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Broke Town, USA

Vallejo, a city about 25 miles north of San Francisco, offers a sneak preview of what could be the latest version of economic disaster. When the foreclosure wave hit, local tax revenue evaporated. The city managers couldn’t make their budget and eliminated financing for the local museum, the symphony and the senior center. The city begged the public-employee unions for pay cuts — all to no avail. In May 2008, Vallejo filed for bankruptcy. The filing drew little national attention; most people were too busy watching banks fail to worry about cities. But while the banks have largely recovered, Vallejo is still in bankruptcy. The police force has shrunk from 153 officers to 92. Calls for any but the most serious crimes go unanswered. Residents who complain about prostitutes or vandals are told to fill out a form. Three of the city’s firehouses were closed. Last summer, a fire ravaged a house in one of the city’s better neighborhoods; one of the firetrucks came from another town, 15 miles away. Is this America’s future?

Vallejo, California
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Vallejo, California

Cities across America are facing dire financial distress. Meredith Whitney, a banking analyst turned independent adviser who correctly predicted the banking meltdown, has issued an Armageddon-like prediction of mass municipal defaults. Others — notably Newt Gingrich — have suggested that state governments as well as cities should be allowed to file for bankruptcy. Congress held a hearing to examine the idea.

These forecasts of apocalypse have touched a nerve. Americans, still reeling from the devastating impact of the mortgage debacle, are fearful that the next economic disaster is only a matter of time. To anyone reading the headlines of budget deficits and staggering pension liabilities, it takes little imagination to conclude that the next big one will be government itself. The problems of cities are everywhere. The city council of Harrisburg, the capital of Pennsylvania, has enlisted a big New York law firm to explore bankruptcy as a means of restructuring a crushing debt. Central Falls, R.I., is in receivership. Hamtramck, Mich., a small city within Detroit’s borders, says it could run out of money next month. Hamtramck has only 90 employees, yet it is saddled with the pensions and health care obligations of 252 retirees. Detroit itself is at risk. Large deficits will mean closing about half of the city’s schools and will push high-school class sizes to 60 students.

These and other struggling locales do not begin to approach Whitney’s forecast of hundreds of billions in municipal defaults this year. (It would take defaults by 40 cities with as much debt as Detroit to reach even $100 billion.) Some industry experts accuse Whitney of exaggerating the crisis and of worsening the cities’ problems by frightening away investors. Whitney’s theory is that states, whose finances are also in desperate shape, will cut off local aid to preserve their own budgets; cities that have been subsisting on government transfers would become fiscal orphans and, in a financial sense, unworkable. She has not elaborated on her thesis beyond a few well-chosen television appearances. (She declined to talk to me.) But in the two months following Whitney’s warning, investors unloaded about $25 billion in shares of mutual funds that invest in municipal bonds. The selling spree sent the prices of these munis, typically among the most reliable investments, into a free fall.

If muni bonds were to default (causing investors permanent harm, as distinct from the temporary discomfort of price fluctuations), ordinary Americans would lose big. Munis are bonds issued by state and local governments, as well as agencies like hospitals, with the interest going to bondholders tax-free. Their relative safety, plus the tax break, has made them a favorite among individual investors, who own about two-thirds of the total, either directly or via mutual funds.

But what if the burden of municipal woes falls elsewhere than on bondholders? Yes, cities and states have creditors. They also have citizens who rely on their services and who pay the taxes, and they have public employees who are dependent on stable public-sector jobs and often-ample benefits. Whitney isn’t wrong about a crisis in local government; the crisis is here. The question is, will it be articulated in terms of bond defaults or larger kindergarten classes — or no kindergarten classes at all? The efforts in Wisconsin and elsewhere to squash organized labor suggest that politicians are no longer so willing to protect public employees. Teachers and nurses are likely to suffer well in advance of investors.

The United States has nearly $3 trillion in municipal bonds outstanding. Though some are backed by specific projects like airports and toll roads, most are general-obligation bonds; local taxes are used to pay the interest on those bonds before other expenses. Unlike a corporation, whose revenue can disappear, cities do not go away — or at least, most of them don’t. Detroit is in trouble because of its shrinking population, as are any number of towns in the former steel region of Western Pennsylvania. Many former industrial cities are burdened with governments that are out of proportion to their shrunken tax bases. Local budgets were stretched even before the recession; now, diminished tax receipts have threatened their ability to balance budgets. Bondholders in those municipalities have reason to sweat.

For areas with a stable economy, however, solvency is largely a matter of political will. Historically, far fewer than 1 percent of municipal bonds fail, and most that do tend to be issued for quasi public projects rather than cities. Typical is a monorail that links Las Vegas casinos — and that defaulted for lack of riders. In 2008, a record 166 issues defaulted, but the great majority were Florida land developments; essentially, builders used the tax code to finance sewers and water lines and then walked away when the mortgage bubble burst. The issues were small; defaults in 2008 totaled $8.5 billion. Last year, defaults fell to $2.8 billion.

Chastened by their failure to foresee the mortgage bust, the credit agencies have downgraded munis as the cities’ troubles have accelerated. But the agencies that evaluate muni bonds are paid to worry about bondholders, not about kindergartners or local fire departments; consequently, they are not alarmed. Moody’s says it expects defaults to rise in 2011. But the agencies do not predict a default epidemic. “Munis are not like subprime bonds,” Eric Friedland, a managing director at Fitch Ratings, said.

Government entities do seem less exposed to the sort of chain-reaction panic that undid banks. Lehman Brothers needed financing every day; when confidence disappeared, Lehman disappeared, too. Cities are generally not dependent on short-term financing. (A sizable exception involves some $80 billion in variable credit lines expiring over the next six months — which could force some governments to scramble.)

Another factor that tilts against default is that states and cities carry much less debt relative to the size of their economies than do troubled national governments like those of Greece or Spain (or the United States, for that matter). And muni debts generally come due in a steady stream — not all at once. Robert Kurtter, a managing director at Moody’s, says, “State and local governments really don’t have a crushing debt problem.”

Which is not to say they don’t have a problem. For most of the past decade, local government was a growth business. Avid consumption and the real estate boom spurred an abundance of sales- and property-tax receipts; with dollars flowing in, governments got used to spending more and borrowing more. Then, in the recession, tax revenues dried up, while demands for services kept rising. For the last few years, both cities and states have faced severe, recurring budget gaps.

As part of the 2009 stimulus package, Washington gave the states $150 billion. The states became dependent on a higher level of federal aid — 35 percent of their budgets, compared with about 25 percent before. But the stimulus is ending, and the states will have to cut.

"It’s better to cut a deal than go through the pain we have in Vallejo." -Partner, Orrick, Herrington & Sutcliffe, Marc Levinson

Determining who will suffer from budget cuts is a political and a legal calculation. The cities’ problem is that annual spending is greater than revenue; that imbalance does not entitle them to walk away from bond payments. Moreover, states and cities devote less than 10 percent of their revenue to annual debt service. In other words, they have ways of balancing budgets without defaulting. Lately, governments have been taking a chain saw to ordinary spending. The cuts sometimes reflect a retreat from what was once conceived as the essential mission of government. Education is being hit hard. Arizona is seeking a federal waiver to remove 280,000 adults from Medicaid rolls. Massachusetts is stripping out funds for homeless shelters. New Jersey has canceled a commuter-rail tunnel under the Hudson River. If the government doesn’t build a rail tunnel, who will?

States are also cutting aid to cities — much as Whitney forecast — aggravating the loss of local tax revenues. Camden, N.J., which has one of the highest crime rates in the country, has dismissed nearly half its police force. Michigan cities have seen aid diminish by $4 billion. In San Diego, where the city has cut other spending to pay for spiraling pension costs, residents have formed 56 “maintenance assessment districts” to take care of parks and patch up sidewalks. When the city failed to pass a hospitality tax, local hotels banded together and agreed to charge a 2 percent visitors’ fee. Scott Lewis, who writes about politics for the Web site Voice of San Diego, says, “I think the city is dissolving.”

In Wisconsin, Scott Walker, the new governor, declared that the state was “broke.” He does not mean that Madison intends to default on its obligations to debt holders; he means that public employees will have to increase contributions toward their benefits in an amount equal to 7 percent of their pay. For some employees, the cuts will mean real hardship. Public institutions like schools are also likely to suffer. Though elected officials prefer not to mention it, taxpayers will also have to ante up. Illinois sharply raised its income tax; Arizona voted for a sales-tax increase. Both of those states had markedly low tax rates to begin with, but Illinois’s case should be troubling to bondholders. Even after raising taxes, the state is planning to borrow about $12 billion to cover pensions and past-due bills — pushing both benefit costs and current expenses into the future.

The deficit problems have, at times, seemed to blend with the issue of pensions into a single, giant mess. As E. J. McMahon of the Manhattan Institute observes, “This is a conflating of different things.” States and cities have to put money aside to pay for future pensions, and the portion of that obligation that is “unfunded” represents a huge liability — from $1 trillion to $3.5 trillion, depending on your assumptions about future pension-fund investment returns. This underfunding won’t be felt in a big bang but as a continuous burden for years to come.

Nonetheless, because governments are required to make catch-up payments to those funds, the pension problem is worsening the current budget squeeze. In some cities, the pressure is suffocating. In Miami, according to Fitch, the pension-fund obligation eats up 25 percent of the city budget. In Philadelphia, which has neglected to make payments, the pension fund could be exhausted as early as 2015, says Joshua Rauh of the Kellogg School at Northwestern. Rob Dubow, the city’s finance director, insists that “we’ll make contributions to make sure that doesn’t happen.” The city has budgeted a huge $460 million contribution next year. “The real story” of the pension debacle, Dubow says, “is that it will leave less money for police and fire and sanitation.”

For a long while, government budget-cutting obeyed a distinctive political calculus: pensions were considered untouchable, so jobs were eliminated instead. Now, governments are going after pensions. Many states have taken the easy step of reducing benefits for new employees. Benefits for existing workers were considered inviolable. But some, like New Mexico and Mississippi, are dunning employees for higher contributions, and Wisconsin may follow. Minnesota and Colorado have watered down pension cost-of-living increases; both have been sued.

Whether such efforts will significantly ease the states’ burdens may depend on the courts. In Illinois, where the pension underfunding is among the most egregious, the state constitution says that “benefits shall not be diminished.” This language has long been interpreted to mean that when a public employee is promised a pension that increases with each year of service, the rate of accrual can never be changed. Sidley Austin, a law firm in Chicago hired by a pro-business civic group, has circulated a memo arguing that the clause refers only to benefits already earned — not to the rate of accrual in the future. That interpretation, if acted on by the Legislature, would shatter previous notions of pension protections. Sidley also makes the even-more-explosive argument that if Illinois’s pension funds dried up, the state could not be forced to contribute more. Let pensioners go hungry.

That is unlikely. Even in Illinois, pensions will be paid. Failure to do so would embroil the government in court for years. That may be the hope of ideologues, who envision that the courts — or possibly even a bankruptcy filing — could be used to alter employee contracts. In the 1930s, progressives persuaded Congress to let cities declare bankruptcy to escape the clutches of creditors. Now, conservatives want Congress to authorize states to file for bankruptcy. “Some people on the right see it as a chance to whack the public unions,” says David Skeel, a law professor at the University of Pennsylvania who has written in favor of state bankruptcy. It’s not hard to fathom why Gingrich, who as speaker of the House in the 1990s briefly shut down the U.S. government, would favor default by the states.

But the fantasy of using bankruptcy to suspend government runs up against a hard truth: even in bankruptcy, cities and states don’t disappear — nor do their obligations. Orange County, Calif., which entered bankruptcy in the mid-1990s after its treasurer ran up massive losses in derivatives, ultimately paid every cent it owed. “Among the reasons so few [cities] choose to go this option is, it’s not clear what they gain,” Kurtter of Moody’s says.

Another reason is that cities are creatures of their states, which fear a negative impact on their own credit. Connecticut prevented Bridgeport from declaring bankruptcy in the ’90s, and Michigan is stopping Hamtramck now. In Pennsylvania, about 20 municipalities are operating under a program to nurse insolvent cities back to health. The program has helped Pittsburgh, despite its woefully underfunded pension plan, to slowly improve its credit.

Harrisburg is a different story. A former mayor wanted to create a destination city with a series of ambitious projects, including a Wild West museum. He also approved an expensive plan to refurbish an incinerator so that it could become a moneymaker — a project that has buried Harrisburg under a mountain of debt. There are other Harrisburgs, cities undone by foolhardy projects, but these cases are particular, not systemic.

Vallejo, which ran out of money when the economy imploded, is more representative. A blue-collar city of 110,000, it had been hurting since a naval base closed in the 1990s. In 2007, the Wal-Mart left town. Then, with the recession, property taxes crashed from $29 million to $20 million. Vallejo cut back on street repairs and vehicle maintenance and reduced its staff by a third. The city sought pay cuts from the police and fire unions, whose members’ pay and benefits accounted for about 80 percent of the budget; the unions offered to defer pay raises. The council considered, but rejected, the idea of putting a tax increase to a referendum. Rob Stout, the outgoing finance director, who noted that the police chief is retiring on a $200,000 pension, says the general attitude was one of resistance to footing the bill.

Vallejo was a failure of political will. It is also an example of why bankruptcies for cities don’t work. All the constituencies who might have hoped to avoid hardship are being walloped anyway. Labor costs are being cut (though not pensions) and holders of $54 million in city bonds will suffer losses — how much won’t be known for years. Even Marc Levinson, a partner with Orrick, Herrington & Sutcliffe, which represents the city, calls the bankruptcy a waste of money and time. “It’s better to cut a deal than go through the pain we have in Vallejo,” he says. Pain is coming regardless. In some cities, bondholders will be burned. But America’s failing governments may be one of those crises whose full impact is not registered in the muni market, or in any market. Until voters can agree on what government services they want and will pay for, it is possible that bondholders will bank the profits while taxpayers, employees and citizens share the losses.

Roger Lowenstein (elrogl@gmail.com) is a contributing writer and the author of “While America Aged” and, most recently, “The End of Wall Street.”

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