Fate of the States: The New Geography of American Prosperity (18 page)

With so many businesses now requiring proximity to little more than a highway, an airport, and a high-speed data network, the nation’s business and industrial hubs have never been more vulnerable to poaching by rival states with better services and lower taxes. The history books offer one ominous analogy for the poachees: New York City. Between 1950 and 1980 high taxes, declining schools, rising crime, and political lunacy (culminating in the 1975 fiscal crisis) contributed to a New York City population decline of 800,000—from 7.9 million to 7.1 million people. It took twenty years before New York City recouped those population losses.
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In 1950 the city of Detroit boasted a population of 1.8 million people. Just 60 years later its population has been reduced to a mere 600,000. Why? Jobs exodus, political and social instability, and steeply reduced social services create a self-perpetuating downward spiral that many cities find impossible to escape. This is how Detroit, once America’s sixth-most-populous city, devolved into a welfare city—another American ghost town.
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The contexts may be different, but stories like Detroit’s are playing out all over the country. Population is declining in the Las Vegas metro area. Even Florida saw its population decline in 2009. The loss of business and jobs always leads to reduced tax revenues, reduced services, and more incentive for residents to leave. What’s different today is causation. Governments are no longer helpless victims of business loss but the catalysts for it. Businesses and families are leaving because they cannot afford the taxes now needed to pay out-of-control debt service. It’s why America’s central corridor—the heartland, the Midwest, the onetime flyover states, the golden triangle within the center of the country—will be the foundation of economic growth for years to come.

David Takes On Goliath: New Political Precedents

When I first wrote about the threat that state and local budget crises pose to the overall U.S. economy back in September 2010, I assumed the first stories to make headlines would involve heavy pressure on the mayors and governors in housing-bust states to cut expenses and, more important, cut payroll. The outcry would arise from social-contract defaults—in the form of citizens receiving reduced services for higher taxes. This first phase would continue until the pain got so acute that taxpayers and voters stepped in to stop the bleeding. Voter outcry would then initiate phases two and three—cuts to public-employee pensions and refusals to make good on municipal-bond payments. To my surprise, the outcry that deafened all others involved the mere mention of municipal-bond defaults, let alone sizable ones. The loudest complaints were from the municipal-bond dealers, who shouted back that widespread municipal-bond defaults had not happened since the Great Depression and therefore could not and would not happen again. Needless to say, this argument reminded me of those who contended that home prices would never go down because they hadn’t since the Great Depression. They also argued that municipal bonds couldn’t default because most bonds were backed by the full faith and credit—the guaranteed taxing authority—of the state and local governments that had issued them. Of course, so too did pension obligations. It was never clear to me why muni-bond folks thought there could be defaults on some tax-guaranteed obligations—i.e., pensions—but not on municipal bonds. When a pension contract is renegotiated, isn’t that a default? And while not explicitly guaranteed by taxes, how are essential state services like education and infrastructure morally subordinate to bondholders? The issue wouldn’t come down to the ability to pay. State and local governments may be technically able to meet their tax-guaranteed obligations, but only if they sacrifice significant services and infrastructure investment. And remember, tax guarantees are only as good as the taxpayers willing to honor them. The bigger and more inflammatory issue would be willingness to pay. So long as willingness to pay was an issue, reform and compromise would be critical.

Reform will be difficult, especially given the outsized political influence wielded by public-employee unions. Ironically, however, many of the early success stories of pension reform come from largely Democratic locales. Voters in San Jose, for example, approved some of the most aggressive pension reform yet in the United States by a margin of nearly 70 percent to 30 percent.
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San Jose passed reforms that doubled the amount new employees contribute to their pension plans, increased the retirement age, capped the cost-of-living adjustment, and altered the calculation upon which benefits were determined by averaging salaries over the last three years of employment (instead of using just the last year). For existing employees the reforms also restricted benefits, either by requiring higher employee contributions or by transferring benefits to a lower-cost plan with reduced benefits.

Why did Mayor Chuck Reed of San Jose get such widespread support for pension reform, which is typically unpopular? How did this come about? The voters of San Jose had reached an inflection point, saying, “Enough is enough.” Since taking office in 2007, Reed had done everything within his power to improve the city’s finances, yet the city could not escape budget shortfalls. Just like most states, San Jose is required to balance its budget, but doing so required cutting programs and reducing services. So in the summer of 2012, after the city cut more than a thousand jobs and cut salaries by over 10 percent—and all the while not properly funding its heath-care programs—the community took a stand, with 69 percent of voters approving a rollback in pension benefits.
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Elected in 2006, Reed says he was not asked one question about pensions in fifty-eight mayoral debates. Today he is the go-to guy across the state of California—and lately across the country—on pension reform. Unwilling to undermine public safety further by reducing the number of police officers and firefighters on the job, Reed focused on the fastest-growing expense in the city’s budget: pensions. He began to focus on the importance of bringing down the costs of future accruals. When he took office, Reed’s budget staff warned him that annual retirement costs could soar from $155 million to $650 million within five years. Reed kept his message simple: Pension expenses had grown faster than any other single expense in the city, and if they were not addressed, there would literally be no money left for public protection and services. “Taxpayers are paying for services,” said Reed. “They should get those services. . . . It’s just going to get worse if we don’t get control of these costs.”
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The Bankruptcy Option

Bankruptcy is the last resort for any individual, business, or government. Filing for Chapter 9 bankruptcy is supposed to give a financially distressed government the time and fiscal breathing room required to develop and negotiate plans for reorganizing debt while protecting the government from its creditors. However, while the option may seem enticing, Chapter 9 bankruptcy can be an expensive and time-consuming process with an uncertain outcome. Any municipality choosing to file for Chapter 9 faces a certain negative impact in the credit market, resulting in increased borrowing costs in the future. Indeed, when Orange County declared bankruptcy in 2004, the municipal-bond market punished not just the county but the entire state, demanding higher interest payments from all California issuers of municipal bonds.

The Orange County Precedent

On December 6, 1994, Orange County made history by becoming the largest municipality ever to declare bankruptcy. Before that time, municipal bankruptcies had been rare. Not since the 1920s and ’30s had U.S. muni investors faced the prospect of defaults on general-obligation bonds by a major bond issuer like Orange County, the sixth-largest county in the country. At the time, the Orange County bankruptcy was seen as an anomaly. The county was a victim of newfangled financial instruments known as derivatives and of the reckless behavior of one man—county treasurer Robert Citron—who played the derivatives market in a failed attempt to boost revenues in the midst of recession. Experts in public finance didn’t see the Orange County bankruptcy as a precedent or even as a red flag, given that bondholders wound up being repaid in full. This line of thinking had some merit, but the reality is that bondholders would not have been repaid in full had it not been for a bailout by the state of California. Because the municipal-bond market had responded to the Orange County bankruptcy by punishing all California issuers with higher interest rates, it was actually cheaper for California to bail Orange County out than to continue to pay higher borrowing costs. Eighteen years later, California is in no position to bail anyone out.
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November 2011: Jefferson County, Alabama

The Jefferson County Commission filed for the largest municipal bankruptcy in U.S. history in 2011
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—$4.2 billion in unpaid debt, more than double the size of Orange County’s once-record bankruptcy filing. Jefferson County’s finances were sunk by a water-and-sewer project that, thanks to graft and engineering blunders, never actually got built despite the county’s borrowing and spending billions. Following the 2008 housing-market crash and subsequent loss of triple-A ratings by Financial Guaranty Insurance Company (FGIC) and XL Capital Assurance (companies that insured the bonds), the interest on Jefferson County’s variable-rate sewer warrants soared. After struggling for years, the county could not support the tentative deal reached with creditors in September 2011 to immediately begin increasing sewer rates by 8.2 percent annually from their current rate for the first three years. The county’s bankruptcy filing resulted in a loss to creditors, higher tax rates for local taxpayers, a dramatic cut in services ranging from police to litter cleanup, and a loss of access to the credit markets. “People are desperate to think of anything they can to get the money,” local businessman David Sher told the
New York Times
.
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The money won’t be coming from the state of Alabama, whose legislature is dealing with a $140 million budget deficit of its own and has so far refused pleas for a bailout akin to Orange County’s. “In areas outside Jefferson County, the feeling is why should we ‘bail them out’ for their poor financial management, for their bribery and kickbacks and for what was a seedy, nefarious indebtedness,” Alabama state senator Arthur Orr, a Republican from Huntsville, told the Stateline news service.
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States just have too many budget problems of their own. In New York, for example, Governor Andrew Cuomo has warned municipalities considering bankruptcy not to expect a lifeline from the state. “Some of them are saying, ‘Well, we should look to the state for effectively a bailout,’” Cuomo told an upstate New York talk-radio station in September 2012. “We are not in the position of being an underwriter for local governments . . . and I don’t believe we should.”
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June 2012: Stockton, California

The Jefferson County bankruptcy was more rooted in the water-and-sewer fiasco than in any fallout from the recession or the housing crash. The Stockton bankruptcy, on the other hand, is a perfect example of how the housing boom and bust subverted municipal budget making. It also foreshadows more bankruptcies to come. With 292,000 residents, Stockton is the largest U.S. city ever to file for Chapter 9 protection under the bankruptcy code. It’s also one of California’s grittier cities—the TV biker drama
Sons of Anarchy
is filmed there—which made Stockton a most unlikely beneficiary of the housing boom. Yet between 2001 and 2006 average home prices in Stockton tripled to $400,000, thanks in large part to a surge in subprime mortgage lending. Flush with new tax revenue, city officials increased spending from $160 million in 2003 to over $200 million in 2007.
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Along the way, the city made some dreadful fiscal decisions—including the back-loading of debt and the granting of overly generous pension deals to city employees. According to the
Wall Street Journal,
even though California state law requires public employees to contribute between 7 percent and 9 percent of their salary to their pension, Stockton actually agreed to pay workers’ contributions for them.
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To top it all off, Stockton rolled the dice in 2007 on pension-obligation bonds, borrowing $125 million in the bond market only to lose $25 million in the stock-market crash. When the real-estate market crashed too—the average Stockton home price fell 58 percent between 2006 and 2011—the city simply could not reduce spending fast enough to pay its bills. By the time it filed for bankruptcy, Stockton had already cut staff 25 percent in its police department and 30 percent in its fire department.
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Stockton now has the tenth-highest rate of violent crime in the country, according to Stockton city manager Bob Deis. “We have the second-lowest police staffing levels in the country for a large city,” Deis wrote in a
Wall Street Journal
op-ed, “and often Stockton Police can respond only to ‘in-progress’ crimes.”
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The city is now locked in an expensive legal battle—as of September 2012, Stockton had spent $4.9 million on lawyers—with two bond-insurance companies that want Stockton to suspend all payments into the CalPERS state-employee pension system and redirect those monies toward bond repayment. The city won a court battle with public-employee unions that objected to the city’s postbankruptcy decision to cut all health benefits to retirees while it reorganizes. Says Deis: “We are trying to be responsible in dealing with our creditors, but in the process we cannot destroy a community and its hope for the future.”
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July 2012: Mammoth Lakes, California

The city of Mammoth Lakes decided to seek Chapter 9 bankruptcy protection after losing a $43 million lawsuit against a real-estate developer, Mammoth Lakes Land Acquisition. The tourist town backed out of the agreement once it realized that the development would thwart city plans to lengthen a runway at the local airport in order to accommodate larger commercial jets. The developer sued the town for breaching the development agreement that was supposed to allow the company to build homes, airplane hangars, and other commercial buildings near the Mammoth Yosemite Airport. The judgment totaled nearly three times the Mammoth Lakes annual budget, a budget already $2.8 million in the red for fiscal year 2011–12.
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July 2012: San Bernardino, California

A story not unlike Stockton’s, San Bernardino’s bankruptcy stemmed from budgetary mismanagement coupled with rising pension and debt costs. Despite having trimmed its public workforce by 20 percent since 2008, San Bernardino faced escalating budgetary pressures due to rising costs associated with the city’s union contracts. Facing a $46 million budget gap and $157 million in unfunded pension and health-care obligations, San Bernardino filed for Chapter 9 protection in July 2012. City Attorney James Penman defended the mayor and city council, claiming budget officials had falsified fiscal reports, hiding deficits over a sixteen-year period.
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In the cases of both Stockton and San Bernardino, the housing boom encouraged politicians to grant excessive pay and benefits to employees and the bust made those pay and benefit increases untenable. Other municipalities in California are flirting with Chapter 9 bankruptcy as rising pension and health-care costs are beginning to push them over the edge. Atwater, a small California city facing a $3 million deficit, recently declared a “fiscal emergency.” (Under California law, before cities can declare bankruptcy they must declare a fiscal emergency and agree to mediation with creditors.) Other municipalities facing mammoth budget deficits include Chicago ($298 million), Los Angeles ($216 million), and the School District of Philadelphia ($218 million).
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