Issue XVII - Municipal Finances

Dear Readers,

As renewed uneasiness about the economy creeps into the public consciousness, one subject of rising concern among economists and government officials alike is the public finances of all levels of government. The range of specific concerns is vast, from underfunded state pension funds to the increasingly precarious task of financing municipalities by issuing bonds. With the increased scrutiny, many questions have been raised about the viability of local and state debt, and rightfully so, as municipal and state bonds are investments to which a great portion of the investing public has direct or indirect exposure. In a few recent issues, I have focused on the situation in Europe, which is potentially a harbinger for what could eventually happen in the US. This issue focuses on municipal governments, whose problems seem to get progressively more unflattering with each new story that makes the news. With the current legal framework regarding local and state bankruptcies, this situation is potentially another problem where the strains will work their way up to the states, and eventually the federal government will be forced to take on the burden.

While it is making its way to the forefront of the public consciousness, the fact of the matter is that municipalities declaring bankruptcy is nothing new. What is different this time, and at the heart of many concerns, is the sheer number of municipalities that are potentially facing bankruptcy. While Chapter 9 filings are much less common than personal and corporate bankruptcies and the ramifications are not as severe as one might think, what carries severe consequences is the possibility of many happening at once. The US Bankruptcy Code for municipalities, collectively known as Chapter 9, ensures that the repercussions are not immediate in nature.

Prior to the 1930s, there was very little in terms of legal infrastructure designed to address municipal bankruptcies. Once the US entered the throes of the Depression, a growing number of municipalities across the nation (particularly in the Dust Bowl, which suffered from crop loss and the subsequent exodus of population) became unable to pay their workers and outstanding debts. To remedy this, laws were altered within the US Bankruptcy Code beginning in 1934-35. Because the 10th Amendment of the US Constitution places limits on the influence the federal government can exert upon the states, Chapter 9 filings are by and large local issues and are resolved on that level. The Chapter 9 process involves several steps. First, a municipality must go to their state for approval (this process varies by state). Second, the municipality generally must prove itself to be insolvent, unable to meet present and/or future obligations. Finally, it must make a good faith effort to negotiate with its creditors before filing. As is the case with corporate bankruptcies, it is often in the creditors’ best interest to do this as well, since they could both potentially lose more in a bankruptcy.

The primary duty of the judge in a Chapter 9 filing is to ensure a municipality is eligible to file, and then place a stamp of approval on its plan for paying off the debt. Judges cannot force a municipality to liquidate assets to pay its creditors. Slate magazine, while reporting on San Diego’s financial debacle in 2005, quoted a lawyer who worked on Miami’s 1996 Chapter 9 filing as saying, “They can’t come and pick up the fire engine(s).” Furthermore, unlike a personal or business bankruptcy, a Chapter 9 filing is not made with the intention of ridding a municipality of its debt. Instead, its purpose is to allow reorganization by assisting a municipality in terminating unsustainable contracts and to ease the process of raising lower-interest financing. For this reason, the city does not need approval of the judge to borrow money and/or engage in other financial transactions, which would be necessary in a corporate or personal bankruptcy.

As is the case with personal and corporate bankruptcy, the causes are predictable and often years, if not decades, in the making. Faced with falling revenue from the loss of an industry or population, a city begins to operate with a deficit, and more often than not gets in the habit of it. This is not a bad thing in and of itself, as utilizing debt markets allows a city to sustain its credit. While this is commonplace in the short-term, during economic downturns it is a situation that can quickly turn ugly, particularly if a government has not planned accordingly.

As mentioned, while municipal bankruptcies occur much less frequently than personal or corporate bankruptcies, they are never out of the question. During the 20th century, there were over 400 municipal bankruptcies in the US, including the near-filings of a few major cities. One of the reasons Chapter 9 is not frequently used is that for politicians, the ends often do not justify the means. In other words, many municipalities that could potentially benefit from Chapter 9 might be hesitant to file because the process would involve tax increases and unpopular service cuts. Thus, the risk of political fallout is extremely high. As is well-known and remembered, in 1975 New York City came close to filing for Chapter 9. This is most remembered by New Yorkers for the cuts in the police force and sanitation departments, and also for the famous New York Post headline covering President Ford’s reluctance to bail out the city: “Ford to City - Drop Dead.” However, at the time it was actually quite difficult for a large city to meet the eligibility requirements for Chapter 9. In response, Congress altered the Chapter 9 bankruptcy codes in early 1976, making it easier for large cities to utilize Chapter 9. A few years later, in 1978, Cleveland defaulted on a few short-term loans, but through the valiant work of their city council managed to push through an 11th hour increase in the city’s income tax to avoid Chapter 9.

Today, California has been attracting attention as one of the hubs of public finance debacles on both the local and state level. Besides the well-publicized state budget problems, the Golden State has a long recent history of financial problems on the local level. The 1976 revisions in the Chapter 9 code are what enabled Orange County to file for bankruptcy in 1994. One of the county’s investment managers had parked its pension funds in derivatives that went sour, causing a sudden $2 billion loss. Even while the real estate market in Southern California was flying high in 2005, candidates campaigning for mayor in San Diego openly talked about filing for bankruptcy to close a swelling pension deficit. Four years later, they haven’t closed the gap. After teetering precariously on the edge of Chapter 9 for the last few years, recent news stories have reported that grand jury investigations into the city’s finances found that San Diego regularly skipped payments destined for the pension fund, while continuing to raise the pensions and benefits of public employees. Each year, avoiding Chapter 9 in San Diego has become a more arduous task, yet politicians seem to be playing the classic game of kick the can down the road.

Another California city brought to its knees by public pensions was the Northern California city of Vallejo in 2008. In this case, it was rather simple, brought about via high fixed costs in employee salaries and pension expenses. This reflects a greater problem throughout California and much of the United States. Due to the fact that California is generally a desirable place to live, the cost of living is high. As a result, public employee unions, which especially in Northern California have the ears of left-leaning politicians, have repeatedly secured lucrative contracts for their members, often in the form of campaign promises. Over the next few years, look for Chapter 9 to be used more often by municipalities across the nation to force renegotiations on public employees.

Obviously, this problem isn’t solely caused by generous contracts for public employees, nor is it confined to California. Along with the recent troubles in California, cities such as Harrisburg, Detroit, Phoenix, Cleveland, and even New York City are struggling to balance their budgets, and will likely witness budget standoffs on a yearly basis until the US experiences a sustained economic recovery. In response to the problems at local levels, states are emerging as the ones who seem willing to initiate cuts. The problems, as is the case on the municipal level, range from the usual suspects of underfunded pensions to outdated governmental structures and bureaucracies. Time magazine recently reported on the efforts of Nebraska state senator Rich Pahls to merge many of his state’s 93 counties. Similar programs in England during the 1960s and 1970s brought about today’s system of counties, while the old borders became “historic” counties. In Nebraska, this means forcing consolidation of road services, vehicle registration, and law enforcement, eliminating many local government jobs in the process. Pahl’s efforts have been quashed thus far, in part because “it seemed too frank an acknowledgement of the passing of small-town America.” With 16 of Nebraska’s counties having less than 20,000 residents, with a handful under 2,000, such measures will no doubt be necessary in the coming years.

Pensions, just as they are on a local level, are increasingly being revealed as dead weight that needs to be reduced in the new economic climate. For years, politicians have wooed public employee unions’ votes via promises of pension raises and benefit security, assuming the funds would always be there. In a tabloid mecca like New York City, there has been no shortage of stories covering relatively lavish retirements for selected public employees. The New York Times recently reported that nearly 3,700 retired New York State public employees earn more than $100,000 a year in pension payments, many who are barely in their 50s. Other such tales have made the news all over the nation recently. It is reflective of a growing public divide between public and private employees and the fact that public employees have found themselves living in parallel, yet separate, economic realities over the past decade. It is unfortunate to potentially need to cut the benefits of those who protect our property and teach our children. However, the fact is that during the past decade private sector employees, particularly in the auto, airline and a slew of other industries, have experienced constant downsizing, stagnant or decreasing wages, and are paying more for health care. Traditional pensions are a thing of the past for the private sector, now almost solely confined to the tax-supported public sector. Private sector employees fund their own retirement via 401(k)s and other such plans, which are subject to the oscillations of the economy. On top of that, public sector workers have always enjoyed a higher level of job security, which is one reason that it has always been a big deal when these sectors have experienced cuts.

As the economy remains uneasy, there is no doubt in my mind that a number of cities will end up filing for Chapter 9 as local and state budgets continue to deteriorate. However, this is unlikely to create a state of anarchy, although there will no doubt be a public outcry by any number of affected parties. With the way such occurrences have played out in the past, business will go on as usual for everyone except those who hold large portfolios of municipal bonds, and of course municipal employees. For practical reasons, when a city declares Chapter 9, it is able to continue its operations. The bigger problem with a Chapter 9 bankruptcy lies in store for a city’s creditors. Municipal bonds, due to their tax advantages, have long been a preferred investment for institutions all the way down to individual investors. While a Chapter 9 filing does not free a city from its debt obligations, it can be a mechanism through which municipal bonds can be terminated before their maturity. The last time so many municipalities had problems at once was, not surprisingly, the Great Depression. Considering that we have just experienced the worst economic downturn since the Great Depression, and municipalities across the country are currently reporting financial troubles, it is reasonable to surmise that municipalities are not out of the woods.

The day of reckoning is closest for municipalities, simply because the ramifications of an individual Chapter 9 filing are much less than a state becoming insolvent. Thus far, states have shown a better ability to push back their problems, while the municipalities deal with them first. Unless a true economic recovery takes hold, things will continue to make their way up the totem pole. A rash of local bankruptcies would place added pressure on states like California to fix the problems on the state level, and do it quickly. However, if that doesn’t happen, the problem would then be passed to the federal level. In the same way that when mortgage originators went bankrupt, next in line were banks that bought the soured loans and repackaged them. When the banks had trouble, eventually the government had to bail them out, adding to its own debt. The public finance debacle could shape up in a similar way. While I am not a doomsayer with regard to the possibility of high inflation from the debasement of our currency, if the government ends up bailing out the states in one way or another, the chances of higher inflation will immediately increase. This provides a reason to hope that governments on the local and state level, employees and elected officials alike, can get their act together. Just as the private sector has been forced to cut and hunker down, all levels of government also need to learn to live with the new realities.


Respectfully yours,
Matthew R. Green
July 5, 2010