Looks like a new world…

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Whether it’s “brave” or not remains to be seen.

As I noted yesterday, the US Bankruptcy Court was set to rule on the Stockton, CA bankruptcy petition.  The court found that Stockton was indeed eligible to file.  This is most likely to be a financial earthquake served up to every city and town, and most states, in the nation.  Like a Richter 10 earthquake.

The ruling was brought on because their creditors, primarily municipal bond holders, alleged that the city hadn’t acted in good faith.  The Court disagreed and the bankruptcy is proceeding.

Governmental units, other than the Federal Government who prints money, fund their activities through tax revenue – property, sales and income – and for capital projects or extra ordinary expenses, through municipal bonds. 

Municipal bonds, munis, are a very popular investment for two reasons.  First, they are typically tax exempt so you don’t pay taxes on the interest paid.  Second, they are secure.  Really secure.  No muni bond investor has ever lost a dime of principal on their investment.  A few have accepted lower interest rates or extended payouts, but the principal has always been safe.

Those two features give cities well below market interest rates for their financing and a ready market for their debt.

Until yesterday.  It’s a new world out there for cities and it’s not going to be a better world.

Dry WellThe city of Stockton managed to dig themselves into a huge hole.  There are lots of factors, but chief among them is their union contracts and the wages and benefit packages the city has given their union employees over the last decade or so.

Here’s Reuters synopsis…

Officials in the city of nearly 300,000, the largest city so far to have filed for municipal bankruptcy, will now be allowed to start drafting a so-called plan of adjustment for the city’s debts.

The case is expected to pit municipal bondholders against the California Public Employee Retirement System, which manages pensions for Stockton and many other California governments.

The Reuters story leaves out a really important tidbit…

During the 90-day mediation period, Stockton’s creditors refused to negotiate unless the city cut payments to the state pension plan, CalPERS.

By law, the negotiations were confidential, but that detail emerged during the three-day trial that concluded last week.

Klein said the creditors could not legally walk away from the table, but he left the door open for CalPERS obligations to be part of negotiations in the coming phases of the bankruptcy.

At issue will be whether U.S. bankruptcy law trumps California law, which says the pension plan must be funded. 

The $900 million Stockton owes to the California Public Employees Retirement System to cover pensions is its biggest debt -– as is the case with many cities in California.

 This is going to get really nasty; everybody’s ox is going to get gored.

  • The bond holders are likely going to get a “haircut.”  When that happens, the idea of “muni security” is going to take on a new meaning.
  • The union’s contract is likely to be rewritten – including cops and firefighters – and it’s fair to expect BIG changes in their benefit plans and who pays as well as work rules.
  • CalPERS may get less money than they think they are due.  This will create a firestorm in the state because Sacramento will have to make up the difference.
  • City contractors are certainly going to get hammered and that won’t help the already lousy business climate in Stockton.

This could extend well beyond California.  Like to the state of Illinois where pension problems are even worse than the Pyrite State.

Overall, my guess is that this is going to be a real day of reckoning for public employee unions across the country.  It has the potential to stick a big pin in the retirement bubble that they thought were in the bag.

It’s also going to put the fear of God – or at least the fear of the – Bankruptcy Court – into municipal bond investors, issuers and underwriters.  The safe harbor will no longer be so safe and I expect that interest rates will go up based on the fact that now investors will face real capital risk.  I also expect issuers to begin to look to securitize bonds with a specific revenue stream like parking fees, etc.  Bottom line, for many cities it’s going to be increasingly more difficult to borrow money.

Prudence in both borrowing and lending is not a bad thing.  $167MM of Stockton’s bond debt is related to an issuance where they raised money to pay their pension obligations to CalPERS a few years ago.

Given the sorry state of finances in hundreds of cities and more than a few states, the money well could be about to dry up.  Frankly, it should have dried up a long time ago. 

Pay attention to Stockton, and to San Bernardino which will be next in line, and expect a shockwave to roll east from Left Coast.

About Author

Michael Becker is a long time activist and a businessman. He's been involved in the pro-life movement since 1976 and has been counseling addicts and ministering to prison inmates since 1980. Becker is a Curmudgeon. He has decades of experience as an operations executive in turnaround situations and in mortgage banking. He blogs regularly at The Right Curmudgeon, The Minority Report, Wizbang, Unified Patriots and Joe for America. He lives in Phoenix and is almost always armed.

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