The Stockton City Council yesterday approved a petition for bankruptcy, the largest of a city in U.S. history. Municipalities all over the country are in fiscal distress, but few are actually declaring bankruptcy. What went so badly wrong in Stockton, and what lessons can other cities learn?
First, Stockton had a huge property bubble, with median home prices rising 200 percent between 2000 and 2006. This flooded the city’s coffers with property tax revenues. Assuming the trend would continue, officials signed employee contracts that proved unaffordable. The city even agreed to a “heads you win, tails we lose” pay structure tied to the city’s tax receipts: In strong revenue years, workers got 7 percent raises, but even if revenues declined, they got 2.5 percent raises.
Then Stockton had a huge property bust. The median home price in Stockton fell 70 percent from 2006 to 2009 (i.e., back to 2000 levels). In many states, municipalities raise property tax rates when values fall; that’s illegal in California, so plummeting home prices meant plummeting tax receipts. But even as tax receipts were falling, compensation costs per employee continued to rise; in recent years, the city sharply cut headcount, but still could not close its budget deficits.
Making matters worse, says the think tank, in 2007 Stockton issued $125 million in pension obligation bonds. As in other jurisdictions that tried to “fix” their pension problems with bonds in the last decade (see Woonsocket, Rhode Island), this backfired: The assets Stockton bought with the bond proceeds declined in value, and the city is stuck with both a pension liability and a bond liability. And that pension liability has been a major driver of the city’s insolvency.
None of these factors was unique to Stockton. Their combined severity, however, was. For example, in the last decade San Jose, California, has seen pension costs skyrocket and signed some regrettable employee contracts. But the economy there has held up better and the decline in property values has been more mild; as a result, the city has identified a path to fix its finances without bankruptcy.
California has several options to prevent more Stocktons. First, the state needs to restructure and relax its Proposition 13 property tax limit, which limits property tax to no more than 1 percent of property value, and in practice often to significantly less. The state needs a regime that allows cities like Stockton to raise taxes when necessary, and that prevents booms and busts in property tax revenue.
California also needs to give municipalities more flexibility to adjust employee benefits, so that places like Stockton do not have to resort to bankruptcy to get compensation costs under control. Public employee unions have excessive political power in the state, which could be curbed by abolishing collective bargaining in the public sector. And the state must reform pensions so that costs are predictable and municipalities do not get into pension bidding wars that leave taxpayers saddled with costs for decades to come.
And a national lesson: Nobody, anywhere, should ever issue pension obligation bonds! Let’s think for a moment about what these really are. They are commonly described as a way of exchanging a pension liability for a bond liability. But really, when a city issues pension obligation bonds, it gets a bond liability and keeps its pension liability -- plus it gains an asset that offsets the bond liability. Typically, the jurisdiction invests the bond proceeds in an equity-heavy portfolio, which may lose value, but the bond liability remains fixed.
If that sounds a lot like buying stock on margin to you, that’s because it is.
In general, pension obligation bonds are sold as a free lunch. That was the idea in Stockton: The bonds bear interest at 5.46 percent while the city was expected to achieve investment returns of 7.75 percent. As such, issuing bonds was supposed to “reduce” the cost of pensions.
But that carry isn’t free. In exchange for a lower average cost, cities that choose pension obligation bonds take on a lot of risk: If the market underperforms, the assets can shrink and become smaller than the bond liability. It’s taxpayers’ responsibility to cover those gaps when they arise, so it’s a big problem that the gaps tend to coincide with weak economic performance and weak tax receipts.
When pension obligation bonds go south, the result is often tax increases and service cutbacks. Stockton shows how, in a worst-case scenario, pension obligation bonding gone wrong can combine with other factors to land you in bankruptcy.
(Josh Barro is lead writer for the Ticker. Follow him on Twitter.)
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