role is neutral to negative. The state offers no assistance to cities and has taken other actions that make financial stability more challenging, including RDA dissolution which has weakened some cities' cash positions. AB 506, a pre-bankruptcy mediation process for municipalities and stakeholders enacted in 2011, may actually accelerate default and bankruptcy if cities believe the process could improve their cost structures.
While the costs of bankruptcy - both financial and reputational - remain high, some cities may see bankruptcy as worthwhile depending on how the outcome of current cases affects incentives.
Stockton and San Bernardino are concerning because in both cases management suggested bondholders accept delayed, and perhaps reduced, payments rather than significant reductions in labor costs, though San Bernardino does provide for full debt service in its current budget.
Fitch rates 40 of the 482 cities in California, maintaining an average unlimited tax general obligation (ULTGO) rating of AA, which is consistent with Fitch's average ULTGO rating for municipalities nationwide.
Fitch downgraded nine California cities in 2011 and another three in 2012 for a total of 30% of its portfolio of California cities over the last 21 months, compared to 12% of general government ratings nationally. 9.5% of general government credits have a Negative Outlook or Negative Watch nationwide, compared to 12.5% of California cities.
