* Pre-bankruptcy mediation tests new state law
* Drastic cost-cutting hits spending on public safety
* City managers optimistic on avoiding the worst
By Jim Christie
SAN FRANCISCO, March 19 When the city of
Stockton, California announced last month it would skip some
bond payments and enter talks with its creditors, the municipal
debt world shuddered.
If Stockton were to go bankrupt, it would be the largest
U.S. city ever to do so. Other troubled Californian
municipalities might be tempted to follow suit. Predictions of
mass defaults on municipal bonds might start to look a little
But a close look at the municipal finance situation across
California suggests mass bankruptcies are unlikely.
Most troubled local governments in the state have taken
drastic steps to cut spending, with city managers asserting they
have their arms around the problems. A new, state-mandated
mediation process may also help municipalities avoid the worst -
though it could force bondholders to accept losses outside the
The new law, passed after the San Francisco Bay area city of
Vallejo filed for bankruptcy in 2008, requires Stockton to try
to corral its major bondholders, bond insurers, city employees
and retirees into mediation for up to 90 days.
"City negotiators will surely hold the bankruptcy gun to
stakeholders' heads, including employees and their unions and
bondholders represented by the insurers," wrote Alan Schankel,
an analyst with Janney Capital Markets, in a recent note.
The city's credit ratings have been slashed. Moody's
Investors Service lowered Stockton's general fund-supported debt
ratings to below investment grade, a move affecting about $341
million in debt, while Standard & Poor's has taken Stockton's
issuer credit rating down to one notch above 'D', the bottom
As in other troubled cities around the state, the depth of
Stockton's problems is a mirror image of the heights the city of
292,000 appeared to reach during the housing boom. An inland
port and agricultural hub for Central Valley farms, Stockton was
abruptly - and briefly - transformed into a distant bedroom
community for the Bay area in those prosperous times.
According to online foreclosure marketplace RealtyTrac Inc,
Stockton last year had the second-highest foreclosure rate of
all large U.S. metro areas, with 5.43 percent of its housing
units receiving foreclosure filings. Las Vegas had the highest
rate: 7.38 percent, compared with a nationwide 1.45 percent.
Stockton's financial problems were worsened by two decades
of profligate spending on items including rich public employee
contracts, a downtown sports arena and other urban
revitalization projects, according to its city manager, Bob
The city faces a deficit of as much as $38 million on its
general fund budget of $165 million.
In Stockton, as in Vallejo and other cities, the root of the
problem is a dramatic fall in revenues. Developer fees have
largely vanished with the near-halt of home building, and
property taxes have followed housing values south. In Stockton,
general fund revenue fell to an estimated $161.8 million for its
current fiscal year, from $217.5 million in 2007-2008.
With unemployment at 10.9 percent across California - and
above 16 percent in hard-hit places such as Stockton and Fresno
- raising revenue with new taxes and fees is difficult. State
law also puts firm limits on property tax increases and makes
any type of tax rise difficult.
Still, many local officials say bankruptcy and default
concerns are exaggerated.
Hercules, a town about 10 miles (16 km) south of Vallejo,
recently defaulted on a debt payment amid a lawsuit with its
bond insurer, prompting Standard & Poor's last month to drop its
ratings on some city debt by five notches to a speculative grade
Since then, though, Hercules and Ambac Assurance Corp, a
subsidiary of Ambac Financial Group Inc, have reached
a settlement; together with union concessions, that will keep
the city from having to consider pre-bankruptcy mediation.
"For the most part, the unions have been willing to come to
the table," said Steve Duran, city manager of Hercules.
The only other California municipality currently seeking
pre-bankruptcy talks is Mammoth Lakes. But the issue in the
7,400-person ski resort town is not the economy but rather a $42
million legal judgment against it over a property development
dispute. Assistant City Manager Marianna Marysheva-Martinez said
the town would not default on its roughly $2 million in debt.
A more typical case might be the town of Lincoln, a bedroom
community outside Sacramento that has also suffered severely
from the housing bust.
Over the course of a decade, Lincoln was transformed from a
sleepy rural community of 8,000 into a bustling suburb of 42,000
and city services were expanded accordingly, including a
full-time fire department put in place in 2001.
BEYOND BARE BONES
When the housing market went bust, Lincoln's revenue shrank.
City leaders responded by tapping reserves and slashing spending
on public safety, which accounts for most of the budget. The
city reduced the number of its police officers to 20 from 40 and
closed two of three fire houses. Increased contributions by city
employees to their retirement accounts also helped.
Bankruptcy isn't an option, said Mayor Spencer Short, adding
that more cuts are coming: "I'm looking at the possibility of
introducing a budget that's beyond bare bones."
Antioch, a city of 100,000 on the eastern fringe of the San
Francisco Bay area, is another municipality clobbered by the
housing slump. Unlike in Vallejo and Stockton, though, relations
between Antioch's city leaders and labor units were not
contentious, allowing quick action to cut costs when the scale
of its financial troubles became clear, City Manager Jim Jakel
Jakel ticked off Antioch's moves to keep its books balanced:
a hiring freeze; furloughs; employees waiving pay increases; and
a city workforce reduced to 245 from 401 through attrition and
Costa Mesa, a city of 110,000 south of Los Angeles, has
slashed its payroll from 611 to 450. It is selling its police
helicopters and has hired a neighboring city for air patrols.
It's also pursuing a controversial effort to convert to a
charter city from a general law city, which would give City Hall
more power to outsource more work, said councilman Jim
In a similar vein, nearby Santa Ana, population 325,000,
recently folded its fire department and turned fire protection
over to the county, saving $10 million a year. Consolidating
fire districts has become a popular cost-saving move across the
In San Diego, Mayor Jerry Sanders wants to hire private
firms for some services - unless city employees undercut them.
Last month, city workers won a bid for street sweeping that will
cut the city's expenses by $560,000 a year. Similar city-worker
bidding last year resulted in $5.5 million in savings.
Sanders, who said cost-cutting and a revenue uptick would
help San Diego post a $16.6 million surplus this year, has a
more dramatic plan to pare expenses over the long term: a ballot
measure that would put nearly all new city employees into
401(k)-style retirement accounts instead of traditional
Voters in San Jose, California's third-largest
city, will vote in June on a pension measure to reduce
retirement expenses that Mayor Chuck Reed blames for consuming
an increasing share of funds for city services. Reed has said
San Jose faces "service-level insolvency" if it fails to control
While political battles over pensions in those two big
cities have been contentious, public employees across California
have been quietly agreeing to pension concessions in recent
years and local officials are seen pressing for more, according
to the League of California Cities.
They'll keep clamping down on other costs too as property
tax revenue remains tight. "Those of us who look at government
economics just don't see a near-term turnaround," said Stewart
Gary of Citygate Associates, a government consulting firm in
The new California law mandating mediation came after the
Vallejo situation exposed the weaknesses of bankruptcy as a
means to address municipal finance problems. City services there
have been eviscerated, many employees lost much of their
healthcare and other benefits, and legal bills have topped $10
Yet many of Vallejo's largest long-term costs, namely
pension liabilities, remain in place, and the hit to the city's
reputation has further depressed its housing market and
discouraged businesses from opening.
Mediation could enable cities to get some debt relief
without the stigma and costs of bankruptcy.
But some in the municipal bond world worry that the process
will create moral hazard.
"I'm just wondering if Stockton's actions are going to
prompt some people to say 'Hey, we've got a quick fix here',"
said Dick Larkin, director of credit analysis at HJ Sims.
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(Editing by Jonathan Weber; Desking by Dale Hudson)