Blind, broke, and bedlam: differentiating fiscal stress from bankruptcy in California.

Author:Singla, Akheil

    Municipal bankruptcy is a process that public managers are reluctant to use. This reluctance is understandable given the legal hurdles to pursuing Chapter 9 bankruptcy relief, the political consequences that public managers will face with such a filing, and the financial costs that the public may experience as a result of the financial market's reaction to such a filing. Notwithstanding the factors discouraging the use of municipal bankruptcy, there have been a number of high profile bankruptcy filings by municipalities over the last several years. Most notably, Detroit filed in late 2013, bringing with it a veritable firestorm of attention from the financial media. This attention aside, the situation in Detroit is only a larger-scale example of what several cities and local governments have been experiencing since the onset of the global financial crisis in 2007. Indeed, the past few years have seen the record for largest municipal bankruptcy broken several times, most recently by Detroit, but preceded by Stockton in California and Jefferson County in Alabama before it. The present study aims to shed light on the decision to file by examining the three recent bankruptcies in California: the cities of Stockton, Vallejo, and San Bernardino.

    The research begins with an examination of the literature on the factors causing fiscal stress, which is thought of as a necessary-but-not-sufficient condition for bankruptcy, with a particular focus on different types of solvency. The literature yielded numerous systems designed to measure fiscal health. Two of these systems were then used to compare the three bankrupt cities to other California cities. Based on these comparisons, we explore three questions: 1) Are the bankrupt cities in California the most fiscally-stressed of all cities in California? 2) If not, what other factors not captured by the measures of fiscal health might be affecting the decisions to file? 3) Are the current measures of fiscal health predictors of bankruptcy risk?

    We investigate these issues by examining three bankruptcy filings in California from 2008 to 2012. More specifically, we compare the fiscal health of San Bernardino, Stockton, and Vallejo to 58 other similarly sized cities in California. This approach has several advantages over previous studies of municipal bankruptcy. First, the three filings in California represents the first time since the Great Depression that more than one general purpose government within the same state has filed for bankruptcy within several years of another. This allows us to make comparisons between the three cases that are otherwise impossible. Namely, that each city is subject to the same state laws governing bankruptcy allows us to put aside concerns of how the legality of filing affects the decision to file. Finally, because all three cities are in the same state and are of a similar size--between 100,000 and 300,000 people--we can establish a comparison group to see whether there are differences in the fiscal profile of each city leading up to and during the bankruptcy proceedings. This allows us to make comparisons that have been previously impossible in studies of bankruptcy. Our analysis finds that while the bankrupt cities were certainly more fiscally stressed than the median city, they were not exclusively the most fiscally stressed. We suggest several reasons why this might be the case, including the stigma associated with filing for bankruptcy, legal costs, and potential issues with fiscal indicators.

    The rest of the paper proceeds as follows: first, we provide an overview of the mechanics of municipal bankruptcy and how they relate to fiscal stress. Next, a review of the literature on fiscal health yields two systems we then employ to measure fiscal stress in the California cities. The third section describes our data, how we obtained it, and gives an overview of our methods. From there, we describe the results of our analyses, with an eye toward comparing the bankrupt cities to the other cities in California. The next section discusses our findings and how we might explain them theoretically, and a final section offers some concluding thoughts.


    As this paper is largely focused on municipal bankruptcy and the factors that cause it, it is necessary to begin with a discussion of the process, what it entails, and what it can mean for municipal governments. The first and perhaps most significant aspect of municipal bankruptcy is its rarity in modern times. From 1970 to 2011, there have been approximately 71 municipal bond defaults, with the majority tied to the business-like activities of governments, like health care services or housing, rather than general activities of governments. As a point of comparison, during that same time, there have been more than 1,700 corporate defaults (Moody's, 2012; Spiotto, 2012). Despite the obvious benefits to the public, the relative rarity of municipal defaults presents a problem for public finance scholars. Namely, because the event is so rare, it is difficult to research the causes and effects in a systematic way.

    Most research in this area has focused on how the legal proceedings--commonly referred to as Chapter 9--operate and understanding the specific mechanics of the Chapter 9 Bankruptcy process. Chapter 9 of the Bankruptcy U.S. Code provides that a political subdivision of a state may file for bankruptcy if a municipality (a) is specifically authorized to file by state law or by a governmental officer to file; (b) must be insolvent; (c) must desire to enter into a plan to adjust its debts; and (d) must obtain the agreement of its creditors, negotiate in good faith with its creditors, be unable to negotiate with its creditors due to impracticability or believe that a creditor may attempt to obtain a preference (11 U.S.C. [section] 109(c)). In order to satisfy the first of the conditions specified, California requires municipalities seeking protection under Chapter 9 to engage in a neutral evaluation process if it is, or is likely to be unable to, meet its financial obligations (CAL. GOV'T CODE [section] 53760.3). This process is known as a conditional approval, and it differentiates California from many other states by providing cities with a much clearer path to bankruptcy (Spiotto, Acker, and Appleby, 2012). (1) If a bankruptcy filing is accepted by the Bankruptcy Court, a stay is entered that operates to prevent collection actions against the debtor, in this case the municipality. The bankruptcy process provides the debtor the opportunity to renegotiate contracts by giving the debtor the ability to cancel contracts that still require performance on its part. Of particular importance for bankrupt cities are employment contracts including contracts that are the subject of collective bargaining. In addition, the debtor may use the bankruptcy proceedings to negotiate the terms of its debt. For general obligation indebtedness, the debtor is not required to make principal or interest payments while the case is pending. In contrast, special revenue indebtedness will be serviced as usual during the case (See 11 U.S.C. [section] 928). While the bankruptcy proceedings under Chapter 9 are similar to those of other provisions in the bankruptcy code, the court and bankruptcy trustee do not have the authority to interfere with the operations of the municipality as it does in the context of a non-municipal debtor. The bankruptcy process will conclude for a municipal debtor when it files a plan of adjustment and has that plan confirmed by the court (11 U.S.C. [section] 941).

    While it is important not to discount contributions of legal scholars, it is also the case that public finance scholars can add to the body of literature in an entirely different way. The few finance-oriented authors writing in this area have mostly focused on individual cases. Park (2004), however, analyzes multiple cases to isolate some of the factors that cause bankruptcy. The study suggests that factors can be political or economic, and within each of those bins, internal and external, and long term or shortterm. For instance, he suggests that fiscal mismanagement is an economic, short-term, internal problem that can lead to bankruptcy. While Park's analysis is useful in case analysis, it is not especially specific on how to measure each of these factors. In other words, it is difficult to know what fiscal mismanagement means, or the extent to which it will lead to bankruptcy. Our study attempts to fill this gap by leveraging the literature on fiscal health to measure the extent to which fiscal variables can predict bankruptcy. Based on this, the next section will review the different ways scholars measure fiscal stress.


    Historically, interest in local government fiscal health has been driven by media reports of problems in large cities. Correspondingly, the issues in New York and Cleveland in the 1970s spawned a great deal of work, from practitioner groups and academics alike, discussing how to measure fiscal health (for a summary of these, see Kloha, Weissert and Kleine, 2005). Nearly a decade later, problems in other major cities spurred more discussion on modeling and predicting fiscal problems (Brown, 1993). More recently, the Great Recession has again placed numerous local governments under duress, leading to more scholarship in this area (Garcia-Sancez, Cuadrado-Ballesteros, Frias-Aceituno, Moran, 2012; Zafra-Gomez, Lopez-Hernandez, Henandez-Bastida, 2009; Jones and Walker, 2007; Trussel and Patrick, 2012). In addition to this current examination, some research has been undertaken to explore municipal default probabilities in California in the wake of the Great Recession (Holian and Joffe, 2013). Despite the difference in timing, the major thrust of this branch of literature has not changed: it aims to develop ways to predict fiscal stress in local...

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