Vallejo's Fiscal Freefall

When the town of Vallejo, California, declared bankruptcy this spring, Mayor Osby Davis predicted -- and rightly so -- that he'd get an earful from...

When the town of Vallejo, California, declared bankruptcy this spring, Mayor Osby Davis predicted -- and rightly so -- that he'd get an earful from his constituents, employees and retirees. What he didn't anticipate was the chorus of phone calls from mayors outside the city, both close by and clear across the country. They told him they were watching Vallejo's bankruptcy proceedings closely, and some of them, he says, indicated that "they find themselves not too far behind us."

Vallejo, a city of 120,000 about 35 miles northeast of San Francisco, flat-out went broke this year through a combination of generous public-safety salaries, declining property values and fiscal mismanagement. The city is estimating a $17 million deficit for the current fiscal year.

Previous municipal bankruptcies generally arose from adverse legal rulings or poor investment decisions. But Vallejo's predicament stems largely from economic conditions felt by cities across the nation, namely declining revenues and rising employee costs. And that scares the dickens out of cities, unions and municipal bondholders.

"Vallejo was sort of the canary in the coal mine -- the sickest patient goes first," says Dean Gloster, an attorney representing Vallejo's unions. "Even better-run cities are going to be facing similar issues as health care costs rise and the baby boomer generation reaches retirement age."

A September report from the National League of Cities points to precarious fiscal conditions in cities across the nation, due to falling revenues from property, sales and income taxes and rising costs from inflation, energy, infrastructure, salaries, health care and pensions. "Vallejo is significant in the sense that the reasons they are doing it are factors that are going to be in place in cities across the country," says Chris Hoene, director of policy and research for the National League of Cities. "You can see the Vallejo situation as something that cities across the country watch as a way to bring costs under control."

Uncommon Ground

Historically, use of Chapter 9 -- the bankruptcy code for municipalities to reorganize their debts -- has been quite rare. Since 1937, there have been a total of 564 municipal bankruptcies -- fewer than 200 of which have occurred since 1980, and most of which have involved governmental units such as utilities or hospitals. Currently, Jefferson County, Alabama, is wrestling with the bankruptcy issue, but its fiscal problems hinge on an issue unrelated to a structural deficit -- the bonds issued to pay for a new sewer system.

A declaration of bankruptcy is a loaded decision. "It's the third rail of municipal finance," says Chicago-based bankruptcy attorney James Spiotto. "If you go into Chapter 9, people are very concerned about your ability to repay and whether it will be habit forming."

Not all troubled jurisdictions can declare bankruptcy. Municipal bankruptcies are illegal in one state, Georgia; untested in several, such as Iowa and Maryland; and unlikely in others, such as New York and Pennsylvania, that have their own procedures on the books for rescuing distressed localities.

The fear that Vallejo's decision will set off a string of similar declarations may not be warranted. When the city of Bridgeport, Connecticut, declared bankruptcy in 1991, experts warned of a possible flood of other bankruptcies due to poor economic conditions and fiscal crises affecting cities nationwide. Bridgeport's bankruptcy was later withdrawn, however, and feared bankruptcies in other cities never materialized.

In large part, this is because of strict eligibility rules under Chapter 9 -- and harsh consequences for cities that do declare bankruptcy. A city's bond rating plunges, making it difficult to borrow money. In the face of fiscal instability, residents and employees tend to vote with their feet. Bridgeport's population declined by more than 10,000 after it declared bankruptcy. In the past year, Vallejo has lost at least 25 of its 150 police officers, many of them younger officers.

"It's not an easy way out, nor did this council take it as an easy way out," says Vallejo's Mayor Davis. "Bankruptcy is not a victory."

Troubled Waters

Reasonable people can -- and do -- disagree about how Vallejo found itself in bankruptcy. There's no doubt, however, that many of the city's problems stem from its inability to recover from the 1996 closure of the Mare Island Naval Shipyard, once the city's largest employer. The city also lost hundreds of thousands dollars per year in sales tax revenue after the closure of a Wal-Mart.

But the largest share of the blame in Vallejo has centered on public-safety salaries and benefits, which make up about 75 percent of the city's general fund budget. Base pay for firefighters is more than $80,000 per year and employees can retire at age 50 with a pension equal to 90 percent of their salary, the result of a retroactive pension increase several years ago.

With the downturn in the housing market hammering revenues, Vallejo is asking the bankruptcy judge to void the collective-bargaining agreements that led to those salary and benefit arrangements. And the possibility of hard-fought union contracts going up in smoke has struck fear in the heart of labor groups.

The California Professional Firefighters union proclaims, "If allowed to stand, Vallejo's attack on its own employees would send shock waves throughout the labor movement." Gloster, the attorney representing Vallejo's firefighters and police officers, says, "It's very difficult to see how their politicians should actually do the hard work to balance their budgets if they can get a do-over with a simple bankruptcy filing." Vallejo's unions are contending in court that the city is not truly insolvent. The city rejected an offer from the unions for about $10 million in concessions.

The Bully Pulpit

For Gloster, the question isn't whether Vallejo will have an effect on other cities but what ramifications other cities are already seeing. Specifically, he pointed to Vallejo's impact on ongoing labor negotiations. "What I hear from people in other cities is that it's already being played as a card," he says. " 'If you don't agree to these changes, we can do a Vallejo.' That's what they call it."

The most effective method of dealing with looming fiscal problems in localities might be for states to shore up provisions for refinancing authorities or municipal assistance agencies -- and perhaps build a framework to deal specifically with pension bailouts. Most analysts put state and local unfunded pension obligations in the hundreds of billions of dollars.

"While Vallejo may become the beginning of the trend," Spiotto says, "we ought to be looking at alternatives." Over the years, he points out, local leaders made spending decisions and assumed the next administration would be able to deal with it. "This has been a gift we've given to each generation, and sooner or later, we'll have to deal with it. It's becoming a growing reality that that sooner is coming now."

Anya Sostek was a GOVERNING correspondent