Cri­sis of ‘08 Lin­ger­ing For Lo­cals

The Bond Buyer - - Front Page - By ricHard Wil­liamson

Ten years af­ter fi­nan­cial mar­kets col­lapsed in what be­came known as the Great Re­ces­sion, many lo­cal gov­ern­ments re­main in worse shape than be­fore the his­toric down­turn.

The ab­sence of ma­jor bank­rupt­cies since Detroit’s exit from Chap­ter 9 fil­ing in 2014 doesn’t mean clear sail­ing, some ex­perts say.

“The eco­nomic re­cov­ery has been help­ful but not so much as to pre­clude the pos­si­bil­ity that the next se­ri­ous re­ces­sion won’t push worst-case gov­ern­ments over the brink,” said Richard Cic­carone, pres­i­dent at Mer­ritt Re­search Ser­vices. “Pen­sion fund­ing ra­tios are still too low in many places.”

Ac­cord­ing to an an­nual sur­vey by the Na­tional League of Cities, all ma­jor tax sources grew more slowly in fis­cal year 2017 than in fis­cal 2016, and all are ex­pected to grow less than 1% in fis­cal 2018. Fi­nance of­fi­cers from the small­est cities are least likely to re­port that they are bet­ter able to meet the fis­cal needs of their com­mu­ni­ties this year over last. Those in the Mid­west ex­press the least con­fi­dence com­pared to last year while those from the South voice the most, the sur­vey found.

“Rev­enues have yet to re­cover from pre-re­ces­sion lev­els,” said Chris­tiana McFar­land, re­search di­rec­tor for the Na­tional League of Cities. “They’re about 98% of what they were but still haven’t achieved pre-re­ces­sion lev­els. What we’re see­ing also is that ex­pen­di­tures are grow­ing, and the pace of growth is slow­ing.”

“These trends come at a time when cities have not yet re­gained losses from the Great Re­ces­sion and face un­cer­tainty from fed­eral and state part­ners,” the sur­vey re­ported.

In­clud­ing spe­cial dis­tricts, there were 60 mu­nic­i­pal bank­rupt­cies na­tion­wide over the past decade, ac­cord­ing to Gov­ern­ing magazine, a tiny sliver of en­ti­ties el­i­gi­ble for Chap­ter 9.

Detroit’s was the big­gest, but the mu­nic­i­pal bond mar­ket was also shaken by Chap­ter 9 cases in Jef­fer­son County, Alabama, and in Stock­ton and San Bernardino, Cal­i­for­nia.

In its most re­cent sec­tor re­port, in De­cem­ber, Moody’s In­vestors Ser­vice con­tin­ued a sta­ble out­look for U.S. lo­cal gov­ern­ment.

“Prop­erty tax rev­enue has grown steadily for lo­cal gov­ern­ments since 2013, fol­low­ing an un­prece­dented multi-year drop driven by the real es­tate down­turn,” said Moody’s an­a­lyst Sam Feld­man-Croug. “Rev­enue grew at an av­er­age an­nual rate of 2.2% from 2013 through 2016.”

Pock­ets of lo­cal gov­ern­ments face in­ten­si­fy­ing credit pres­sures, Moody’s said, namely, those that do not en­joy ex­pand­ing economies, grow­ing tax rev­enue or am­ple op­er­at­ing re­serves.

While most re­gions have seen hous­ing prices re­bound above the pre-re­ces­sion lev­els, oth­ers have not fully re­cov­ered.

MIXED RE­COV­ERY

Ac­cord­ing to the CoreLogic Home Price In­dex, the U.S. as a whole saw a 29.4% drop in hous­ing values from Oc­to­ber 2006, be­fore the crash, to Fe­bru­ary 2009, right be­fore the mar­ket started to re­cover.

“Many Mid­west­ern states and cities, like other Rust Belt re­gions and lo­ca­tions, found them­selves in a longer-last­ing, more vul­ner­a­ble sit­u­a­tion in which their slow eco­nomic growth made it harder to fund ris­ing pen­sion con­tri­bu­tions with­out squeez­ing nec­es­sary ser­vices and in­fra­struc­ture re­build­ing,” Cic­carone said.

“One of the main fac­tors cush­ion­ing the cri­sis is that in some of the most hard-hit states, es­pe­cially in Michi­gan and Ohio, state in­ter­ven­tion pro­grams were trig­gered to pro­vide emer­gency re­lief,” Cic­carone said.

Lo­cal gov­ern­ments in other states that lack such in­ter­ven­tion pro­grams — no­tably Illi­nois, where gov­ern­ments aren’t even per­mit­ted to file Chap­ter 9 — are forced to tough it out on their own.

“The risk is that bud­get squeezes, es­pe­cially dur­ing a se­ri­ous down­turn, pose a long-term risk that bank­ruptcy or de­fault could knock on the door of these cities, es­pe­cially if the state is un­will­ing or too weak to step in to help lo­cal gov­ern­ments that have high lev­els of li­a­bil­i­ties to fund,” Cic­carone said.

Rat­ing re­ports for Chicago and other strug­gling lo­cal gov­ern­ments re­flect un­cer­tainty as some econ­o­mists say the end to a nine-year eco­nomic ex­pan­sion is at hand and many note that state and lo­cal gov­ern­ments did not use stronger eco­nomic times to pre­pare.

Chicago, which car­ried Moody’s rat­ing of Aa3 with a sta­ble out­look in 2008, fell to a junk-bond rat­ing of Ba1 on its $6.7 bil­lion of gen­eral obli­ga­tion debt.

Moody’s dropped Chicago in 2015 af­ter the state’s high court shot down state pen­sion cuts, sig­nal­ing that the city’s own pend­ing re­forms faced the same fate.

CAL­I­FOR­NIA

While Detroit’s bank­ruptcy made the big­gest head­lines, Cal­i­for­nia accounted for three sig­nif­i­cant Chap­ter 9 cases: Vallejo in 2008, and Stock­ton and San Bernardino in 2012.

In 2013, the Cal­i­for­nia Debt and In­vest­ment Ad­vi­sory Com­mis­sion pro­vided a study of fac­tors in the lo­cal bank­rupt­cies with an eye to­ward iden­ti­fy­ing fu­ture risks.

The study ap­plied two ap­proaches to model­ing de­fault.

The first was based on the re­la­tion­ships found in mu­nic­i­pal de­faults that took place dur­ing the Great De­pres­sion. The sec­ond drew from case stud­ies of Cal­i­for­nia mu­nic­i­pal de­faults from 1979 to the present.

“Com­bined, these two ap­proaches iden­tify five fac­tors that ap­pear to be linked to de­faults: pop­u­la­tion, in­come, the ra­tio of in­ter­est cost to to­tal rev­enues, the ra­tio of change in rev­enues to to­tal rev­enues, and gen­eral fund bal­ances,” the study said.

Based on the De­pres­sion-era model, a rank­ing of Cal­i­for­nia cities most at risk of de­fault places Los An­ge­les at the very top, with San Bernardino 18th and Stock­ton 33rd.

“L.A. looks bad on the De­pres­sion model, but I would no longer de­fend that ap­proach,” Marc Joffe, a co-au­thor of the study, told The Bond Buyer.

“We have enough new de­faults and bank­rupt­cies to build con­tem­po­rary mod­els,” he said. “A prob­lem with the De­pres­sion-era model is that it in­cludes pop­u­la­tion, be­cause sev­eral high pop­u­la­tion cities de­faulted back then. This makes L.A. look bad.”

Un­der the new model, which places greater em­pha­sis on mea­sures of the gen­eral fund, Los An­ge­les ranks 22nd most at risk of de­fault, while Compton ranks first.

“The last time I looked, Compton was among the most fi­nan­cially dis­tressed cities in Cal­i­for­nia due to its neg­a­tive gen­eral fund bal­ance,” Joffe said. “It is also four years be­hind in pro­duc­ing au­dited fi­nan­cial state­ments and was the sub­ject of a crit­i­cal state con­troller re­port ear­lier this year.”

“Cal­i­for­nia cities are gen­er­ally in bet­ter shape than 10 years ago, but many face large and rapidly es­ca­lat­ing pen­sion con­tri­bu­tions,” Joffe said. “Berke­ley is a prime ex­am­ple of a city in this cat­e­gory.”

Leonard Jones, a Moody’s an­a­lyst, de­scribed the state as a bar­bell with a small per­cent­age of cities do­ing very well, a small per­cent­age not far­ing well, and the ma­jor­ity in the mid­dle. Moody’s gen­er­ally views the San Fran­cisco Bay Area and the Sil­i­con Val­ley cities as far­ing the best.

Growth in Cal­i­for­nia since the re­ces­sion has gen­er­ally been bi­fur­cated with the coastal ar­eas far­ing bet­ter than the in­land ar­eas. Stock­ton and San Bernardino were both in­land cities hit hard by the Great Re­ces­sion.

Moody’s doesn’t rate all of Cal­i­for­nia’s cities, but among those it does, about 5% to 10% are ex­pe­ri­enc­ing stress, Jones said.

“It’s a mixed bag. But the econ­omy is do­ing well.”

The Cal­i­for­nia State Teach­ers’ Re­tire­ment sys­tem and the Cal­i­for­nia Pub­lic Em­ploy­ees’ Re­tire­ment Sys­tem are the two largest pen­sion funds in the U.S. Both have re­quired in­creased con­tri­bu­tions from school dis­tricts and cities since the re­ces­sion — which came a few years af­ter both sys­tems boosted ben­e­fits. The higher con­tri­bu­tions are pres­sur­ing lo­cal bud­gets.

“Most pen­sions run through CalPERS and CalSTRS,” Jones said. “They have to in­crease the con­tri­bu­tions and lo­cal gov­ern­ments have to deal with that in­crease — and most have ad­justed.”

Cities na­tion­wide tare now fac­ing an­other chal­lenge as re­tiree health care costs, known as “other post-em­ploy­ment ben­e­fits” or OPEB go on the bal­ance sheets.

Un­der Gov­ern­men­tal Ac­count­ing Stan­dards Board Rule 75, state and lo­cal is­suers must rec­og­nize “other post-em­ploy­ment ben­e­fits” as debt, just as they did with un­funded pen­sion li­a­bil­i­ties un­der GASB 68 in 2016. The im­ple­men­ta­tion of that rule re­sulted in nu­mer­ous down­grades as gov­ern­ments reeled from the credit cri­sis of 2008. As a re­sult of GASB 68, Hous­ton’s net worth fell to a neg­a­tive $95 mil­lion in 2016, ac­cord­ing to Hous­ton Con­troller Chris Brown.

“Un­funded OPEB obli­ga­tions will con­tinue to stress bud­gets ab­sent any mean­ing­ful and sus­tained fund­ing progress,” Brown told The Bond Buyer. “Left un­ad­dressed, un­funded OPEB li­a­bil­i­ties could threaten the bot­tom lines of cities across the coun­try as li­a­bil­i­ties con­tinue to bal­loon.”

Though the mu­nic­i­pal mar­ket hasn’t seen large bank­ruptcy fil­ings since Detroit’s, there have been near misses.

Hart­ford, Con­necti­cut, rated AA-mi­nus by S&P Global Rat­ings in 2014, fell to CCC a year ago when de­fault or bank­ruptcy ap­peared im­mi­nent. The state gov­ern­ment stepped in to as­sume Hart­ford’s debt in April, un­der a work­out pro­gram that gives the state over­sight over the city bud­get.

Neigh­bor­ing Rhode Is­land also came to the res­cue of Cen­tral Falls when the city of 19,000 peo­ple filed for Chap­ter 9 in 2011. The state’s ac­tions to pro­tect bond­hold­ers and other mea­sures were cred­ited for Cen­tral Falls’ short, 13-month stay in bank­ruptcy court.

Rhode Is­land, which acted as re­ceiver for Cen­tral Falls, was the only state to im­mu­nize bond­hold­ers from a bank­ruptcy, ac­cord­ing to a 2013 re­port from the Pew Char­i­ta­ble Trusts.

By con­trast, Cal­i­for­nia took no ac­tion in the Vallejo, Stock­ton and San Bernardino fil­ings.

In Cal­i­for­nia, cities are left to fend for them­selves with lit­tle help from the state, while a mul­ti­step process ex­ists to aid dis­tressed school dis­tricts and pre­vent them from be­com­ing in­sol­vent.

Lo­cal gov­ern­ment gen­eral obli­ga­tion bonds in Cal­i­for­nia are widely seen as be­ing bank­ruptcy-re­mote, but nei­ther Stock­ton, Vallejo nor San Bernardino had GO debt. They did have other types of bond debt, which took hits in their bank­ruptcy set­tle­ments.

“Fewer than half of the states have laws al­low­ing them to in­ter­vene in mu­nic­i­pal fi­nances,” the Pew study found.

Lo­cal gov­ern­ments’ long slog back from the re­ces­sion faces new chal­lenges.

“While the pic­ture ap­pears brighter for lo­cals from an eco­nomic per­spec­tive, since tax re­form was fi­nal­ized late last year, pol­icy changes from the Trump Ad­min­is­tra­tion have con­tin­ued to por­tend real con­se­quences for lo­cal gov­ern­ments,” S&P Global Rat­ings wrote in an April re­port. “While the most re­cent an­nounce­ments on changes to tar­iffs don’t of them­selves seem neg­a­tive for lo­cals, the pos­si­bil­ity for an en­su­ing trade war could hurt. Mu­nic­i­pal­i­ties around the coun­try have eco­nomic links to trade, ei­ther through di­rect trade ac­tiv­ity or through the man­u­fac­ture of goods — and fluc­tu­at­ing prices or de­mand could cre­ate an eco­nomic hit.”

Bloomberg News

A fore­clo­sure sign in Stock­ton, Cal­i­for­nia, in 2008. The real-es­tate cri­sis helped drive the city into Chap­ter 9 bank­ruptcy in 2012.

The next se­ri­ous re­ces­sion could push some worst-case gov­ern­ments over the brink, said Richard Cic­carone, pres­i­dent at Mer­ritt Re­search Ser­vices.

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