City bankruptcy 101

Forbes/ Jed Kolko, Trulia Chief Economist, 7/13/12 "My city went bankrupt. Should I FLEE?  

Trulia’s Chief Economist takes a deep dive into what causes a city to file for bankruptcy and whether homeowners living in those city should get out of town.

In recent weeks, three California cities have filed for bankruptcy: Stockton, in the Central Valley; Mammoth Lakes, near Yosemite and the Sierras; and San Bernardino, in the sprawling Inland Empire east of Los Angeles. If you live there, should you get out of town? And if you don’t live there, should you worry that your city is next?  In short: no, and no. Here’s why.

What does it mean for a city to be bankrupt? Cities can file for bankruptcy if they are insolvent or are unable to pay debts that have come due. When in bankruptcy, the city doesn’t have to pay its creditors while it negotiates a plan for dealing with its debts. Despite the recent bankruptcy filings in California, municipal bankruptcies are extremely rare. Because cities have the power to tax, most have a hard time convincing a bankruptcy court that they truly cannot pay their debts. Few cities file for bankruptcy in the first place, and in the past few years, only Vallejo, CA, and Central Falls, RI actually went into full-fledged bankruptcy. Despite predictions of recession-stressed cities falling like dominos, the vast majority of cities have managed their finances well enough to avoid default or bankruptcy.

What causes cities to file or go bankrupt? The housing crisis played a supporting role: lower home prices led to lower property tax revenues, which many cities depend on for revenue. But other revenues that many cities depend on, like sales taxes, fell too. Most importantly, pensions and other long-term financial obligations have increased, stressing city budgets. Random factors trigger city bankruptcies, as well: Mammoth Lakes, CA, and Boise County, ID, filed for bankruptcy after losing big lawsuits, and Orange County, CA was pushed over the cliff in 1994 by risky investments. Most places with huge home-price declines, including Arizona, Nevada and Florida, haven’t had municipal bankruptcies. Why the recent rash of bankruptcy filings in California? One reason is that California’s cities have less control over their own revenue than cities in most other states do: Proposition 13 – which caps both the property tax rate and annual assessment increases — and other rules severely limit California cities’ options for raising revenue.

What happens when a city files for bankruptcy? It’s hard to say what’s typical since bankruptcy is so rare. One thing we can say is that city employees – including retirees – take a big hit. As a result of bankruptcy, Vallejo cut back its contributions for retired city employees’ health insurance premiums, and Central Falls reduced employees’ pensions. Even if a city doesn’t go bankrupt, the bankruptcy filing itself can be enough of a threat for unions, creditors and others to whom the city owes money to re-negotiate contracts so that the city can lower its expenses. In other words, filing for bankruptcy can be a “catalyst for generating serious dialogue regarding a city’s finances.” At the same time, bankruptcy is not an instant or easy solution to a city’s fiscal problems. In Vallejo, the bankruptcy process took three years and was painful, with cutbacks to police and other local services. And bankruptcy makes it more expensive for the city to borrow in the future.

Back to our original questions: Should you flee? Should you worry? If your city has filed for bankruptcy, don’t panic. There may be more pain to come, but the big price declines or cutbacks in services probably already happened. Bankruptcy should be the beginning of a solution to a city’s financial problems; it is not itself the problem. Bankruptcy means your city now might have a chance to get its fiscal house in order. What about your own house? By the time your city files for bankruptcy, it’s too late: declining home values are more cause than effect of city bankruptcy. Poor city services reduce housing demand and can hurt prices, but bankruptcy itself doesn’t cause city services to disappear. Struggling cities will cut back on services long before they go bankrupt.

And if your city hasn’t filed for bankruptcy, remember that bankruptcies are extremely rare. Instead, worry about your city’s financial health long before it files for bankruptcy. Although some bankruptcies are sudden or surprising, the declining revenues and – especially – the rising pension and retirement obligations have often been going on for years, long before bankruptcy is even considered.  Better to worry when there’s still time to do something about it.

Note: this post draws heavily on a report by Tracy Gordon, a municipal finance expert at The Brookings Institution, and a report published by Michigan State University.

Submitted by Jim Alex

Posted by Kathy Meeh