Policy Documents

Research & Commentary: Stockton, California and Municipal Bankruptcies

April 15, 2013

According to Governing magazine, there were 28 public bankruptcies in 2011 and 2012. Although that number fell short of many experts’ predictions, it still represents a significant increase in defaults.

Of the dozens of cities considering bankruptcy, Stockton, California is the largest and has received the most attention. A recent court decision should allow Stockton to continue its path through bankruptcy court, which some experts believe could lead to more cities moving in this direction to manage their debt.

During the housing crisis, Stockton spent millions on urban revitalization projects, including a theater complex, sports arena, waterfront walkway, and marina. And as the city’s property tax revenue grew, the government sweetened the benefits packages for city employees—a worker could become eligible for full retiree health care benefits after only one month of city employment. Stockton now faces a total long-term health care liability of more than $400 million.

The other problem Stockton faces, as do many other cities, is the growing liabilities of government worker pensions. Stockton is currently paying 94 pensions worth at least $100,000 a year. The municipal government took many steps to attempt to stop the bleeding: It cut employment costs, renegotiated labor contracts, cut employee health benefits, and even scaled back the local police department. But the measures were too little, too late.

Stockton financed many of its major projects through municipal bond offerings. Although muni bonds are a viable method of raising funds for projects, many municipalities have become overly reliant on the bonds and are beginning to have difficulty paying them down. Stockton’s bankruptcy could have a wider effect on the nation’s muni bond markets. Stockton is likely to reduce its bond debt in court; the creditors who lose out in the process may be less likely to invest in similar ventures in the future, possibly harming bond markets.

Cities like Stockton have relied on property tax revenue as an endless cash cow for far too long. Instead of making excessive promises to employees and building projects they cannot afford, cities should make long-term plans that embrace a competitive tax structure that provides more reliable revenue.

Fixing pensions is a more serious problem, but solutions do exist. In the short term, per-year pension payouts should be capped at a sensible level, the retirement age should be raised, double-dipping should be eliminated, pension rate of return assumptions should be changed, and workers should be required to make higher contributions. Long-term, governments should move away from pensions to 401(k)-style defined-contribution plans that allow governments to lower their pension costs while giving employees control over their retirement plans.

The following articles examine municipal bankruptcy and how Stockton’s experience could affect other cities nationwide.


How Stockton Went Bust: A California City's Decade of Policies and the Financial Crisis that Followed
http://heartland.org/policy-documents/how-stockton-went-bust-california-citys-decade-policies-and-financial-crisis-foll-0
In this report from California Common Sense, Sydney Evans, Bohdan Kosenko, and Mike Polyakov cite the three main factors contributing to the Stockton bankruptcy. 

What Stockton’s Bankruptcy Means for the Rest of Us
http://reason.com/archives/2013/04/04/what-stocktons-bankruptcy-means-for-the
In the aftermath of the legal decision accepting Stockton’s bankruptcy petition, Andrew Napolitano writes about the likely outcome of such overspending and unrealistic pension promises: “[T]he odds are that the states and the similarly situated Stocktons in America will go to the Obama administration and ask for free cash. And the president will no doubt find it for them. That ‘found’ cash will be borrowed from the Federal Reserve and, like all of the federal government’s debts to the Fed, will never be repaid. But countless generations of American taxpayers will make enormous and endless interest payments on it.”

‘Defaults Will Outstrip Bankruptcies,’ Economist Says
http://news.heartland.org/newspaper-article/2012/10/30/defaults-will-outstrip-bankruptcies-economist-says
The federal and state governments may receive most of the attention for what are widely acknowledged to be unsustainable fiscal policies, but local governments also have unsustainable policies of their own. The Heartlander digital magazine reports on an event at DePaul University in Chicago discussing local governments’ problems with debt and possible bankruptcy, where California State University-San Bernardino finance professor James Estes argued, “Defaults will outstrip bankruptcies.”

Moody’s, Others Worry About Municipal Bankruptcies to Come
http://news.heartland.org/newspaper-article/2012/07/24/moodys-others-worry-about-municipal-bankruptcies-come
The Heartlander digital magazine reports on the market’s reaction to the increasing number of municipal bankruptcies: “‘The looming defaults by Stockton and San Bernardino raise the possibility that distressed municipalities—in California and, perhaps, elsewhere—will begin to view debt service as a discretionary budget item, and that defaults will increase,’ Anne Van Praagh, a Moody’s managing director, said in a published report.” 

Give States a Way to Go Bankrupt
http://www.weeklystandard.com/articles/give-states-way-go-bankrupt_518378.html?page=3
Writing in the Weekly Standard, David Skeel argues that although government bankruptcy isn’t perfect, it’s far superior to any of the alternatives currently on the table. Skeel says governments should be given a means to address their debts in court, if only to give the federal government a compelling reason to resist the urge to bail out these governments. 

When Cities Go Bankrupt
http://news.heartland.org/newspaper-article/2013/01/08/when-cities-go-bankrupt
Tim Cavanaugh of Reason argues municipal bankruptcy offers a real chance to solve the most important problem in local government today. Although bankruptcy is never pretty, it is not the catastrophe that media and politicians claim, Cavanaugh states. “Dragging out the pain of bankruptcies, foreclosures, deflation, and reorganization doesn’t fix or even moderate the problem,” he writes. “It just zombifies things, resulting in a stagnant economy that causes more cumulative pain, over a longer period, than you would have had to endure if you’d taken your lumps all at once.”

Municipal Bankruptcy: An Overview for Local Officials
http://www.statebudgetsolutions.org/publications/detail/municipal-bankruptcy-an-overview-for-local-officials
This guide from State Budget Solutions provides an overview of the basics of municipal bankruptcy and boils down the process to give officials and citizens a framework within which to discuss whether bankruptcy is a viable option.

The Risks of a Municipal Debt Bubble
http://news.heartland.org/newspaper-article/2011/02/21/risks-municipal-debt-bubble
Veronique de Rugy of the Mercatus Center argues municipal debt could create a new bubble and possibly result in another major government bailout:The parallels with the housing bubble are worrisome. Before the meltdown, mortgages were perceived as low-risk investments. Both lenders and borrowers had faith nothing would go wrong—and that if anything did go wrong, Washington would save the day.” She concludes, “The state and municipal debt crisis could culminate in a request for the third near-trillion-dollar bailout of the last two years. That much federal borrowing on top of the current debt could very quickly have an impact on interest rates and on the dollar.” 

Research & Commentary: Public Pensions and the Assumed Rate of Return
http://heartland.org/policy-documents/research-commentary-public-pensions-and-assumed-rate-return
The Heartland Institute’s Matthew Glans argues the expected rates of return on pension funds should be lowered to reflect the market. In states and municipalities across the country, the high cost of traditional defined-benefit public pensions has become a hot-button issue as unfunded liabilities have raced out of control. These increasing liabilities are further complicated by the fact that in many instances the regulators controlling pension funds have overestimated the value of future investments and the rate of return they can expect from the investments held by the pension fund.

Political Will and Fiscal Federalism in Municipal Bankruptcy
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1793173
Clayton P. Gillette suggests that allowing bankruptcy courts to impose tax increases serves to neutralize the strategic behavior of local officials and thus encourages localities to internalize the costs of their activities in a manner more consistent with the tenets of fiscal federalism. 

States of Bankruptcy
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1907774
Should Congress provide a bankruptcy option for states, or would that be a mistake? Instead of an “on the one hand, on the other hand” assessment, David Skeel structures his analysis as a case for allowing bankruptcy, using all the theoretical, empirical, and historical tools currently available.

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the FIRE Policy News Web site at http://news.heartland.org/insurance-and-finance, The Heartland Institute’s Web site at www.heartland.org, and PolicyBot, Heartland’s free online research database, at www.policybot.org

If you have any questions about this issue or The Heartland Institute, contact Heartland Institute Legislative Specialist Matthew Glans at 312/377-4000 or mglans@heartland.org.