Bankrupt. Not just California, the Nation.

There’s a tidal wave forming on the west coast and there’s no stopping it.

Since May three California cities have declared bankruptcy.  Stockton, Mammoth Lakes and last week, San Bernardino.  Mammoth Lakes is a small town that lost a multi million dollar lawsuit to a developer.  The other two were the result of stupid planning and having politicians who’ve been bought and paid for by public employee unions negotiate contracts with their owners.

They certainly aren’t the first cities to file for bankruptcy protection, and they certainly won’t be the last.  Even Warren Buffett is sending out warning signals.

July 13 (Reuters) – Billionaire-investor Warren Buffet said on Friday bankruptcies by three California cities in three weeks are making traditionally objectionable Chapter 9 municipal bankruptcy filings more palatable to local governments in financial crisis.

“The stigma has probably been reduced when you get very sizeable cities like Stockton or San Bernardino to do it,” Buffett said in a Bloomberg Television interview. “The very fact they do it makes it more likely.

As he notes, there once was a stigma attached to a city admitting they’d failed.  That stigma is quickly going away, although probably not for reasons that Buffett would endorse.  The stigma is going away because the debt load from failed city projects and from contracts with public employee unions isn’t sustainable.

Some states have taken steps to avoid the inevitable.  But when something is inevitable, it’s unavoidable.  Basic law of both nature and economics.  Think of it as a “fundamental”.

Scranton, PA will be lining up for a Chapter 9 shortly.  It’s taken a while, but it looks like they’ve finally run out of wiggle room.  The state of Pennsylvania has a program called Act 47 that theoretically helps cities with problems as discussed in the Pennsylvania Independent:

“In general, bankruptcy should be an absolute last resort after all other options have been exhausted,” said Steve Kratz, spokesman for the state Department of Community and Economic Development, which operates Act 47, Pennsylvania’s program for financially distressed municipalities.

Scranton has been under Act 47 for more than 20 years and is one of about 20 municipalities in the program. As part of the program, municipal officials must submit to the state a recovery plan outlining their plan to dig out of the financial mess.

The whole point of Act 47 would seem to be to help cities work their way out of a financial mess.  Scranton has been in the program for 20 years.  Sounds to me that Act 47 is nothing more than an AA meeting for drunks who have no interest in sobering up and who routinely show up for the meetings drunk.

Herein lies the problem.  Governments are not set up to reduce spending or to offend their masters the public employee unions.  They exist to dole out benefit and to increase taxes.

Compton, CA will likely become the number four California city to file a Chapter 9 in September.  While their issues are somewhat different than Scranton or San Bernardino, they appear to be out of cash and out of time.  According to Reuters:

Compton, which has an accumulated $43 million deficit and has depleted what had been a $22 million reserve, will run out of cash to make its payroll on September 1 at its current cash consumption rate, city comptroller Steven Ajobiewe told the city council during a July 17 meeting.  […]

Compton Mayor Eric J. Perrodin also said he brought unspecified charges of “waste, fraud and abuse of public monies” to California officials, and had met with auditors from both the state and Los Angeles County.

He told the city council that at one point in its past the city had overspent legally set limits on certain programs by $17 million but would not elaborate.

Interestingly enough, Compton’s pension fund is fully funded.  If that’s true, it’s one of the few fully funded municipal/state pension funds in the country.   I’ll be interested in the audit the state is going to perform because I would like to know how much of the $17M shortfall ended up in the pension fund.

The most interesting part of this whole drama is going to be played out in Stockton, CA.

In the history of Chapter 9 bankruptcies, never has a city tried to pay their bondholders less than full face value of their bonds.  Frequently the terms are renegotiated with lower interest rates and longer terms, but the full face value has never been written down.

This is very important because municipal bonds are a market unto themselves and amounts to about $2.9 trillion.  They provide low cost funding for cities.  One of the reasons they are able to do that is because municipal bonds are historically about the safest investment you could make.  No defaults.  No write downs.

If Stockton has their way, as reported in Newsmax, those days are over.

… an outbreak of bankruptcy filings will probably scare the market and make it more costly for cities to issue bonds … for the past 30 years bondholders and creditors have been protected in many bankruptcies.

However, before its filing, Stockton officials said it will try to impose losses on lenders, not just employees, Bloomberg reported, noting that since at least the early 1980s no city has used bankruptcy to force bondholders to accept less than the full principal amount.

There are hundreds of cities on the edge right now, maybe thousands.  It won’t take much to push them over the edge and if Stockton gets their way, you can expect the cost of borrowing to go up and the process to get more difficult and more selective.

Oh, and don’t expect Fresno, CA to last the year out.

Our final thoughts today on this subject, and we will be covering it extensively in the future, is this, from UnionWatch:

“Cities are running out of options,” Michael Sweet, a partner specializing in bankruptcy at the San Francisco office of law firm Fox Rothschild LLP, said today in a telephone interview. “As they see pension contribution obligations and retiree health-care costs going through the roof, revenue is at best stable if not declining.”

And remember, the problem can’t be solved by new or increased revenue.  All that does is feed the beast and make him larger and hungrier.

Pretty soon, as cities are finding out, the beast eats you.