Thursday, July 12, 2012

Reality Starts To Hit California Cities: Feds To The Rescue

After the City of Vallejo, CA filed for bankruptcy protection in 2008, it was deemed a special case.  Presently, it is said to be in recovery, although given the state of municipal financial accounting, it's hard to say what this means. 

Fast forward to 2012, and the larger city of Stockton, CA files for bankruptcy protection. Surprisingly, Wall Street friends who are experts in this field write this off too.Now comes the report of the City of San Bernardino preparing for a bankruptcy filing.  Here is a quote from a Wall Street money manager's blog:
The financial failure of Stockton, California, is a sad tale of inflated expectations and poor decision making, but it’s not a harbinger of things to come in the US municipal bond market. Stockton is a unique case..."

The City's report, prepared by a new, Interim City Manager should raise at least as much ire as the continuing dust up about the LIBOR fixing issue.

The City of San Bernardino has a population of 211,674.  65 miles east of Los Angeles, it is primarily a bedroom community.  Local government agencies are the largest employer, followed by Cal State University San Bernardino and other non-profits.  This is not a great situation for the tax base.

The number one revenue source for the city budget are sales taxes, which of course respond most quickly to changes in income and consumer sentiment. Property taxes were only 13% of peak municipal revenues in 2007-2008.  This is true despite the fact that residential property represents 52% of taxable land use value in the City of San Bernardino, $5.3 billion.  Also, the average residential property value is about $118,000 which along with a statewide cap on the tax rate means there is no blood to be squeezed out of this stone.

Commercial property values are stated at 19% of assessed value, while industrial properties represent 15% of values.  The City already has a huge backlog of commercial property property owners who are fighting to have their current assessments reduced.  These property owners won't be able to provide any revenue relief for the city.

California unemployment rates are said to be 10.9% by the City of San Bernardino staff report. San Bernardino County's rate is 11.7%, while the City of San Bernardino's reported unemployment rate is 15.7%!  This is a shocking and depressing number. 

There's the background, now for the rest of the story.  Reserves in the City of San Bernardino's General fund were exhausted "years ago."  Reserves of other internal services funds are badly depleted.  In municipal accounting, these various funds are like cookie jars where "rainy day" funds can be accumulated.  In San Bernardino, there is no cushion and no rainy day funds which can be tapped.

What went wrong? Accounting errors. A lack of revenue growth. Deficit spending. Increases in personnel and pension costs.  The only real surprise in this list are the accounting errors, which is probably why there is a new Interim City Manager. 

City Staff had previously reported a General Fund balance of $2,044,100.  A recent, audited balance shows a deficit of ($1,181,603).  Do you think that municipal bond investors or capital markets analysts care about this kind of thing? 

73% of the city budget goes to Public Safety, namely police and fire services.  This is typical for most municipalities in the U.S., and these are the services that homeowner (and their insurers) want.  The problem is the cost.  There are news reports of San Bernardino police officers making north of $200,000 a year in salary and overtime.  This is vigorously denied by police spokesmen today as untrue.  It may be "technically" untrue only because a previous $10 million rollback of salaries stopped some of these particular abuses.  This kind of salary featherbedding is a fact of life in many municipal budgets.

Talking about potential cost saving measures, the City Manger's report suggests "the City have employees pay the employee portion of retirement costs."  Again, this is very common that municipal employees don't even contribute to their own retirement costs or health care costs.  This is not sustainable under any kind of rational economics or accounting.  Yet, it probably won't change, except at the margins.

San Bernardino becomes the third California city in a month to look at bankruptcy.

The mortgage welfare scheme put forward by Mortgage Resolution Partners and its investment bank partners is aimed squarely at reelecting the President by handing out taxpayer candy out to the L.A.-Riverside-San Bernardino market homeowners.  The legal authority cited for this shell game is a paper by Cornell Law Professor Robert Hockett.  He really twists himself into a pretzel to make an argument for connecting urban blight to eminent domain via underwater mortgages.

Allies in the financial press, like the New York Times, cite this scheme as a "last chance" to rescue housing.  It's nothing of the kind. If so, then do it nationwide! That was the original Columbia University Business School proposal years back, put forward by Glenn Hubbard, Chris Mayer and other professors.  We were in favor of that proposal, as blog readers know because though draconian, it didn't pick winners and losers. At this point, this program is clearly a reward to borrowers who bought homes they couldn't afford in the frothiest pre-crisis market, with mortgages originated by the biggest subprime abusers, like Countrywide, IndyMac, New Century and others.

All of this is a diversion from the real issue of the unstable and unsustainable nature of municipal finance in many cities in California. This is a state issue, not a federal one.  Cities and municipalities with unsustainable tax bases need to be better managed and, perhaps, combine with adjoining municipalities to get scale and leverage on expenses like police and fire. The folks in Sacramento need to wake up all the promises they have made but which cannot be kept.

Even the City of San Bernardino's report itself calls for a "change in compensation philosophy."  No kidding.

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