Stockton Tries a Chrysler

Further NorthFurther North Senior MemberPosts: 1,699 Senior Member
Stockton Tries a Chrysler

The municipal bankruptcy unfolding in Stockton, California is giving investors a bad case of deja vu. Just as the Obama Administration bailed out the United Auto Workers in Chrysler's bankruptcy while hanging bondholders out to dry, the city of Stockton is subordinating its bond debt to worker pensions. But what's really scary is that the Stockton case could be replayed in dozens of California cities.

The San Joaquin Valley's second largest city filed for Chapter 9 bankruptcy this summer after a three-month mediation with creditors and unions ended in stalemate. Bond insurers that guarantee about $200 million in debt wouldn't submit to a haircut unless the rich pensions that helped drive the city to bankruptcy were also clipped. Yet unions wouldn't countenance an even modest reduction to their pensions.

Over the last two decades the city sweetened benefits and pay such that the average firefighter's total compensation is more than three times the city's median household income. Public safety officers can retire at age 50 with pensions equal to 90% of their highest salary, and until this year free lifetime health benefits. These benefits weren't sustainable even in good times. In 2007 the city had to borrow $127 million to pay a delinquent pension bill.

The city issued these pension obligation bonds which temporarily juiced city coffers and served as an arbitrage tool for city politicians who wanted to get in on the booming stock market. Stockton officials bet they could save money by borrowing at a rate 200 basis points below the 7.75% yield that the California Public Employees' Retirement System promised and invest the bond proceeds in the pension fund. But Calpers's actual returns have fallen short of the city's borrowing costs, so Stockton's total debt has increased.

Unions claim it's unfair to trim pensions since the city intends to terminate retiree health benefits. But few comparable California cities (and even fewer companies) provide retirees with medical benefits, and most pensioners will be eligible for Medicare or federal subsidies on the new state health exchange. When companies can't pay their bills, they usually freeze or terminate their pension plans and restructure benefits as part of bankruptcy.

Instead Stockton is seeking to use bankruptcy to wipe out $197.5 million in principal and interest on the pension obligation bonds it issued in 2007. But not so fast. Bond insurer Assured Guaranty has challenged the city's attempt to "transfer the cost of lucrative, above-market employee wages and benefits, granted when tax revenues were flush, to capital market creditors by haircutting bond principal." In none of the 43 municipal bankruptcy filings over the last three decades has principal been slashed.

Assured Guaranty fears that other cities will follow Stockton's bad example. The Bay Area suburb of Vallejo set that precedent four years ago when the union-influenced Calpers threatened litigation if the city attempted to modify pensions in bankruptcy. Calpers insisted that pensions were protected by the state constitution's contracts clause, though the very purpose of bankruptcy is to break and rewrite contracts.

Concern that insolvent cities might strategically declare bankruptcy to cancel their bond debts is finally getting noticed by investors, even by the famously late credit-rating agencies. "The recent uptick in bankruptcy filings in California could signify not only a lack of ability, but a lack of willingness to pay debt service at the expense of other financial obligations," Moody's MCO -0.78% prophesied earlier this year. Meanwhile, the Imperial Valley city of San Bernardino, having run out of cash, is going the Chapter 9 route.

Dozens of cities in California including Oakland, Sacramento and Los Angeles are slouching toward insolvency, but only a few such as San Jose and San Diego have taken on the unions and restructured worker retirement benefits. Many are instead borrowing to pay their retirement obligations just as Stockton did, thereby shifting the risk of paying for pensions to the bond markets. Oakland approved $210 million in pension obligation bonds this year, despite coming out $245 million behind after investing $417 million from a pension obligation bond sale in Calpers 15 years ago.

Once upon a time in America, a city that reneged on its bond debt would have taken decades to issue new debt, but Stockton's behavior suggests there is little such fear today. Investors who fail to impose discipline on deadbeats are likely to find the deadbeats playing them for suckers.

Ratings agencies downplay the "systemic risk" that the Stocktons of the United States pose to the $3.7 trillion municipal bond market. But then they also said mortgage-backed securities were Triple-A. While the market may not be in danger of blowing up soon, bondholders face a very real danger of being blown off to preserve worker pensions.

A version of this article appeared December 30, 2012, on page A14 in the U.S. edition of The Wall Street Journal, with the headline: Stockton Tries a Chrysler.
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