Three California cities recently declared bankruptcy. So how do investors regard the Golden State’s debt?
Apparently, with ardor.
According to Bloomberg, bond funds focusing on California issues have added assets for 18 consecutive weeks, with local yields close to their lowest in more than 40 years.
Clearly, investors see the woes of three fiscally ailing cities as specific to those municipalities, while the state is heading in the right direction.
Problems are self-inflicted
A look at Stockton, Mammoth Lakes and San Bernardino show their fiscal challenges to be largely self-inflicted. Years of poor financial management—Stockton and San Bernardino have discovered accounting irregularities in past financial statements that preceded the onset of the depressed economic conditions particular to their regions.
For the resort town of Mammoth Lakes, the immediate cause of its Chapter 9 filing was a 2008 damages award of $30 million that grew to $42 million, a whopping 2.5 times the town’s general fund revenue for 2010-2011.
But the town was in trouble anyway: It had run general-fund deficits for at least five years. Escalating retiree benefit costs, insurance premiums and generous compensation increases inflated expenses while revenues, heavily dependent on hotel occupancy, sales and property taxes, lagged. Now the town proposes to cut pay and municipal services to make ends meet, and must negotiate with the developer.
Standard & Poor’s lowered the rating on the town’s outstanding debt—mostly certificates of participation backed by lease revenues—from “BB” to “C” after the bankruptcy filing, a rock-bottom rating that does not imply actual default. Unlike private parties in bankruptcy, a municipality may service debt without court approval while it negotiates a reorganization.
At 2% of expenses, debt service is too small to make a meaningful dent in the deficit, and since Mammoth Lakes would face higher interest costs in the future if it were to default, bondholders may still come out whole.
Ambitious plans and pay sink budgets
Stockton and San Bernardino were hit hard during the recession and have been slow to rebound. Soaring revenues during the housing boom prompted Stockton to undertake ambitious downtown redevelopment plans and grant overly generous benefits to city employees. When the bust came, unemployment surged to 19.9%, more than double the 8.2% national average, while revenues plunged and home construction collapsed (152 permits issued in 2010 vs. 2,954 in 2005). City officials say Stockton now has the highest foreclosure rate (1 in 60 homes) in the country, the second highest ratio of underwater mortgages (56%) and has suffered the third largest reduction in home values (57.2%) over the past five years.
Staff reductions, furloughs and other cuts weren’t enough to balance the budget and city officials didn’t think residents would support tax hikes.
Stockton’s proposed reorganization plan makes additional cuts to compensation and benefits but the city still plans to default on its general obligation debt. Standard & Poor’s cut the city’s rating to “D” (default), although the outstanding bonds are still rated “C.” Most city debt, including its taxable pension obligation bonds, is covered by bond insurance so bondholders can still expect to receive interest and principal on time.
One-time fixes didn’t work
A similar tale unfolded in San Bernardino. Years of deficits covered by one-time fixes, depleting reserves, compensation and benefits the city couldn’t afford, lower tax revenues and high unemployment led to its downfall.
But again, bond debt was a small portion of the budget.
Public safety consumed 73% of the city budget in fiscal 2011-2012 compared to just 3% for debt service. The city has not yet filed a restructuring plan, although budget stabilization proposals include deferring interest payments on outstanding taxable pension obligation bonds, which will trigger a default.
Despite the adversity faced by a few cities, municipal bond yields have drifted lower since the end of June, suggesting investors recognize the bankruptcies in California don’t foreshadow a national trend.
Debt service is typically such a small budget item that any immediate savings upon default is always weighed against the higher cost of future financings and the reputational damages such a move would incur.
Hunger for tax-free income
Meanwhile, investor appetite for tax-free income remains high, and is bolstered in California by proposed increases in state income taxes. There’s also hope that California’s annual budget fiascos are abating. June marked the second consecutive year the state executed a budget on time.
Although municipal bond defaults lend themselves to bold headlines, according to Moody’s, they make up only 0.13% of rated bonds from 1970 to 2011.
A little homework goes a long way toward avoiding the potential trouble spots.