Does the Court’s limited power in a Chapter 9 translate to any greater power or interest vested in a taxpayer or organized group of taxpayers whose interests are largely ignored in a Chapter 9? Much attention has been paid to the plight of bondholders and pension interests when a city is in distress.  But what about the taxpayer who has paid for police and fire protection, street maintenance, sewers, garbage collection, parks, and other vital services? Does the limitation on the Court’s powers mean that the taxpayer has a louder voice?  The answer to each of these questions is “No.”

A taxpayer has no statutory authority to object to the confirmation of a city’s plan.  Neither does an organized group of taxpayers; however, a “special taxpayer” may object to plan confirmation.  What makes a taxpayer “special?”  By definition, a “special taxpayer” means the owner of real property against which a special assessment or tax has been levied,  the proceeds of which are the sole source for payment of an obligation incurred by the City to defray the cost of an improvement relating to the property.  Any attempt to increase the proportion of special assessment or special taxes, vests the taxpayer with the standing to object to plan confirmation, which, in the right hands could be an effective voice, to address deficiencies in the plan that may otherwise slip through unnoticed.

Any concerned citizen, impacted by a city seeking to adjust its debts, should look first to see the extent to which the plan may impact special assessments or taxes.  This awareness could give standing to a potentially large group with only a very small voice in a process that may have long term consequences.

With the elimination of these agencies, property tax revenues are now being used to make bond payments and to meet other obligations.  The remaining property tax revenues can be allocated to cities, counties, special districts, educational institutions, and other vital core public services. Successor agencies are assisting in the winding down process, which includes payments on enforceable obligations and the disposition of redevelopment assets and properties.

Interestingly, State Controller John Chiang has completed his review of the assets transferred by the City of San Bernardino Redevelopment Agency prior to its dissolution.  The review found $108.4 million of RDA properties, cash and invested funds, inappropriately transferred to the City’s Economic Development Corporation, with another $420.5 million of assets still being held by the City.

In the context of municipal insolvency, the sum of almost $529 million is a staggering amount. Mr. Chiang is anxious to make sure that these redevelopment assets go where they belong. Differences of opinion on this issue are bound to occur, particularly as the Chapter 9 case works its way through the Bankruptcy Court and the battle lines are drawn between bond holders, pension recipients, general creditors and, of course, the tax payer.

Proposition 13,  or the Jarvis Initiative, was a tax payer revolt.   The impetus for it was the perceived rate at which people could be priced out of the affordability of home ownership, but the benefits also flowed through to commercial property owners; generally speaking, a group with greater sophistication and access to financial resources.  Critics are now saying that commercial property owners have enjoyed a free ride for too long at the expense of counties and the state, which are being radically short-changed.

Past efforts to reform Proposition 13 have failed.  The opposition lobby of commercial property owners has been successful in continuing the tax benefits; however, with the number of Chapter 9 filings likely to increase, more attention is being paid to the idea of a split roll ballot initiative under which the benefits available on the commercial side would be diluted in order to increase the revenue base.

This issue has become even more prominent as CalPers does battle in the more recently filed Chapter 9 cases.  If pension benefits are to be preserved, particularly with underfunding issues, then other sources of revenue must be explored.   According to Moody’s, in order to meet new public and more stringent financing rules, six counties would have to dedicate all of their existing property tax to pay for pensions or face bankruptcy.  Those counties include:  Alameda, Contra Costa, Marin, Mendocino, San Mateo and Sonoma.

These are the pressures that are forcing a closer look at a tax initiative that has withstood the pressures of time, but circumstances have changed dramatically and economic issues are forcing a thorough re-examination of who should bear the financial burden.

The City of Stockton is trying to use its bankruptcy to force bond holders to take less than the principal they are owed.  The reason is that pension holders need that money to fund their benefits, which have been characterized as quite generous.

The other major player in the battle is Assured Guaranty, the company which insured about $161 million in pension obligation bonds that were issued by Stockton in 2007.  The money was used to plug the City’s unfunded pension liability with a payment to the California Public Employees Retirement System (CALPERS).  Unfortunately, the invested funds sustained significant losses in the stock market and now bond holders are being asked to discount not just income on their bonds, but a reduction in principal.

Assured Guaranty has become the nemesis in the Chapter 9 filing, claiming that Stockton is not really insolvent and that the bankruptcy filing was a sham; filed in bad faith.  Stockton responds by suggesting that slashing the City’s labor costs, police, fire, etc., will jeopardize public safety and that their best employees will seek work elsewhere.

The hard part in all of this is that both sides present compelling arguments,  but the economic reality means that one will have to take the bigger hit.  However this battle plays out, and January should be an interesting month in the Bankruptcy Court, it is clear that the financial burden will fall most heavily on general creditors and taxpayers, while the titans in this battle continue to wage war.

Right to work laws govern the extent to which an established union can require employee membership and the payment of dues or fees as a condition of employment, either before or after hiring.  Right to work laws make it harder for workers to organize and maintain negotiating power.  The issue is not just about unions; it is also about politics and economics.

Michigan recently became the 24^th state to adopt a right to work law.  The governor of Michigan is a Republican.  Wages in right to work states are 3.2% lower than those in non-right to work states, according to The Economic Policy Institute, a non-partisan think tank.   This translates to an average of $1,500 per year, per employee, taking into account cost of living.

This raises the question of whether other states will be emboldened to do the same. The odds are that they will.  In addition, there are moves at the federal level to create a national right to work law.  The politics of the issue breaks down into union opponents who claim that it is a victory for business that will lead to greater job growth.  On the other hand, union proponents say that without unions, workers will have much less security and will make less money.  Supporters of right to work point to lower unemployment in states where union membership cannot be mandated.   Michigan looks to Indiana (a right to work state)  to see business growth and economic viability, while the City of Detroit, birthplace of the nation’s most powerful unions, is laying the foundation for what could be the largest Chapter 9 filing in the country’s history.

Silva enters office with a great deal of work ahead.  Not only is Stockton the largest city in the nation to have ever declared bankruptcy, it also has yet to successfully prove eligibility for Chapter 9 protection amidst its high rates of crime, unemployment and home foreclosures.  Silva vowed in his campaign not to take a paycheck in office until the city’s budget is balanced and police presence is restored.

As the community awaits such promise to manifest, Stockton’s Chapter 9 proceeding continues.  On November 13, 2012, a U.S. Bankruptcy Court entered an Order, granting the creditors’ Motion for Leave to Introduce Evidence Relating to Neutral Evaluation Process.  Pursuant to Section 53760.3 of California’s amended bill, AB 506, Stockton’s creditors are entitled to maintain complete confidentiality during the neutral evaluation process in Stockton’s municipal bankruptcy.

As of November 2, progress had indeed been made.  City officials declared that $29 million of the city’s budget deficit has been eliminated, with further reduction efforts being made.  Most notably, on November 5, the City Council held a meeting to consider a proposal to contract with county law enforcement for policing services.  Although this outsourcing could be San Bernardino’s fiscal answer to staying afloat, it faces extreme opposition from the city’s police union – the San Bernardino Police Officers Association.  The union’s arguments range from issues of officer job security, to concerns that the county Sheriff’s Department is incapable of tackling specific safety concerns that are better addressed by a local, independent police force.

The City Council voted, and results were split 4-3 in favor of the proposal.  Nevertheless, the city charter requires operations of this kind to be modified only by voter approval.  Therefore, until the nearly 210,000 residents of San Bernardino can agree on whether or not to outsource policing as a means of maintaining the protection provided by the Chapter 9 filing, city officials are continuing to explore other options.

Business with a city can be transacted at two levels: first, on a one-off or occasional basis under which the city delivers a purchase or work order on terms that require payment when the goods are delivered or the services are performed.  An unpaid vendor has certain rights governed by the Bankruptcy Code, but it is most likely that the City will schedule the claim as unpaid and part of the largest class of creditors known as unsecured. Secondly, the City and vendor may be operating under service or supply contract.   These are known in bankruptcy parlance as “Executory Contracts.”  A city engaged in the adjustment of its debts can reject an executory contract.  This also includes unexpired leases.  A real property lease must be assumed or rejected within 120 days of filing.

If the City wishes to continue with a contract relationship, it must assume the contract obligation and continue making payments required under the terms of the deal.  Alternatively, if the City wishes to jettison the agreement or the lease, it may do so.  The vendor or lessor will be given the right to assert a contract or lease rejection claim which drops down to the level of an unsecured claim, and may not be worth much at the end of the debt adjustment process.  To the extent that the City avails itself of the benefit of the contract or lease after the Chapter 9 case is filed, then the payments should continue as scheduled.   If they are not, then the vendor or lessor will end up with an administrative claim that must be paid as a condition of plan approval.  There is no way to know how long that the process will take and there may not be much comfort in knowing that the claim will be paid without knowing when.

Rights and responsibilities in this area can become quite complex.  Bonds which have issued for public works don’t help the contractor when the municipality defaults. Renegotiation of a work in process will almost always be required to minimize the actual loss and potential for further losses.

Pension Obligation Bonds

As each and every security downgraded by Moody’s was a Pension Obligation Bond (“POB”), an understanding of California POBs may provide bondholders relevant information upon which to make investment predictions and/or keep a safe distance from a particular security.

Pension Obligation Bonds were first authorized in California in 2003.  The intended purpose of issuing POBs and creating ancillary obligations was the funding and/or refunding of a municipality’s pension costs and obligations.  In short, California municipalities use POBs to take out high-interest loans from private investors to make up for shortfalls in their municipal pension funds.

The need for these bonds, however, exists only because of the unusual way municipal pension funds are managed.  Unlike other divisions of local governments that consistently pay citizens as they come and go, pension funds survive by taking annual payments from government employees and investing that money elsewhere to pay for future retirement benefits.

The Risk: Reasons for Across-the-Board POB Downgrading

Risk #1:  POBs are paid from municipality’s general fund

Because the principal and interest on these obligations are paid from general funds (as opposed to being paid from specific funds often created and reserved for certain bonds), POBs are forced to compete for payment with other essential governmental services.  The recent economic recession has obviously had significant impact on general funds across the board, as cities struggle to generate revenues to keep up with expenditure demands.  Accordingly, as Moody’s notes, “as long as general fund revenue growth is lagging the growth in fixed costs, funding for some general municipal services must be cut to maintain core services and a balanced budget.”

Risk #2: Unsecured POBs have the lowest priority

When making budget cuts, municipalities consider what they might lose if they default on their obligations.  With a lease-backed obligation, for example, a city risks losing the use of an essential asset in the event of a missed lease payment.  With a pension-backed obligation, however, no such loss is possible, thus the motivation to continue payment on the debts is lacking in hard financial times.

Risk #3: The gamble

Although the money coming into pension funds has the potential to be profitably invested elsewhere, it is quite different gambling with a municipality’s true revenue than it is with the hard-earned money of a government employee.  In fact, the management of POBs has been reported by Reuters to be “little more than a bet by a local government that it can earn more from investing in the markets than it will pay in interests on the bonds,” as quoted by a city mayor.

Conclusion

Amidst California’s earthquakes and aftershocks felt from tip-to-tip, perhaps the most accurate of all predictions in the region will stem from the great shake in modern municipal finance.  In the end, payment of municipal bonds requires obligors to prioritize between the bondholder and their own citizens when funds are not abundant.  The recent downgrading by Moody’s on the ratings of 16 Pension Obligation Bonds seems to indicate that currently, California municipalities don’t place great value on pension funds.  Nonetheless, the risks and rewards remain:

Too much focus on bondholder and pension benefits will be slashed/government employees walk away.

Too much focus on pensioner and a city’s access to credit is tarnished/investors are turned away.

Whatever your position, financially or otherwise – it behooves all who are involved with municipal bonds to consider trends of downgraded ratings.

A Metaphor for Municipal Finance Prediction

Before a time, place or magnitude of the next big quake can be predicted, the underlying factors upon which a prediction is made must be examined. In the world of science, seismologists may rely on existing, natural processes of the earth’s movement as a factor of earthquake prediction.

In the world of finance, investors may rely on current trends of debt obligations as a factor of Chapter 9 prediction.  The not-so-distant worlds of science and finance both value patterns as a factor of their predictions.  Although little precedent exists for municipal bankruptcy in California, the influence of bond ratings on the ‘municipal debt market’ is widely accepted:

Higher bond ratings make it easier for a municipality to borrow $$

Lower bond ratings make it difficult for a municipality to borrow $$

As bond ratings decline, investors assume greater risk of potential default.  Accordingly, rates at which to purchase municipal debt rise, resulting in financial pressure on a city that could force an eventual Chapter 9 bankruptcy.

Municipal Bond Downgrading

On October 9, 2012, Moody’s Investment Services released a “Special Comment” announcing rating actions and reviews affecting a number of municipal bonds issued by California cities and pooled financing entities.  In light of the above-mentioned ‘domino effect’ in municipal financing and the recent flare of municipal bankruptcies, it is worth highlighting the securities that Moody’s has officially downgraded.

Of all securities rated and reviewed by Moody’s, a total of 16 bond ratings were downgraded. 100% of the downgraded securities (16/16) are labeled by Moody’s as “Pension Obligation or similar.”  The obligors responsible for the 16 downgraded pension obligations include the following eight California cities and one pooled financing entity:

1.  Downey

2.  Fresno

3.  Huntington Beach

4.  Los Angeles

5.  Oakland

6.  Oceanside

7.  San Leandro

8.  Santa Rosa

California Statewide Communities Development Authority

Next post: Pension Obligation Bonds and the risks of POB downgrading.