Crisis of ‘08 Lingering For Locals
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.
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.
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.”
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.