The Californian city of Stockton went bust last month, one of three such casualties. Could this lead to a crisis in the municipal bond market? Matthew Partridge reports.
What happened?
In the past month, three municipalities in California – San Bernardino, Stockton, and the small ski resort of Mammoth Lakes – have voted to file for Chapter 9 bankruptcy protection. It’s the first time this has happened in California since Vallejo filed for bankruptcy in 2008.
Stockton is the largest city in the US to go bust for over 50 years, and San Bernardino the second-largest. As a result, Stockton, for example, “will suspend payment on bonds, cut the salary and benefits of municipal employees, end contributions for retiree’s medical insurance and modify labour agreements”, reports the FT.
However, it will be able to keep running services and paying workers and suppliers. Although Stockton had been in talks with its creditors, who hold $350m worth of debt, both sides failed to reach a deal. The Daily Telegraph reports that banks have already repossessed a building that was planned as Stockton’s new city hall, which cost $35m to build, and three city car parks.
Why did the cities go bankrupt?
While Mammoth Lakes’ troubles are mainly due to a legal dispute with a property developer, which resulted in a $43m judgement against it (more than twice its annual general-spending budget), the problems of Stockton and San Bernardino are more fundamental: poor cost control during the property boom, compounded by a collapse in tax revenues as the bubble burst. As The Guardian points out, Stockton was transformed by the housing boom from a “farming city into a distant bedroom community of the San Francisco Bay area”.
The bust left it with one of the worst repossession rates in the nation, and sliding property tax revenues. Meanwhile, the city gave overly generous compensation deals to staff during the good times, which it can no longer afford, says The San Francisco Examiner.
“Public-sector workers were given a contract that allowed them to retire with benefits that amounted to up to 90% of their final salary, for as long as they lived. And they could retire as soon as they were 50 years old, living 30 more years on their most lucrative pay base.”
Why is this such a big deal?
As Nicole Gelinas points out in the US magazine City Journal, municipal bonds, issued by US cities, states and state agencies, have been seen as virtually risk-free. Historically, they have had very low default rates: even “in the Great Depression, municipal-bond investors lost a tiny one half of one percentage point of their money. Between 1970 and 2000, no investor took a loss on a state’s or a city’s general-obligation debt,” notes Galinas.
This is partly because local and national laws make it very hard for a municipal issuer to declare bankruptcy. Defaulting will deny them the access to the credit markets that they need to fund day-to-day operations. There is also the assumption that the Federal government will bail out most large cities and states.
However, similar arguments were made regarding mortgage-backed securities. Yet just as the housing crisis led to a large number of delinquent loans, the debt burden may force more cities to default. “Once state and local governments have borrowed too much, they may well find a way not to pay their lenders back.” Indeed, there have been calls to make it easier for states to go bankrupt (see below).
Will other cities follow suit?
“Cities are running out of options,” Michael Sweet, a partner specialising in bankruptcy at law firm Fox Rothschild, tells Bloomberg. “As they see pension contribution obligations and retiree health-care costs going through the roof, revenue is at best stable if not declining.”
However, whether or not they opt for bankruptcy could depend on the deal Stockton gets from its bondholders, says Matt Fabian of research firm Municipal Market Advisors. “Stockton could set important precedents for how different types of creditors are treated,” notes The Guardian.
The lawyers representing Stockton also worked for Vallejo when it filed for bankruptcy. “The former Navy town emerged last year from bankruptcy with sharply reduced payments for its retiree medical programme.”
How is the bond market reacting?
Calmly, so far. A recent bond sale by the state of California went so well that the yield on the bonds actually fell. Fabian is also bullish, pointing out that Stockton’s problems have been priced in. As long as US interest rates remain low, investors will find municipal bonds attractive due to their higher yields and tax-free status.
However, the New York Post notes that last year JP Morgan circulated an early warning report to “a few big clients”, which looked at “which states and cities are most likely to default on their debt as their pension liabilities fester”. Bond market complacency may yet backfire.
Should states be allowed to go bust?
Former Florida governor Jeb Bush and ex-Speaker Newt Gingrich have argued that it should be easier for states to declare bankruptcy. They claim that “voluntary bankruptcy offers taxpayers the option to restructure state finances responsibly to achieve long-term fiscal health — which can only improve California’s bond rating since it is the worst in the nation”.
However, the New York Post’s Nicole Gelinas disagrees, claiming “the complications of the municipal-bond markets make this plan hopelessly naïve”. She points out that “states like New York run up ‘their’ debt indirectly. They issue bonds through tens of thousands of separate legal entities.”
Overall, she thinks that “states’ problems aren’t pretty. The solutions may be messy. But bankruptcy wouldn’t be a messy answer; it would be no answer at all.”