Dogfight Ahead in Stockton, CA Bankruptcy

A precedent-setting government spending case likely headed to the Supreme Court.

On Monday, U.S. Bankruptcy Judge Christopher Klein ruled that the city of Stockton, CA, will be allowed to enter bankruptcy. Klein noted the move was necessary so that the city could continue to provide basic municipal services to its residents. "It's apparent to me the city would not be able to perform its obligations to its citizens on fundamental public safety as well as other basic government services without the ability to have the muscle of the contract-impairing power of federal bankruptcy law," Klein said. Yet the real story has yet to unfold: it must still be determined whether the city's creditors or its public employee retirement funds get paid off first.

Klein himself was unsure. "I don't know whether spiked pensions can be reeled back in," he said during his ruling. "There are very complex and difficult questions of law that I can see out there on the horizon."

The biggest part of Stockton's debt is the $900 million it owes to the California Public Employees Retirement System (CalPERS). Since this is the first Chapter 9 bankruptcy case challenging state pension obligations, what Klein is essentially referring to is whether the 10th Amendment of the Constitution preserving states' rights trumps federal bankruptcy law. Thus, it is likely this case will eventually end up before the U.S. Supreme Court.

During the hearing, Klein twice noted that the city's creditors had acted in bad faith, referring to the reality that they had refused to negotiate with the city unless it cut its payments to CalPERS during the 90 mediation period required by state law. The creditors challenging the city are the ones who lent it $165 million in 2007 to fund CalPERS. The debt associated with CalPERS skyrocketed during the recession, when Stockton property values plummeted, leaving the city unable to meet its pension obligations. The creditors had sought to keep the city out of bankruptcy because it will enable Stockton to avoid repaying what it owes in full. Toward that end, they argued Stockton had not sufficiently cut expenses or raised taxes. City attorneys contended they had cut their expenses to the bone. The judge agreed with the latter assessment.

"The creditors got a big black eye today," said Karol Denniston, an attorney who helped draft the legislation guiding the mandated mediation process that preceded the bankruptcy protection filing. "Now the stage is set for the real dogfight." Despite the ruling in the city's favor, Bob Deis, Stockton's city manager, was less than enthused. "There's nothing to celebrate about bankruptcy," he said. "But it is a vindication of what we've been saying for nine months."

It's a Pyrrhic vindication. During the go-go years preceding the real estate crash, this bedroom community of San Francisco passed several bond resolutions to fund new municipal buildings. Public employees were promised overly generous pensions, as well as the state's most generous healthcare plan: lifetime benefits for each retiree plus one dependent--irrespective of how long they had worked for the city. Since then, Stockton has tried to restructure some of its debt by cutting employment, slashing services, renegotiating some of their labor contracts, and cutting some of those health benefits.

The cutbacks, especially those in the Police Department, which now only responds to emergencies in progress, has turned the city into a war zone. The murder rate is four times the national average, and the sobering reality is that 1-in-17 city residents face the likelihood that their car will stolen, or their house will be broken into, this year alone. In short, Stockton has become one of the most dangerous cities in the nation.

Nevertheless, the city's creditors are arguing that the pain of bankruptcy should be shared, and that currently untouchable pensions negotiated when the city thought the boom years would last forever should be part of the equation. It is expected that creditors will address this reality in the next phase of the process. "That's where it will be precedent-setting," contended Denniston. "Does bankruptcy code apply to CalPERS or not? If bankruptcy code trumps state law, then that's huge and it has huge implications in terms of what happens next for other municipalities across California."

The state pension plan manages $255 billion in assets, but it is dealing with an $87 billion shortfall. CalPERS is determining new rates to offset the deficit, but those rates will more than likely put additional strain on at least two dozen other cities in the state, including San Bernardino, San Jose, Compton, Fairfield, Watsonville, and Atwater. If an eventual ruling comes down that allows cities to stop fully funding CalPERS by declaring bankruptcy, many of them may follow Stockton's lead.

Yet in the bluest of blue states, it is likely that the progressive worldview will prevail. "Greedy" Wall Street bondholders will be expected to take the hit, while "put upon" public sector employees will have their pensions and health benefits, bloated as they may be, preserved. Yet such inevitable posturing obscures the reality that 75 percent of outstanding muni bonds are owned by small, mom-and-pop retail investors, whose own pensions and healthcare costs were to be underwritten by their investments in the ostensibly "safe" securities that muni bonds represented.

Until now.

And it is precisely that uncertainty that could reverberate far beyond Stockton. Since the 1930s, and possibly earlier, bond holders involved in major municipal bankruptcies have had their principle repaid in full. If that equation changes? As of now, the $3.7 trillion U.S. municipal bond market is a major source of funding for cities and towns across the nation, many of whom would be forced to file for bankruptcy should that funding dry up.

Many muni bond sellers dismiss this reality. Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, expressed the prevailing attitude. "There are lots of areas where the city can go before looking for a big discount from bondholders," he said. "We don't think it will be as much a negative as many believe." Peter Hayes, head of the municipal bonds group at BlackRock, which oversees $109 billion, echoed that assessment. "We've seen this coming for quite some time and the market has expected it, so it's not the big attention grabbing headline that would necessarily create volatility or a selloff in the market," he said.

Of course, this attitude is eerily reminiscent of the prevailing attitude that preceded the collapse of the real estate bubble in 2007. That crisis too was allegedly  "contained."

To reiterate the other side of the equation, if the ultimate determination here is that cities burdened by unsustainable public employee contracts can get even partial relief from those contracts via bankruptcy, that too will drive many of them to embrace insolvency. Thus, one way or the other, the eventual outcome of this case will be precedent-setting.

A partial solution for the future comes to mind. Perhaps every major municipality in the nation should constitute some sort of citizen review board that would be invited to the party whenever government and union officials negotiate public service employee contracts. Such a change would go a long way towards ensuring that the people who actually pay for those contracts have a voice at the table. For far too long, the quid pro quo of unions donating large campaign contributions to politicians who, once elected, are expected to negotiate municipal contracts with those same unions, has been left unchallenged. Yet it is plain that such an arrangement has, in numerous cities across the nation, amounted to nothing less than legalized collusion. The city of Stockton is the latest example proving such an arrangement is unsustainable. Sadly, it won't be the last city to do so.

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