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.

Public Education Can't Be Reformed

The ideology that drives our system of public education has deep roots, going back to the French Revolution and the Jacobins. The philosophical foundations were articulated by Jean Jacques Rousseau in his "Social Contract." Rousseau had the notion that education had little to do with books, but with inculcating into all students core ideas about the "commonweal." 

These ideas had a great influence on Horace Mann, the first Commissioner of the Board of Education in Massachusetts who went on to serve in the Massachusetts Senate and House of Representatives. His influence on American public education has been profound.  Charles L. Glenn's book, and its copiously footnoted sources, provides the best exposition of this history.

Mann felt strongly that the "common school" was to be the preferred instrument for eliminating idiosyncratic local cultural practices among immigrants of different national and religious origins, levelling them into one identity.  The large Irish influx in Lowell, MA came to work in the new factories.  Catholic religious orders set up schools to educate, as best they could, the large influx of new immigrants.

Meanwhile, as often happens in American society, there was another background social struggle among competing elites. From Mann's earliest days at the Board of Education in 1837, educational discussions were dominated by the property holding classes.  With the flowering of Rousseau and Danton's ideas, a new elite arose to dominate the discussion about the "common school."  Glenn describes this group as being comprised of lawyers, Protestant clergymen, journalists and self-styled commentators who saw the French ideals as a fertile new area in which to expand their influence by championing these quirky ideas.

When Horace Mann began his career, he was a relatively obscure lawyer, with few social connections. Mann found worthy allies in this new elite, and they would propel his ideas and career.  Together, they concocted the notion of a necessary state monopoly on education so that citizens could be educated about virtue, the need to combat indolence, intemperance, and even prevent the spread of crime among the new immigrant populations. 

The new ideas of the "educational reformers' also picked up support from Protestants in Massachusetts who were worried about the large Irish Catholic influx into Lowell's burgeoning industrial center.  They feared a conspiracy to take away a supply of new students from public schools.  Fearing the growing influence of what they libelously called "papists,"  they too joined the new educational elite to support the common school movement. 

From these deep roots in the American educational psyche, we had to pass through the debilitating effects of the Sixties and Seventies, where the common school became a giant, impenetrable, self-sustaining machine, stronger than the any corporate industrial machine.  Even the most powerful American corporations--pick your favorite example--can easily be felled by bad management, the business cycle, or by changes in their business paradigm.  The educational establishment is truly bullet proof because of its ties to the State and its tax and regulatory powers. 

It may make you laugh or it may raise your blood pressure, but go and find a catalogue from your local College of Education, whether in a private or public university. Read the course descriptions. Courses on teaching mathematics talk about how to connect to local resources, design assessments, integrate technology and plan lessons.  Courses in Human Relations will challenge students to produce environments in which diverse learners can experience learning which is "multicultural, gender fair and disability aware."  I know that elite schools in China are not spending any time with their students on these objectives. Then, we complain that we are behind Country X in math and science and therefore we need to spend more money with the failing public system.

There are many good teachers in public schools, but there are many more mediocre teachers who are merely punching the clock, and there is the other end of the curve which should be removed.  The teachers, however, don't operate in a vacuum.  Today's public school teachers have to deal with an administrative bureaucracy whose sole job is to monitor the incoherent and unattainable mandates put upon the school by the state and federal educational bureaucracies.  I have yet to meet a public school teacher who expresses respect, let alone enjoyment, at working for their district administration.

What these teachers are asked to do is totally ridiculous.  Andrew Coulson's recent article cited the disproportionate growth in the teacher population versus the student population nationwide. I don't know if this is the real problem.  I believe that it is relentless growth of educational mandates which teachers have to fulfill, which takes them away from the tasks which they enjoy and for which they joined the profession, namely to help young people succeed.

To serve all these mandates, there are way too many administrators, and specialists in all kinds of unnecessary endeavors, from cultural norms to bullying.  The state of Texas, one of the largest school systems in the country, is said to have a 1:1 ratio of administrators to teachers.  Thees positions have higher salaries and therefore much higher pension liabilities than do teacher positions. 

None of this can change, though because as long as states and the federal government can created new unfunded mandates, there is no choice.  Don''t comply and your school will be decertified or closed.

Have you ever gone to a local school board meeting?  Go with a Costco sized bottle of Tylenol.  It is even more inane, cynical and boring than the Senate.  Reform can never penetrate into this closed system. 

Private groups like Teach for America have contributed to better outcomes for students in troubled schools.  When they entered the Minneapolis market, the union funded PR guns fired out accusations about elitist outsiders who were unqualified to teach and doing nothing but padding their resumes.  They certainly didn't care for "the kids." 

Former Medtronic CEO Bill Hawkins wrote a letter to the local paper counteracting the propaganda:

"...the schools are getting new teachers from a talent bank that has never been richer. They come from the Ivy League, from the best colleges in Minnesota and from states around the country, with a grade point average of 3.6 (on a 4.0 scale) and majors ranging from industrial engineering to music. Sixteen percent of graduating seniors at Yale this year applied to teach with Teach for America, as did 450 seniors from schools in Minnesota, including the University of Minnesota, Macalester and Carleton.


Teach for America's expansion to the Twin Cities is funded with a $2.7 million grant from local businesses, including Medtronic and General Mills, as well as leading area foundations. This reflects our respect for the results achieved by the program in other cities and our commitment to addressing the alarming rate at which our state is failing to ensure a proper education for far too many young Minnesotans.

In a state renowned for academic prowess, it should concern us that one of our largest school districts is falling behind the rest of the country. A national study published last spring rated Minneapolis 45th among America's 50 largest cities when it came to our high school graduation rates. Equally troubling is what young people aren't learning while they're still in school. Less than half the students in the city school system are proficient in reading, and only 40 percent in math. The numbers are particularly discouraging if you single out math and science, the two areas most crucial to the future of our children and the future of the nation.

This is unacceptable. It's time to do something different"

I admire Teach for America and its objectives and achievements,  I don't think that it is the best model, and I certainly don't believe that it is the only model for really making education deliver on its mission.

No educational model delivers comparable outcomes at a lower cost, especially for inner city minority populations, than the system of Catholic schools.  I spent twelve years in a New York City Catholic elementary school and high school. I've volunteered in these schools most of my professional career. Many of their students are not Catholic, and many of them can't afford to pay the very modest tuition; but, no student is turned away. 

I agree with Bill Hawkins that it is time to do something different. Americans have a common interest in producing the next generation of educated, informed citizens and productive taxpayers. Any educational system that produces this output should be funded with public funds, since the future benefits attached to creating this citizenry accrue to all..  Parents and students should have choices. If certain systems are overburdened with bureaucracy and inefficiency and can't adapt, then they need to wither, just like W.T. Grant or Digital Equipment.  That is the only kind of real reform which will work: competition and choice.

Hyrdraulic Fracturing and Groundwater: A Connection

Engineers and scientists at Duke University and Cal State (Pomona) have published a paper in the Proceedings of the National Academy of Sciences which confirms my long-stated belief that the industry certainly doesn't know everything about the effects of hydraulic fracturing of deep shale gas formations and possible impacts on shallow, drinking water aquifers.

This paper is not a smoking gun for condemning the burgeoning shale gas industry.  What is its value?  It shows that there is a mechanism for hydraulic connectivity between shallow drinking water aquifers and deep-lying shale gas formations.  The researchers found evidence of a "strong geochemical footprint" in salinized water in the Alluvium, Catskill and Lock Haven aquifers in northeastern Pennsylvania. The salts are chlorides of the s-block elements, alkali metals and alkaline earth metals. 

They speculate about the conditions that might provide a pathway for the salinization of the aquifers, but it is an educated supposition.  Shale formations with extraordinary hydrodynamic pressures and a natural pathway might cause migration into the lower pressure areas of the aquifers.  Where, how, and why this occurs at some locations and not others is unknown.

Results on methane gas migration are sketchy in this sample.

The authors conclude,"The occurrences of saline water do not correlate with the location of shale-gas wells and are consistent with reported data before rapid shale-gas development in the region." 

The research is in this paper definitely shows that continuing research is needed, and that industry and regulators should work together with conservatism and caution in well head designs, drilling techniques, and documentation of geological characteristics of the formations, integrated with existing data about the aquifers.  There is indeed a way in which methane and brines could migrate into drinking water supplies. 

Because such damage would be prohibitive to mitigate, the industry should make sure that the shale gas boom is not a California gold rush or a replay of early wildcatting of oil wells in Western Pennsylvania.  Meanwhile, this paper is a small beginning and far from the last word.

Government Overreaching on Seizing Mortgages

The wicked never rest, and there is no rest for beleaguered citizens who are not fortunate enough to be chosen for government largesse.  The Wall Street Journal story about California cities contemplating an absurd, Kafkaesque use of eminent domain powers is truly "appalling," as described by Scott Simon, Managing Director at PIMCO.

Mortgages are private contracts between a homeowner/borrower and a financial institution/lender.  Eminent domain is typically used, for example, when a new public highway project requires a right of way which is now occupied by homes and private businesses.  The government entity's powers of eminent domain are exercised in order to construct a project which is in the interest of a larger population, including outsiders.  In exchange for exercising this right, the government entity must demonstrate need and come to some market driven settlement with the existing property owners exchanging value for giving up their homes and business locations, plus some value for the inconvenience and costs of moving.  All of this is subject to negotiation, in theory.

As it is, eminent domain powers are often abused and applied arbitrarily to property owners who don't necessarily want to play ball at the proposed settlement rates.  We have some egregious examples here in the Minnesota Nice Midwest.  The California proposal brings abuse of government power and eminent domain to  levels that should be laughed out of town or struck down in courts.  

Cities in the California case would seize individual underwater mortgage loans. After seizing the loan, via the eminent domain subterfuge, a City would use Mortgage Resolution Partners to pay a reduced amount to the lending institution.  Mortgage Resolution Partners CEO Graham Williams comes from a background of lending to low income borrowers through a program called "Neighborhood Advantage" and from subprime lender ITT Financial Services and later at Bank of America.  The smell testalyzer is flashing red already.  Mortgage Resolution Partners would then put the formerly underwater homeowner into a new, low interest mortgage insured by the FHA with equity requirements as low as 2.25% according to the Journal.  So, of course, taxpayers are again handing out a subsidy and taking risk.  In these transactions is a nice, upfront profit for the wizards who came up with the scheme.

Professors Mian and Sufi of Chicago Booth Business School did an original and well known analysis on the explosion of mortgage lending from 2002-2006 covering a sample of 238 U.S. counties. The top decile counties for the growth in household debt to income are in California and Florida.  The single largest growth in debt ratios occurred in Monterrey County, California.  The California counties had the frothiest growth in real estate values, and we know from companies like Countrywide and IndyMac, that these Zip codes were precisely the targets for aggressive mortgage origination.  Professor John Coffee of Columbia has testified about these abuses before Congress.  Now, all taxpayers will be asked to fund a bailout for these homeowners.  Why not for homeowners in the Midwest or in Westchester County or in Appalachia?

Did I mention that Roger Altman of Evercore Partners, one of the investment banks backing Mortgage Resolution Partners, served in the Clinton Administration and is raising funds for President Obama's re-election efforts?  I have to leave the room now because the smell test is over and the stench is too much.

Nokia: Microsoft's Private Label Provider

It seemed intuitively clear to us that Microsoft couldn't let Nokia go down the drain, and we wrote about it recently.  The website Seeking Alpha had an article which came to the same conclusion by looking at the industry dynamics among Microsoft partners, including Samsung, HTC, Nokia, HP and Dell. It's good reasoning.  Here's an excerpt from the blog:

"With Nokia and Surface, Microsoft achieves two important goals. First, there will be enough hardware support for Windows 8 in the categories that are the most important for Microsoft's expansion from PC to mobile devices. Second, these two products set the standard for Windows 8 based mobile devices. In order to stay competitive in the market, Samsung and HTC can no longer support Windows 8 half-heartedly, as they did with Windows Phone 7. Their Windows 8 smartphones will have to be good enough to compete with Nokia's. As pure play hardware companies, there is very little incentive for them to give up on Windows 8, but Nokia will ensure their full support. The similar goes with HP, Dell, and Microsoft's own Surface. It will be too dangerous for HP and Dell to stay out of the tablet market. Now they have to provide something capable of competing with at least Surface, and to some extent, Apple's (AAPL) new iPad and Google's (GOOG) Nexus 7.

In this sense, Nokia is Microsoft most important partner in its mobile strategy. Microsoft will not allow Nokia to fail, not within the first year of Windows 8's introduction anyway. It will not 'write off' Nokia." (Seeking Alpha)

There are some interesting articles in Vanity Fair from staff writers and an interview with Paul Allen.  The bottom line is that they lay the blame for the long-term malaise at Microsoft at the feet of Bill Gates for his insistence, according to the story, on choosing Steve Ballmer to run the business many years ago.  Overall it paints a very ugly picture of a Microsoft internal culture too weighed down by its Office/Windows franchise to the detriment of initiatives which would acknowledge and hasten the demise of the franchise.  No wonder the stock was a value trap in the past!

Can it still right itself?  The Windows 8 launch will truly be a big deal. 

Happy July 4th!

Don't Forget the IndyMac Debacle

While Countrywide Financial is back in the financial news, it's worth readers remembering IndyMac Bank and New Century Financial.  The linked post above still makes good reading, but I want to expand on IndyMac from the role of the CEO and his enabling board.  None of these folks are in jail either, as far as I know. 

IndyMac CEO Michael Perry began his career as a KPMG auditor, and was an inactive CPA during his tenure at IndyMac. After working in the mortgage business at Commerce Security Bank, he joined IndyMac when it had four employees. By 2006, the bank had about 8.000 full time equivalent employees.  Despite the complexity of subprime financial services Perry clearly understood subprime mortgage origination, and how the product affected the income statement and balance sheet.

The board of directors included Lyle Gramley, a retired member of the Board of Governors of the Federal Reserve System. Gramley's pronouncements about monetary policy, interest rates and banks had been very visible in the financial press for years.  Hugh Grant was a director who served as the Managing Partner for the Western Region of KPMG, where he worked for 38 years.  Retired California Senator John Seymour was a board member whose legislative career had centered on housing and finance issues. 

According to the 2006 proxy, the CEO's incentive compensation rested on EPS and ROE targets, both of which were subject to the highest degree of accounting manipulation in this subprime mortgage business.  IndyMac's reported earnings were of low quality, and its balance sheet reported inconsistently with its risk profile.  We've noted a few of thise points in the previous posts, and won't repeat anything here.

In 2004, the CEO expressed to his risk managers via emails his concern that credit quality was deteriorating.  Yet in the corporate culture of the firm, risk managers were routinely overridden by a network of roguish, non-employee mortgage originators whose only objective was to maximize their own commissions.  By 2006, the Office of Thrift Supervision's Inspector General noted that 75% of IndyMac's option ARM holders were making only the minimum monthly payments on their mortgages.  Yet, provisioning levels continued to be minimal, and reported earnings were high.

At the end of fiscal 2006, three sophisticated institutional investors held stakes that were reported in the proxy: Barclay's at 13%, NWQ (Nuveen) Investment Management at 10%, and Capital Guardian Trust at 7%.  Investors got what they wanted with outsized earnings growth, the share price outpaced the Russell 1000 Financial Services Index by a wide margin, and management paid itself handsomely, despite the fact that they had to have known that the reported numbers were of dubious quality and the business unsustainable.  These sophisticated investors apparently couldn't see through the numbers to the fundamentals either.   The problem is not about process. It almost never is, yet our regualtion only addresses layering on more process. It is all  about individuals being bad actors and not doing their jobs, for which there is no accountability. 

Fixing the LIBOR

I remember one of the first references to LIBOR in a money and banking textbook describes a quaint process in London where market makers got together before the open to"fix the LIBOR."  The British use of the word "fix" wasn't meant to be nefarious, but the news of Barclay's settlement tells us that "fixing" refers to the same fixing that happens in Italian professional soccer games.

I read on one blog that the benefit to the brokers from some of the rate manipulations amounts to an estimated £46 billion.  In the case of insider trading scandals, the illegal profits are clawed back, along with fines on top of these amounts.  In the case of Barclay's the total fine amounts to a relatively paltry £163 million pounds.  Nobody from Barclays does any jail time. 

The rigging of the rate setting process was so widely known in the company that emails fly around routinely about rates being set at a level which "kills" some profit centers, or alternatively at a rate setting that generates a  "thanks for the favor."  Clearly a bad tone at the top if everyone knew about the rigging and carried it out routinely. 

Lord Turner has talked about the so called "financial innovation" process as producing products which only serve to enrich the City/Wall Street.  There can be no social benefit to "dark pools," another financial innovation.  Mark Cuban's describption of high frequency traders as the "ultimate hackers" is perfectly apt.  Another innovation that society doesn't need.  If we value transparency and a level information field as critical to our capital markets, there is no rational argument for supporting the long list of current abuses, none of which have been substantively curtailed as a result of Dodd Frank or other regulatory frameworks.