Last year's bankruptcy filing by the city of Vallejo, Calif., and the prospect of bankruptcies of several other cities have been a wake-up call for municipalities across the state. California's districts are dealing with reduced revenue, generally caused by a reduction in local tax dollars collected. At the same time, the Legislature has elected to close the state's huge budget gap by permanently taking about $2 billion from local governments. On top of all of this, many cities and counties face increased expenses due to rising health care costs and pension obligations.
As with any business enterprise in a time of economic distress, the sooner leaders of California's cities, counties, and special districts acknowledge looming financial shortcomings and work to address the fundamental problems, the higher the likelihood that bankruptcy can be avoided. And while Vallejo will probably not be the only California city that ends up filing bankruptcy in the face of these dire economic times, municipalities can, and should, take proactive steps to avoid being forced into insolvency.
In the private sector, bankruptcy can be avoided when an enterprise is able to sufficiently grow its revenue, reduce its expenses, or achieve some combination of the two. The concept is the same in the public sector, although for a municipality this can be a particularly difficult task. First, localities cannot create new revenue streams with the same agility as private businesses. Second, many municipal expenses are nondiscretionary, which means a relatively small portion of their budgets have to account for a disproportionately large portion of cuts. Despite these difficulties, the municipality that can successfully implement a strategy of cutting costs while implementing new revenue measures places itself in a good position to avoid bankruptcy.
California's local governments and most municipal governments around the U.S. have had much in common financially. They are not-for-profit municipal corporations that provide essential services financed by relatively safe sources of income, mostly in the form of taxes and fees. They have had generally strong and inexpensive access to capital, often through the use of tax-exempt debt, that allowed them to build the facilities needed to maintain and grow their economies. As a result, they have had excellent credit profiles and, with rare exceptions, have paid their debt and other bills on time.
Over the last 21 years, based on Standard & Poor's municipal default studies, the cumulative default rate on all rated tax secured municipal debt has been 0.03%. However, that trend may be changing. As reported in the Bond Buyer in June, it is estimated that 150 bonds, equal to $7.8 billion or 2% of the year's new issuance, defaulted in 2008. That rate is already on course to be higher in 2009. Much of this was not related to general governments, like cities, but could be a sign of more to come.
California's local governments face unique financial challenges, such as restrictive tax provisions, limitations on debt, restrictive expenditure mandates, and an often-difficult relationship with the state due to competition for declining revenues. Nevertheless, many factors in the 20th century, such as an educated workforce, mild weather, a relatively new infrastructure, cheap oil, abundant water resources, low pension obligations, an expanding tax base, and diverse economic activities have driven continued growth of the state and allowed most local governments to continue to enjoy a solid level of prosperity and fiscal stability despite the aforementioned challenges.
That level of prosperity, however, is now threatened. The significant increase in foreclosure rates and related reduction in real estate values will severely reduce local property tax collections. Additionally, public employee pension funds have not been immune to the declines in the stock market. And, as a result of complex agreements between cities and municipal employee unions, these losses in fund value will result in the requirement that local governments increase contributions into retirement funds at a time when revenues are on the decline. Changes in accounting standards to reflect other post-retirement costs will further darken the picture, creating a financial "Perfect Storm" for governments across the state.
As cities and counties increasingly struggle with the realities of budgeting with less when it is becoming more and more expensive to run local governments, there are a number of steps that leaders can take to reduce the impact on residents. First and foremost, elected officials need to work with labor unions to reach compromises to restructure long-term collective bargaining agreements, ideally without loss of jobs or services.
The pension structure that virtually all cities and counties currently utilize evolved at a time when people would work entire careers with a single employer. Private-sector expectations of fully funded lifetime pensions fell by the wayside decades ago. With little expectation of local-level revenue growth in the near future, pension obligations (particularly defined benefit pensions), which continue to grow in real-dollar terms, are quickly becoming an unhealthy percentage of government budgets. In the face of these difficult circumstances, public-sector union leadership would best serve members by working with local government to facilitate a transition to a system that provides an appropriate level of benefits to retired employees without forcing a reduction of services to taxpayers nor mass layoffs.
Other opportunities exist to help address the coming crisis for local government officials. Depending on the nature of a city or county's bonded indebtedness, local governments may be able to restructure certain long-term financial obligations. This could be effectuated by refinancing existing debt or funding future pension requirements with pension obligation bonds. Alternately, governments can look for existing revenue streams or municipal assets that might be leveraged to support new bonds to fund infrastructure needs and/or create resources for ongoing operations. For example, California cities could follow Chicago's lead by contracting private-sector companies to monetize municipal assets, such as parking systems or toll projects.
There is also the possibility of creating new revenue streams. Governments around the state and across the country have begun exploring the concept of user fees and assessment districts - a system where people who want and benefit from certain services, pay directly for them. In many situations this is an effective way to preserve existing service levels or pay for new ones that might not otherwise be affordable. Revenue could also be generated by new redevelopment projects - a time-tested technique in California. And many governments have surplus properties that could be sold to fund new programs or facilities.
Each of the alternatives discussed above, as well as a myriad of other potential fixes, can help cities and counties try to avoid bankruptcy. However, there is also the possibility that competing interests become so inflexible that officials will be forced to take extreme measures to break the stalemate. This is when bankruptcies will occur: not because decision makers are predisposed to filing for bankruptcy protection, but because dire financial circumstances leave no alternative. If negotiations among each of the various interests fail, then only bankruptcy will bring all constituencies together to achieve a resolution for the benefit of the public.
Many well-known companies have successfully restructured through bankruptcy, though, including United Airlines, Pacific Gas & Electric and, most recently, General Motors. In the mid-1990s Orange County, Calif., became the largest municipal bankruptcy in U.S. history, and the county emerged from bankruptcy with revived fiscal health. In many situations bankruptcy has been the vehicle through which a financially crippled entity was brought back to fitness.
It is crucial that decision makers not lose sight of their role as stewards of the public interest. In doing so they should ensure that all options remain on the table as they pilot their local governments through these uncertain times.
Michael A. Sweet is a San Francisco attorney who practices in the areas of bankruptcy and litigation. He was part of the legal team that worked with the city of Richmond to avert a bankruptcy filing in 2004.
Peter Bianchini, a Bay Area-based financial analyst, is the senior municipal strategist for Mesirow Financial.
