Bankrupt Cities

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.  

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  1. So Cavanaugh continues to exist, eh? (Or at least he did three months ago when the January 2013 issue was put together.)

    1. I think it’s actually the Cavanaughbot 3000 being run by The Jacket now.

    2. I wish Reason would lets us know what happens to some people. Like Cavanaugh, he’s been here for a long time and now he’s vanished.

      1. He moved to VA and he just writes for the mag now. He did not vanish. Just day in, day out, us, must get old.

      2. Maybe he got a job with the Jerry Brown administration.

      3. From the staff page it looks like he left california to go into the movie business.

  2. And the people who rely on these pensions in their retirements, like my father who was a high school teacher for 35+ years?

    Don’t know ’em, don’t owe ’em!! Libertopia 2016.

    1. More than likely the pensions will be lowered not completely eliminated.

      “Don’t know ’em, don’t owe ’em!! Libertopia 2016.”

      Why should the grandchildren of your fathers generation be forced to lay off current teachers to pay for long ago retired teachers (or cops, fire fighters, city workers, etc)? Realistically that’s the decision that must be made.

      More specifically, why should I be bound by very generous benefits given out by a politician in order to buy votes from civil servants 40 years ago?

      1. The current government union members hopefully see the reality of what’s going on, and now live in fear of losing their retirement as the rest of us on Social Security do as well. That fear might lead to them actually promoting downsizing government.

        1. I wouldn’t hold my breath on that one. Look at the union that put Hostess under. They KNEW they would lose their jobs if they didn’t agree to the contract.

    2. It’s cute how people like this really just cannot comprehend the idea of there literally not being enough money.

      To your father I’d say: You had it good for a while, but unfortunately there’s no more blood in the turnip. Sorry. If 75% of your pension isn’t good enough, go find a better deal in the private sector.

    3. Those relying on pension promises have a duty to make sure they are fully funded from the start, rather than conniving at decades of underfunding and then expressing shock that an insolvent city is not ready to tax and cut itself into oblivion to pay an unfunded promise.

      State and local government employees should have standing to sue in Federal court to require full funding of foreseeable pension liabilities each year. If they don’t, then “silence is consent,” and the underfunded promise may eventually be converted to its 401K equivalent. If they do sue, of course, they take the risk that the politicians responsible for excessive promises will be voted out of office.

      States and localities should be required to keep up on Social Security and Medicare payments as a minimum.

  3. It’s naive to think the problem is because of pensions per se. Sure, it IS because of pensions in one regard, but the reason pensions are so out of hand is the explosion of the scope of government services provided in recent times(even at the local and state level). The more services municipalities decide to provide, the more government employees they end up taking on, complete with their own massive benefits package and pension requirements. In the long run, local governments can’t operate that way(like the federal government can) because the ‘high rollers’ can almost always move between cities, counties, or even states relatively easily to escape the parasitic underclass that pays no taxes and leeches off government largess.

  4. As cities get in worse shape, I expect there will be some politicians who see this as an opportunity to get elected, by promising more funds to spend in the city, by going thru bankruptcy. Rather than protecting the government union workers, they will protect the taxpayers who far outnumber the union members. And the unions will have no one to blame but themselves.

    It will also be funny to watch Democrats, who’ve been using government to steal for them, to accuse these politicians of using government to steal from them. After all, it’s been mostly Democrats who’ve worked so hard to get government in the “redistribution” business whereby government steals from some only to give to others. Both classes of Democrats have been playing this game: the Democrats living on government assistance, and the rich who use government power to further enrich themselves. The more power government has to pick winners and losers, the more power the rich will have relative to the rest of us. That is until the money runs out and government can no longer pick winners and only choose who loses. Then Democrats will turn on each other as they fight for the dwindling share of loot.

  5. And that’s just what’s on the books. If you want to get really scared about your city’s financial health, see Hint: the cities have NO accounting of their long term liabilities in terms of replacing roads, sewers, etc. and generally have zero set aside for it. Moreover, while those living in the dense urban core MAY be paying their way in taxes (because it costs less to provide those services in the urban core), most suburban homes (read: the majority of tax payers) are paying but a small fraction of what they should be paying.

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