California State Auditor Found El Cerrito at High-Risk of Financial Distress — Before COVID-19

The economic crisis arising from the public health crisis we now face shows why the state auditor was correct in calling out El Cerrito and several other California cities for their perilous financial positions during a decade of economic growth. While El Cerrito may have been able to get away with uncontrolled spending during good economic times, the economic downturn being caused by the coronavirus pandemic is likely to put pressure on the city to get its finances in order or potentially face Chapter 9 bankruptcy.

In her Feb. 26 audit request to the Joint Committee on Legislative Audit, State Auditor Elaine Howle focused on El Cerrito’s inadequate general fund reserves. Just as individuals should maintain a reasonable checking account balance to deal with financial emergencies, like job loss or unexpected expenditures, local governments need to keep liquid assets in their general fund.

Looking at El Cerrito’s most recent audited financial statements, the city had $40.2 million in general fund expenditures for the last fiscal year. That means, El Cerrito spends about $6.7 million every two months (on average). The Government Finance Officers Association recommends cities set aside money to pay for around two months’ worth of bills. Unfortunately, rather than reporting $6.7 million in unrestricted general fund reserves, El Cerrito’s balance was negative $1.7 million – equivalent to a large overdraft in an individual’s checking account.

How does El Cerrito keep operating with a negative fund balance?  It takes short-term loans. Last July, the city borrowed $9 million from Westamerica Bank via a loan payable over one year with a then-favorable interest rate of 2.19 percent.  But that was then, and this is now.

It’s hard to imagine Westamerica or any other bank loaning El Cerrito money at anywhere near the low rate. Since the loan was made, El Cerrito appeared on the state auditor’s list of California’s 18 most financially-distressed cities. Next, Standard and Poor’s downgraded its rating on the city’s bonds from AA- to A- (three notches) and its certificates of participation from A- to BBB (two notches). And most recently the COVID-19 pandemic hit. Coronavirus will have numerous near-term impacts on the finances of all Bay Area governments but will hit ill-prepared cities like El Cerrito especially hard.

First, it will reduce sales tax revenues since people have been mandated to shelter-in-place, reducing shopping and eating at restaurants, among other things. In its 2019-2020 budget, El Cerrito projected that sales taxes would account for 19 percent of its general fund revenue, which is unlikely now.

The economic downturn could also affect other government revenue sources, including real estate transfer taxes, licenses, permits, facility rentals and inspection fees. And if the economy enters a prolonged recession it could reduce property values, thereby decreasing property tax revenues.

On the cost side, El Cerrito participates in CalPERS. whose assets have shrunk due to the financial and stock market turmoil. As of March 19, CalPERS investments were 10.5 percent below the levels they were at as of the beginning of its current fiscal year. Barring a sharp turnaround between now and June 30, when its fiscal year ends, CalPERS will significantly underperform its 7 percent investment return target. To fill the resulting funding gap, CalPERS will be obliged to increase employer contribution rates—meaning local governments like El Cerrito must pay more into the pension system—effective July 1, 2022.

Finally, El Cerrito should expect to pay more interest on future bank loans. Recently, municipal bond rates spiked as COVID-19 prompted investors to become increasingly concerned about state and local government default risks.

Before the Bay Area’s financial conditions potentially worsen further, the El Cerrito City Council should start to get its fiscal house in order by carefully reviewing all city expenditures and cutting the items that are not absolutely necessary at this critical time.

This column also appeared at the California Policy Center.