How To Avoid Bankruptcy (If You’re A City)

The city of Stockton, Calif., filed for federal bankruptcy protection Thursday, becoming the largest city in U.S. history to do so.

Some worry it’s part of a wave. Six other municipalities have filed for bankruptcy protection this year. That’s roughly on track with last year’s pace, which saw 13 bankruptcies — the most in two decades.

A wave of municipal bankruptcies could be the country’s next big financial crisis, several Wall Street analysts have warned.

But others dismiss such predictions. Bankruptcies like Stockton’s are prominent because they are so “colossally rare,” says John Mikesell, a public finance expert at Indiana University. He points out that there are more than 80,000 units of local government nationwide: cities, counties and independent entities such as school districts.

“Since the mid-1930s, there have been less than 600 municipal bankruptcies,” Mikesell says. “You can see just how black a swan they are.”

Still, local governments across the country are struggling. Their revenues have been hit hard by falling property tax receipts and cuts in aid from state governments. In 2011, cities saw their fifth straight year of declining revenues, according to the National League of Cities, with no turnaround yet on the horizon.

For that reason, mayors and city managers in California and elsewhere have been made nervous by Stockton’s problems, worrying that the contagion could possibly spread. Here are a few ways other cities may be able to avoid Stockton’s fate:

Buy Now, Pay Now

Local governments often use bonds or other forms of borrowing to pay for capital projects such as new buildings and roads. The problem in Stockton and other places that have gone bust in recent years, such as Harrisburg, Pa., and Jefferson County, Ala., is that they became overly ambitious in both building and borrowing.

But a more general problem is that local governments — which devote about 80 percent of their spending to labor costs — have been pushing those costs down the road, offering employees generous pension and retirement health benefits in lieu of salary increases. Now, many can’t afford the costs for both current and past employees.

“The basic rule is, don’t spend it if you don’t have it,” Mikesell says. “Don’t kick the costs of your services now down the road to another set of local officials in the future.”

Remember: What Goes Up Can Go Down

Cities in Southern California, which got hammered during the housing crisis, are in better shape than some of their counterparts in the San Francisco Bay Area and California’s Central Valley. That’s because there is better “institutional memory” in that region that rising housing prices can come back down, says Kim Rueben, a senior fellow at the Urban Institute.

Starting a decade ago, officials in Stockton became accustomed to increasing revenues that came from development fees, thanks to a local boom in housing. But as the economy slowed, it became clear that Stockton, which is some 80 traffic-clogged miles from San Francisco, couldn’t sustain its ambitions of becoming a growing suburb of the Bay Area.

Now Stockton is one of the foreclosure capitals of the United States.

“The key in some ways is not expanding when things seem like they’re going gangbusters,” Rueben says.

Use Bankruptcy As A Weapon

By far, the vast majority of localities will not go bankrupt. That doesn’t mean people aren’t scared that some will.

This fear can be enough to allow city and county officials to renegotiate the terms of their agreements, both with public sector unions representing their workers and with creditors who hold their debt.

“In some ways, bankruptcy is the most credible threat you have to get your creditors and unions to the table,” Rueben says. “You try to avoid it because all parties involved do not want to go into the bankruptcy system,” under which most contracts can be voided altogether.

Don’t Wait Too Long

But cities shouldn’t wait until they’re on the brink of bankruptcy to try to renegotiate. Impending doom helped officials in Central Falls, R.I., seek salary and benefits changes with their employees and retirees — but not quickly enough to avoid having to file for bankruptcy last August.

“Central Falls got unions on board by being very open about how close to the precipice they were,” says Tracy Gordon, a fellow in the economic studies program at the Brookings Institution. “Unfortunately, they were so close that they went over the cliff even with concessions, including from current retirees, which is a big deal.”

That’s the fate San Jose Mayor Chuck Reed sought to avoid. His city had slashed its budget 10 years in a row when it asked its employees — whose numbers had dropped from 7,400 to 5,400 over that time frame — to accept salary cuts of 10 percent last year.

Some of the city’s unions balked, saying finances were not that bad, despite the warnings offered by the bankruptcy of nearby Vallejo, Calif., in 2008.

It’s true that San Jose wasn’t quite ready to go bust, but Reed says he wanted to avoid waiting until bankruptcy became the only option.

“If we had sat quietly in San Jose and hadn’t done the things we did a year ago, we’d be in a position where we’d be having to think about bankruptcy,” he says.

And earlier this month, Reed persuaded San Jose voters to limit the city’s pension benefits and costs by a convincing margin.

“Don’t wait until it’s too late,” Reed says. “You have to be able to look a little bit ahead and figure out you’re going to be in trouble if you don’t implement the changes.”

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