Searching for Signs of Municipal Distress in Stale Data

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When Stockton, California filed for bankruptcy protection in June 2012, its latest audit covered a year that ended 729 days earlier. When Vallejo filed, its last audited data was 311 days old. And San Bernardino's audit was two years old when it filed for bankruptcy. With financial data this stale, how can analysts and policymakers predict the next case of financial distress? A look at the past suggests that historic audited financials remain quite useful.
And combined with more timely economic data, the signs of future distress can reveal themselves.

Vallejo, Stockton, San Bernardino, Detroit, and Puerto Rico all reported low unreserved or unrestricted general fund balances in their audited financials prior to bankruptcy or default. In the cases of San Bernardino, Detroit and Puerto Rico, these balances were negative. When economic conditions deteriorated after 2007, none of these municipalities had substantial cushions to deal with revenue losses or growing expenses. Fund balances and cash balances are good indicators of near-term resiliency to economic downturns.

While historic fund balances are important, so too are changes in local economic conditions between audits. Fortunately, useful economic data is published with greater frequency. The U.S. Bureau of Labor Statistics releases monthly unemployment rates at the city level. And Zillow has made available monthly median home value data. Both sources provide clues as to the direction of government revenues since the most recent audit. During the Great Recession, Detroit, Stockton, and San Bernardino saw some of the highest increases in local unemployment rates anywhere. And Stockton, Vallejo, and San Bernardino experienced dramatic declines in home values. Rapidly increasing unemployment and falling housing prices lead to a distressed local economy and potentially a decline in tax revenues.

A common criticism of Comprehensive Annual Financial Reports is that they represent the past, while what is needed is forward-looking information. But certain data points in the CAFR do provide insight into the future. A city's net pension liability is certainly a historical point-in-time measure. But its size relative to the municipality's overall revenues gives the analyst a solid indicator of potential future pension-related distress. Which municipalities are most likely to experience distress from their debt, pension, or OPEB obligations? A look at the historic ratios of these liabilities divided by revenues produces some good candidates.

In the case of Stockton, the OPEB liability prior to bankruptcy particularly stands out. The unfunded liability totaled about $543 million as of 2010, representing a high 147% of primary government revenues. The city took this liability to zero in bankruptcy, defaulting on its public debt along the way. Detroit's OPEB liability was even higher at 249% of primary government revenues. This was on top of Detroit's governmental debt totaling 158% of governmental revenues. 

The Jefferson County, Ala., sewer system provides another example of past data foreshadowing future distress. In 2005, well before the county's financial implosion, the system had $3.3 billion in debt outstanding. This was more than 23 times its gross operating revenue and 34 times its net operating revenue – very high levels for a municipal utility. The system's complex debt profile, with interest rate swaps and variable-rate debt, hastened the downward spiral when the financial crisis hit. But even without these issues, it seems likely the system would have been strained under that debt burden.

Dallas provides a more recent case study. The city has been making news with its pension issues and rating downgrades. Its police pension plan has unique features that are problematic. But these specific characteristics aside, a simple historic calculation of net pension liability divided by revenue suggests eventual pension affordability problems. Dallas' governmental net pension liability of $5.4 billion represented 324% of its revenues in fiscal year 2015. Among major cities, only Chicago has a higher pension burden by this measure.

The economic picture has improved since the last round of high profile bankruptcies. Housing prices are up in most large cities. And unemployment rates have declined during the last six years. Though many municipalities are still experiencing the financial stress of long-term liabilities, they are doing so with the wind of a healthy economy at their backs.

But if the economy eventually dips as it has in the past, analysts can anticipate that municipalities reporting low fund balances and high long-term liabilities will experience financial distress first. The timeliness of data remains an issue in public finance and analysts should keep pushing for improvements. In the meantime, we should not dismiss the usefulness of those stale audited financial reports.

Robert Hannay, CFA, is the founder of Munitrend, a provider of municipal finance data and analytics.

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