November 1, 2014

The California municipalities of San Bernardino, Vallejo and Stockton filed for bankruptcy; Stockton’s Chapter 9 filing represents the largest such case in U.S. history. Continually depressed home prices have led to unusually high foreclosure rates in these markets. According to foreclosure data from RealtyTrac, a site that tracks housing data, these cities had among the worst foreclosure rates in the country.

Stockton, California Statistics as of September 2012

Decline in home prices: 62.8%
Unemployment rate: 15% (12th highest)
Median home price: $170,000 (76th highest)
Foreclosure rate: 1 in 66.2 housing units (the highest)

When Stockton filed for bankruptcy in June 2012, it became the largest-ever U.S. city to do so, according to the Wall Street Journal. The city’s economy has been plagued for years by falling home prices, which declined at an annualized rate of 16.6% between the first quarter of 2007 and the first quarter of 2012. Stockton also has one of the nation’s highest unemployment rates, at 15%, and a foreclosure rate that leads the nation, with one in every 66.2 homes in foreclosure. Though Fiserv projects home prices will rise at an annualized rate of nearly 6% between the first quarter of 2012 and the first quarter of 2017, the housing market remains weak: 54% of all second-quarter home sales were foreclosure sales, and the number of property listings in July was down more than 40% from a year earlier.

What led the city of Stockton to insolvency?

Stockton is a fairly large city of 300,000 or so, located about 80 miles east of San Francisco and about 50 miles south of Sacramento. With housing prices in those cities out of reach for many workers, long-distance commuting to Stockton became commonplace.

Stockton’s economy was largely dependent upon real estate prices, and the city flourished as home prices soared. Then came the crisis in late 2007, and Stockton was hit extremely hard by the ensuing recession. Property values declined by 60% from their highs in 2007 and at one point Stockton trailed only Las Vegas in terms of total number of foreclosures.

The graph above shows the steep decline in median home prices in the city. The problem in Stockton is exacerbated somewhat by California’s Proposition 13, which restricts annual increases in assessed value. As a result, even as the housing market recovers, the city’s recovery will lag.

The housing market decline resulted in draws on the city’s general fund as expenditures far outpaced incoming revenues. Stockton’s generous labor contracts and retiree benefits made reducing expenditures extremely difficult.

The pie chart on page two shows Stockton’s 2013 pro-posed budget. Even after layoffs and some concessions, the police and fire departments make up over 74% of Stockton’s general fund budget. Debt service accounts for 1%. In fact, even if Stockton were to default on all of its municipal debt, the city still projects a $100 million deficit over the next decade.

Contributing to the problems faced by the city were the extremely generous benefits granted to employees. Anecdotally, according to a 2012 Bloomberg report:
“Police Chief Tom Morris was supposed to bring stability to law enforcement when he was appointed to the job four years ago. He lasted eight months and left the now-bankrupt city at age 52 with an annual pension that pays more than $204,000the third of four chiefs who stayed in the position for less than three years and retired with an average of 92 percent of their final salaries.”
While these luxury pension plans aren’t the norm, they are also not altogether uncommon.

Given that Stockton’s credit issues are due in large part to the generous benefits provided to employees, it is perhaps appropriate that the crux of the Chapter 9 case revolves around the treatment of those benefits under bankruptcy protection.

While the municipal market waits patiently for a decision in the Stockton case, the lessons learned for investors should be clear:
  • Avoid municipalities that were hit the hardest by declining home prices.
  • Be aware of the portion of the budget that is being spent on labor; these contracts are difficult to amend, leaving the municipality little flexibility.
  • Avoid municipalities with large unfunded pension obligations.
Thornburg Investment Management has no exposure to the City of Stockton, but we will continue to monitor the situation closely. In the meantime, we will continue to be guided by the basic lessons above, along with rigorous, bottom-up, fundamentally driven credit analysis designed to steer the portfolios clear of future credit issues — both in California and across the country.

Stockton bankruptcy ruling preserves city pensions

Bankruptcy Court Judge Christopher M. Klein’s ruling will set a precedent that will have a far-reaching impact. All municipal investors should be watching this case closely. Not since the collapse of the bond insurers in 2008 has a single event had the potential to fundamentally alter the analysis of municipal credit risk. Should he rule in favor of pension holders, protecting their benefits above the claims of bondholders, it would essentially subordinate bondholders to the claims of public workers. A ruling of that type would immediately decrease the credit quality of all municipal bonds. In the future, public employees would have no incentive to negotiate with stressed municipalities, knowing that their benefits are protected. The result could be an increase in Chapter 9 filings as municipalities lose the flexibility to control future expenses. On the other hand, should Judge Klein rule that public employees must take a haircut in line with other creditors, municipal bondholders will benefit. Under that scenario, public employees would be much more willing to come to the bargaining table if they believe their benefits are no longer protected under Chapter 9. [Source]
Bankruptcy Court Judge Christopher M. Klein approved Stockton's bankruptcy recovery plan, allowing the city to continue with planned pension payments. (U.S. Bankruptcy Court).

Stockton's plan slashes city spending, cuts salaries and eliminates jobs — but preserves worker pensions. Also, companies owed money by the city will get back only a fraction of what they're due.

The case was being closely watched after the judge ruled this month that the city's payments to the California Public Employees' Retirement System could be cut in bankruptcy, just like any other obligation.

If Judge Christopher M. Klein had rejected Stockton's plan and forced the city to reduce its payments to CalPERS, it could have opened the door for other financially ailing cities struggling with escalating pension costs to follow suit.

The decision was good news for public workers and retirees statewide, said CalPERS Chief Executive Anne Stausboll, whose agency fought any pension cuts as part of the Stockton bankruptcy proceedings.
"We will continue to champion the integrity and soundness of public pensions to protect the benefits that were promised to the active and retired public employees," she said.
Pension reformers were not happy. They criticized the decision, saying the city's rising pension costs would continue to take money from essential services and keep Stockton on the brink of a second insolvency.
"The city of Stockton missed an opportunity to use a powerful tool to save their city's finances that's only available in Bankruptcy Court," said Dan Pellissier, president of California Pension Reform.
Stockton officials had argued that it was not possible to cut pensions or to create another retirement plan for city employees. They said employees would leave Stockton for other cities offering retirement benefits through CalPERS.

CalPERS had said that if Stockton left the state retirement system, the city would immediately owe it $1.6 billion — far more than the city's current bill to the pension plan.

On Thursday, Klein said the city's 1,400 workers and 2,500 retirees had already taken enough hits in the bankruptcy.

Stockton's salaries and benefits for workers had been higher than those at other cities, the judge said, but workers had agreed after the bankruptcy filing to take big cuts, including eliminating the free medical care they received in retirement.
"It would be no simple task to go back," Klein said, "and redo the pensions."He added, "This plan, I'm persuaded, is the best that can be done."
Klein said that rejecting the plan after two years in court and tens of millions of dollars in legal and other fees would have put the case back to "Square One."

Stockton's plan sharply cuts payments to its creditors, including Franklin Templeton, an investment firm that holds more than $36 million in bonds the city used to borrow money. Franklin had asked Klein to reject the city's plan so that it could get more of its money back.

Franklin's financial expert used the city's own projections to show that it would soon be paying CalPERS nearly 19% of general tax revenue — up from 11% today. Franklin had argued that the increasing cost of pensions would put the city at risk of another bankruptcy.

But Klein said Thursday that Stockton's plan for paying creditors over the years was adequate and passed all legal tests.

City Manager Kurt Wilson said after the ruling that it "confirms that Stockton is fiscally stable and on the road to recovery."
"We are going to have stability that impacts our ability to attract and retain employees," he said.
It was a turnaround from Klein's oral ruling Oct. 1, when he said public workers' pensions were not sacrosanct and could be reduced in a bankruptcy.
"It looked like he was telling cities they had an easy offramp" to rising pension costs, said Harvey Leiderman, a lawyer at Reed Smith who advises CalPERS and other retirement funds. "Now he's shut down that offramp."
Klein explained in court what happens when employees and retirees are given equal standing in bankruptcy compared with all other creditors. The workers and retirees then far outnumber the other creditors and would have the power to veto any decision that is not favorable to them.
"You'll never come out of bankruptcy, and that's what he recognized," said Leiderman, describing Klein's decision.
In recent years, pensions have been a political hot potato in Stockton. Overly large pensions approved by city officials for employees are among the reasons that Stockton found it could no longer pay its bills, critics say.

Stockton's promised pensions for police and fire employees are some of the highest in the state, according to an analysis by Franklin's expert. The city is now paying the equivalent of 41% of police salaries to CalPERS for future pensions — an amount that will increase to 57% in five years.

As a result, the city will face continued challenges in the years ahead.
"They're betting on a rosy scenario for years to come, said Pellissier of California Pension Reform. "Only time can tell whether the city of Stockton can continue to provide services without relief from its unsustainable pension obligations."

Stockton and San Benardino, California ranked last in national survey of economic conditions in the nation's 150 largest cities

Sacramento Bee
October 8, 2014

The national economic recession ended five years ago, but recovery has varied widely and California doesn’t fare particularly well in a national survey of economic conditions in the nation’s 150 largest cities.

In fact, Stockton and San Bernardino, two California cities that have filed for municipal bankruptcy, were ranked 149th and 150th in the survey. The highest mark for any California city was San Francisco’s No. 20.

The city-by-city evaluation of economic conditions was conducted by Wallet Hub, a website that gathers and disperses personal economic data.

Its team of university economists assembled 18 key indices of economic health, including employment and unemployment data, personal income changes, real estate values, poverty rates, personal bankruptcies, personal debt and crime rates with scores for each.
“Whenever a city is left behind in a recovery, collateral effects are bound to afflict already struggling economies,” Wallet Hub said in its report. “From a public standpoint, this could lead to further complications: Crime rises, education suffers, local administrations collapse.

“In the private sector, property values decline and businesses shut down. If and when that happens, skilled workers are forced to seek better opportunities in more thriving communities. And a town that had little hope remaining is completely crippled.”
Two cities in Texas, Laredo and Irving, were ranked No. 1 and No. 2 in the survey and most other high-ranking cities were in the South and Southwest, although Denver was No. 4 and Minneapolis No. 7.

Among California cities, Bakersfield, which is experiencing an oil boom, came in at No. 23 and San Jose, in the heart of Silicon Valley, was No. 35. Los Angeles, the state’s largest city, was ranked No. 99, but it outranked the second largest city, San Diego, which was No. 103, followed by Sacramento at No. 104.

Beyond Stockton and San Bernardino, other California cities low in the rankings included Fresno at No. 125, Long Beach at No. 129, Riverside at No. 140 and Modesto at No. 146.

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