California City Becomes Nation’s Largest to Declare Bankruptcy

California City Becomes Nation’s Largest to Declare Bankruptcy
July 11, 2012

Tim Kelly

Tim Kelly is a political cartoonist, policy advisor, columnist for the Future of Freedom Foundation... (read full bio)

Stockton, California, has gone into bankruptcy, making this city of 300,000 residents the nation’s largest city to seek protection under the U.S. bankruptcy code.

The Stockton City Council voted 6-1 on June 26 to adopt a spending plan for operating under bankruptcy protection, and to file a motion with the courts to enter into confidential mediation.

The City Council had voted to enter into bankruptcy mediation in February 2012. Negotiations between city officials and the city’s creditors had been ongoing since March, but the two sides failed to come to terms.  The bankruptcy filing is in compliance with AB 506, a new California law requiring cities to enter into mediation before they may file for reorganization of their debt.

Several bankruptcy attorneys have said the mediation may help the city avoid the fate of Vallejo, California. That much smaller city became a target of multiple lawsuits after it declared bankruptcy in 2008.

‘Pendency’ Plan

Stockton City Manager Bob Deis recommended a so-called pendency plan after telling the council that mediation with creditors had failed. The pendency plan is an alternative to a balanced budget that eliminates bond payments while maintaining city services, although at reduced levels.

The city cut $90 million from its general fund in the last three years, reducing the Fire Department by 30 percent and the Police Department by 25 percent, and cutting pay and benefits to all employees.

"This is not where any of us wanted to be, but, absent restructuring agreements with our creditors, any other options would decimate the city," said Deis in a statement. "The pendency plan allows us to operate until we can get a long-term plan of adjustment negotiated and approved through bankruptcy."

A federal judge will now decide how many pennies on the dollar Stockton will pay creditors and how the city’s future budgets will be structured.

“Bankruptcy is a terrible option until it's the only option” said Stockton City Attorney Marc Levinson.

Stockton’s fiscal health took a turn for the worse when its once-booming housing market turned south and revenue collection fell. 

Spending Binge

But some say Stockton’s financial problems were exacerbated by reckless spending during the fat years, which left the city financially vulnerable and burdened with crushing liabilities.

“The unfunded liabilities are so large that it’s unlikely that an economic rebound will correct a problem long in the making. Even when the economy was doing well, legislators continued to increase benefits beyond the ability of taxpayers to pay for them,” writes Steven Greenhut, vice president of the journalism at the Franklin Center for Government and Public Integrity.

California Common Sense, a non-partisan organization dedicated to government accountability, issued a report on Stockton’s financial problems that generally comports with Greenhut’s assessment.  “How Stockton Went Bust: A California City’s Decade of Policies and the Financial Crisis that Followed” cites three main factors contributing to the city’s bankruptcy:

  • The housing bust and financial collapse decimated the city’s property tax (and related) revenues.  This problem was made worse by a skyrocketing home foreclosure rate.
  • The real estate bubble encouraged large spending increases, ambitious redevelopment initiatives, and unsustainable compensation packages for city workers.
  • The proceeds from Stockton’s 2007 bond offering were given to the California Public Employees’ Retirement System (CalPERS) which was overexposed to the real estate and stock markets.  The original pension obligation bond money is now worth less than $100 million while the city owes $248 million.

Unclear Impact

It is unclear whether Stockton’s bankruptcy will affect the rest of the state.  Other cities have been hit hard by the economic downturn and state’s budget woes and are negotiating with employee unions for concessions.

Most of the 18 municipal defaults since 2008 have involved small cities struggling to maintain general services. Those isolated instances—out of about 9,700 rated cities and a $3.7 trillion market—are too small a sample for any sweeping lessons, said Bhu Srinivasan, principal at Munigo, a municipal bond distributor.

“Defaults capture headlines, but it is man bites dog,” he said. “You could go the other way and say in even the deep recession, municipalities are strong and bonds aren’t defaulting.”

“The most important takeaway right now is that, no, Stockton’s decision to file bankruptcy is not necessarily a harbinger of things to come” said Reason Foundation’s Harris Kenny. “The city’s financial situation is unique and does not reflect the financial standing of a significant number of municipalities in the U.S. That being said, there are relevant themes that policymakers and investors should recognize.”

Spreading Problem

Steven Greenhut sees the long-term outlook for California’s cities as more dire: “The state’s legislators are so beholden to public sector unions that they are oblivious to the financial meltdown all around them and aren’t about to do anything before more cities’ finances hit the wall.”

According to Greenhut, the problems in Stockton and smaller municipalities constitute evidence of an economic contagion that will eventually force many more cities to implement so-called austerity measures.

“Poor cities, such as Vallejo and Stockton, are going to face fiscal disaster first, but the problem is spreading across California, and there’s nothing much the unions can do once cities start running out of money,” said Greenhut.

Tim Kelly (tkelly67@comcast.net) is a political cartoonist, policy advisor, columnist for the Future of Freedom Foundation, and a correspondent for Radio America's Special Investigator.

Tim Kelly

Tim Kelly is a political cartoonist, policy advisor, columnist for the Future of Freedom Foundation... (read full bio)