Under a new California law governing municipal distress, Stockton has entered into a mandated mediation period before it can file for bankruptcy under Chapter 9 [read "Stockton, California's Bankruptcy Makes 'Normal' Cities Nervous"]. The city, state, employees, retirees and bondholders -- not to mention the citizens -- have a lot riding on how the story unfolds. Moreover, the unfolding could have major consequences for public employee pension plans and bondholders nationwide.
Stockton faces an avalanche of obligations that it cannot meet. Foremost among them are contributions to public employee pensions, as well as debt service on bonds earlier sold to fund its pension contributions. All told, the retirement-related annual payments by the city amount to about $37 million of its total budget of $196 million, not including another $17 million spent on retiree health care. With only $1 million left in its cash balances, the city is on the brink of collapse.
While a number of special districts and specific projects have filed for bankruptcy, it’s been rare for general governments (such as cities or counties) to do so. In the past, the major concern was often with outstanding bonded indebtedness or a legal judgment against a small city. But times have changed. Now, the major de facto creditors are likely to be a jurisdiction’s retirees and current employees that have unfunded pension or post-retirement liabilities. The question that likely will be faced if the Stockton bankruptcy goes forward is the ability of a government to retroactively change contract provisions that have promised benefits and required levels of contributions to fund pension plan commitments.
Where one stands in the chain of creditors’ claims is a critical issue for general obligation bondholders, who have long considered themselves to be the first in line. Governments have an interest here, too: If a state allows the bondholders to be pushed behind in the line, credit ratings will suffer and borrowing costs will go up for everyone in the state.
The major players as Stockton’s unraveling continues are likely to be the public employee unions and the state’s giant public employee pension program, the California Public Employees’ Retirement System, or CalPERS. The key issue: Are the pension fund benefits and required contributions constitutionally protected? If the Stockton case lands in a federal court, will the state law prevail over that of the bankruptcy court as it works out an equitable recomposition of the debt? CalPERS, in particular, is not anxious to see an escape hatch open for localities since it could reduce contributions to the pension system.
The stakes of a confrontation between public pensions and bondholders are potentially very high. State and local governments have $3 trillion in municipal securities outstanding, with perhaps $1 trillion of this amount representing general obligation debt. Meanwhile, state and local pension systems have an estimated $1 trillion to $2 trillion in unfunded liabilities, depending on how one calculates the liability. It is not the huge sums themselves that are at issue. There is little doubt that most claimants will get paid as promised. Rather, the issue is how debt and pension obligations will be viewed in the future as the judicial and legislative sorting process takes place and priorities among claims on revenues are established.
The growing number of fiscal difficulties -- the aftermath of the Great Recession -- should not be misinterpreted. Painful reductions in spending are going on, and governments are deleveraging by paying off debt and growing more reluctant to borrrow. Moreover, they are not defaulting on bond repayments. Only five general obligation bonds rated by Moody’s have defaulted in the last 40 years; only one in the last three years.
Despite the favorable history, bondholders are not free from worries. Bankruptcy or state-managed rescue operations may lead to questions about the pecking order of various forms of obligations. The range of indebtedness now extends to the pension fund and post-retirement health benefit liabilities. States and localities have shown a growing appetite for altering pension agreements, but to date have usually avoided changes affecting retirees and current employees. Faced with the need to deleverage unsupportable obligations, such forbearance may no longer be possible.
This is John Petersen’s final Public Money column. He passed away last month.
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