When Cities Go Bankrupt

Municipal failure is bad for creditors and unions, but potentially good for taxpayers.

I must doff my hat to Charles Gasparino. Early last year, the fiery Fox Business Network correspondent and I were brought together for a few bread-and-circuses TV debates on the topic of municipal bankruptcy. We were both keying off some late-2010 comments that CNBC banking analyst Meredith Whitney made to the effect that the U.S.A. might see "50 to 100" municipal defaults in the near future. I argued that many city governments were indeed headed for insolvency and Gasparino countered that the problem was not as grave as Whitney claimed.

The nearly two years since have proven Gasparino more right than Whitney. According to Governing magazine, there were only 28 public bankruptcies in 2011 and 2012.

But that's still a substantial increase in defaults. There have been 640 public bankruptcies since 1937 (when federal public bankruptcy rules were established), a rate of about 8.5 cities, counties and (in most cases) public utility districts going belly-up per year. But even at a new rate of 14 muni defaults per annum, it's a slow-moving apocalypse at worst.

Or maybe I should say, at best. As I have argued (see "Worse Than the Recession," October 2012), dragging out the pain of bankruptcies, foreclosures, deflation, and reorganization doesn't fix or even moderate the problem. 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.

And make no mistake: Bankruptcy, municipal bankruptcy in particular, is powerful medicine. Bond holders hate it because it requires them to take a hit on what were thought to be ultra-safe investments. Public finance experts hate it because it limits—though it does not totally eliminate—their ability to take on more debt in the future. (Boo hoo!) But here's the good part: Nobody hates municipal bankruptcy more than government employee unions.

That's because bankruptcy is the best bet most cities have for getting out of their crushing health and retirement obligations to public workers. While many reformers —including many liberal good-government types who see how the pension crisis is slowly paralyzing activist government—want to renegotiate these contracts, this is almost impossible to do. California (where the pension crisis is most acute) has a voluminous history of court decisions generally ratcheting up protections for public worker contracts and prohibiting governments from making any changes. Beyond the legal question, there is an ethical argument: Sanctity of contract, no matter how stupid or vile the parties may be, is not to be thrown aside lightly.

But the United States has established bankruptcy provisions for a reason: to give hopeless debtors a way out that minimizes damage. The 19th-century move away from a universe of debtors' prisons to a legal framework that allowed debts to be discharged in court was an important step in the creation of modern finance. Chapter 9, which treats municipal bankruptcy, was added to the U.S. Legal Code during the Great Depression to give shelter to underwater cities for which tax hikes were not an option.

Many towns around the country are in that boat today, and while the long stagnation that began in 2007 usually gets the blame, the recession merely revealed a pre-existing problem. In California, two large cities (Stockton and San Bernardino) and one small one (Mammoth Lakes) defaulted this year; another large city (Vallejo) went bankrupt in 2008. Last year Jefferson County, Alabama, became the second-largest public bankruptcy in modern times (after 1994's default in Orange County, California). Although only 24 states allow cities to file for bankruptcy, Fitch Ratings in August updated its criteria for rating local government bonds, with the note: "Fitch believes that in an extreme case the state would make the legal provisions necessary to file.…Therefore, Fitch makes no distinction…between entities in states that allow for local government bankruptcies and those that do not."

History backs up Fitch's decision. Everybody knows the New York Daily News headline "FORD TO CITY: DROP DEAD," and New York's 1975 fiscal crisis is now remembered as a near-bankruptcy. But this legend is wrong. A month after the Snooze's page 1 howler, President Gerald Ford did deliver federal assistance to New York. Around the same time, the state government allowed the city a three-year moratorium on bond payments. Although the Empire State's Supreme Court ultimately reversed that moratorium, the city's creditors took a massive loss in the meantime. The Big Apple defaulted in all but name.

As you may have noticed, New York survived and ultimately prospered, as did Orange County. Vallejo—having renegotiated city worker pay and health benefits in bankruptcy—is also doing comparatively well these days.

Government employee compensation, mostly for health and retirement, is at the heart of nearly all the current and looming municipal bankruptcies across the country. Whether the economy is truly recovering or not, getting out of these obligations is essential for future fiscal sanity. Leaving aside the gross unfairness of putting taxpayers on the hook for these debts, it's just not possible to raise taxes high enough to cover the country's $3 trillion pension hole. That leaves bankruptcy as the most viable option.

But even that is a long shot. In the Golden State, union-backed Assembly member Bob Wieckowski (D-Fremont) got a law passed in January 2012 making it harder for bankrupt cities to discharge their contractual obligations with investors and public-employee unions. Even insolvent Vallejo ended up leaving its pension obligations alone.

Nevertheless, municipal bankruptcy offers a real chance to solve the most important problem in local government today. Bankruptcy is never pretty, but it's not the catastrophe that media and politicians pretend it is. It's certainly a better option than continuing the combination of cutting services and raising taxes.