SAN FRANCISCO — California should brace for more municipal Chapter 9 filings as its local governments continue to strain under the weight of national economic burdens and local policies, according to bankruptcy and market experts.
That wave may be more of a splash than the tsunami some doomsayers have predicted, however.
In less than a month, Stockton, Mammoth Lakes, and this week San Bernardino, have all moved toward bankruptcy. Stockton and Mammoth Lakes have filed, while San Bernardino’s City Council voted to authorize a filing, marking the first Chapter 9 filings by California cities or towns since Vallejo in 2008.
The quick burst of bankruptcies is like nothing ever seen in the state in such a short period.
The last general municipal governments to file for bankruptcy in California were Desert Hot Springs in 2001 and Orange County, the state’s largest bankruptcy case ever, in 1994. There have also been filings by other public entities, such as hospital districts.
“Do I believe there will be more in California? Yeah,” said Richard Larkin, head of municipal research at Herbert J. Sims & Co. “I think that California municipal leaders are starting to look for the easy way out.”
Echoing Larkin’s concerns, Municipal Market Advisors released a report Wednesday following San Bernardino’s decision saying it “believes the decision, and the speed in making it, is worrisome in that it may suggest that the stigma of bankruptcy is waning among issuers in California.”
Bankruptcy didn’t turn out to be a cakewalk for Vallejo, which spent three years and more than $12 million on its Chapter 9 process. It still hasn’t returned to the market to sell bonds since emerging.
What is pushing municipalities toward bankruptcy now, some observers say, is a complex web of difficult fiscal issues, some of which are specific to the Golden State, that have left the hardest hit and most poorly managed municipalities teetering.
“Yes, there are a lot of municipalities in California that should be thinking about taking steps to restructure,” said Karol Denniston, an attorney with Schiff Hardin who helped draft California’s recent AB 506 legislation that created a mediation process meant to help local governments avoid bankruptcy. “The hope will be that we can learn from someone else’s problems.”
Many of the problems in California are also common nationwide. Local governments are struggling with recouping tax revenues lost during the combined housing meltdown and recession and slow economic recovery. And like California, many are trying to find ways to lower pension and retiree medical benefit costs.
Similar factors spurred the Central Falls, R.I., bankruptcy.
Stockton and San Bernardino were hit hard by the recession and real estate crisis; they are in regions with some of California’s highest unemployment and foreclosure rates. San Bernardino has a jobless rate of 15%.
Mammoth Lakes is an outlier; like Desert Hot Springs in 2003. It is a small town that filed for bankruptcy after losing a lawsuit brought by a developer, and faces a hefty judgement.
California also has unique factors that influenced the Stockton and San Bernardino situations.
Experts interviewed for this story pointed to side effects stemming from 1978’s Proposition 13 property tax limits. The measure set a base 1% property tax rate and restricts the growth of assessed property values to 2% a year until a property is sold.
The result is that California cities lack authority to change property tax rates and must look elsewhere for tax revenues from sources that are often more volatile.
Stockton and San Bernardino are among many California cities that experienced an extreme housing bubble and an ensuing big burst — property taxes revenues jumped and then fell off a cliff, and will be slow to climb back.
“Maybe it’s time to consider does [Prop. 13] really work — should we have more available sources of tax revenue for certain municipalities?” said James Spiotto, a bankruptcy expert with the law firm Chapman and Cutler LLP in Chicago.
Spiotto said he doesn’t think the three recent bankruptcy decisions in California necessarily make a trend, but he added that people need to start taking a hard look at oversight and how to help municipalities raise revenues.
The Proposition 13 era set up a love-hate relationship between cities and the state government, which collects taxes that are then redistributed to local governments to help replace the loss of property tax revenue. Municipalities have complained for years about lawmakers’ “raids” on those revenues during down years.
“It also doesn’t help that every time there is a recession the state itself goes into a budget funk,” Larkin said. “In California it is common — every time there is a slowdown you see the same thing.”
Most recently this took the form of the dissolution of redevelopment agencies, which collected incremental property tax growth in redevelopment zones ostensibly to spur economic development.
The end of the RDAs may be the last straw for many local governments.
“It is sort of the last hole in the dike before the flood starts,” said Larry Kosmont, a local government consultant who recently served as interim city manager in troubled Montebello, Calif. “You started out with a bad economy, you started out with increasing pension contributions and underperforming PERS [California Public Employees’ Retirement System] actuarial results, and then it grew to the loss of redevelopment and the problem was that cities didn’t respond quickly to the first two events.”
Many California cities, including Stockton and San Bernardino, had complex, intermingled financial relationships with their redevelopment agencies.
Kosmont said those relationships set up two lines of credit, long-term and short-term, “and all of that got pulled in a matter of 60 days.”
All of those issues are further complicated by the potential for mismanagement and poor financial disclosure as seen recently in several California cities, such as Hercules and Bell, leaving them few options. The state’s cities require a vote of the people to impose a new tax or increase an existing one.
Even with the headlines about bankruptcies in California, the market is likely to remain calm.
Municipal Market Advisors said in report Wednesday that it doesn’t expect near-term weakness in the market because of San Bernardino’s decision.
“Having been shocked out of their bonds in late 2010 and then 're-educated’ on the strength of individual municipal credits by the broker-dealer, asset management and analyst communities, retail investors are now much less likely to worry about knock-on impacts to their own portfolio from drama in a single city,” the MMA report said.
Larkin said in a report Wednesday that the “headline risk” that has been created by the recent California bankruptcies may present an opportunity.
“For intelligent investors, the California market will continue to offer bonds issued by well-run local governments,” Larkin said.
San Bernardino’s news appeared to come out of the blue, after both Stockton and Mammoth Lakes engaged in the AB 506 mediation process.
San Bernardino officials say the depths of their problems only became apparent recently and that the city may be able to take advantage of a provision in AB 506 allowing cities that declare a fiscal emergency to skip mediation.
The City Council is expected to decide that on Monday.
The city may file within 30 days, interim city manager Andrea Travis-Miller said in a statement Wednesday. Officials said the city is in danger of missing payroll on Aug. 15.
“If San Bernardino follows through and files in 30 days, it is going to be the poster child for what not to do, ” Denniston said.
San Bernardino, a city of more than 211,000, 65 miles east of Los Angeles, faces a $46 million deficit for fiscal 2013, according to city officials.
Its city attorney, James Penman, clouded the situation further by telling the City Council Tuesday that the city has misstated its financials for 13 out of the last 16 years, raising questions about whether the city misled bond investors during that period.
“What a Chapter 9 filing will provide us is some relief while we develop and institute a sound and realistic budget and financial practices for the city,” Travis-Miller said.
