What Happened in Stockton?

Last night the Stockton, California City Council voted 6-1 to adopt a spending plan for operating under bankruptcy protection, and to file a motion with the courts to share information from the confidential mediation. With almost 300,000 residents, Stockton is the largest city to file for bankruptcy in U.S. history.

In February 2012 Stockton voted to enter bankrupcty mediation. Policymakers negotiated with the city’s creditors for months starting in late March 2012 and ultimately failed to prevent the filing. Negotiations were in compliance with AB 506, a new California law requiring municipalities file for reorganization of debt, and Stockton was the first city to file for use the law since its passage. Negotiations may not have been a waste of time though because they may help the city avoid a string of lawsuits, according to the Los Angeles Times, which is what happened after Vallejo, California’s filing in 2008.

While high profile stories like this signal blood in the water for narrative-hungry national media outlets, think tanks and pundits, there are often layers of complexity. So, what happened in Stockton? And is it happening anywhere else?

The most important takeaway right now is that no, Stockton’s decision to file bankruptcy is not necessarily a harbinger of things to come. The city’s financial situation is unique and does not reflect the financial standing of a significant number of municipalities in the U.S. That being said, there are relevant themes that policymakers and investors should recognize.

California Common Sense issued the definitive report on Stockton’s financial situation entitled, “How Stockton Went Bust: A California City’s Decade of Policies and the Financial Crisis that Followed.” The report details the three most significant factors, which are distinct but interrelated, contributing to Stockton’s bankruptcy.

1. The housing and financial collapses.

The housing bust decimated Stockton’s housing prices, and so went the city’s property tax (and related) revenues. Housing prices plunged from nearly $400,000 in median home prices in 2006, down to $110,000 in 2009 (where median prices were in 2000 before the bubble.) Meanwhile the city has the second highest rate of foreclosures in the country. Revenues from related areas, such as: sales taxes, utility user’s taxes and housing permit fees also plunged.

The city burned through emergency cash funds and took efforts to rein in spending that weren’t enough. For example, they issued a hiring freeze for open positions in May 2008 and cut the general fund by $90 million in the last three years. Despite those efforts they continued to run budget deficits.

2. Excessive optimism and unsustainable compensation promises.

City policymakers appear to have mistaken the real estate bubble for real growth. (The Los Angeles Times reports that state mediation law requires assigning blame in cases of bankruptcy, which will determine whether this was an honest mistake or if there was corruption at play.) This reported optimism led to breakneck pace spending on various redevelopment initiatives. The city sold $129 million in bonds to fund rehabilitating the Philmathean building’s rehabilitation, the downtown marina and waterfront’s development and the Hotel Stockton’s renovation.

California Common Sense found that the city also renegotiated generous compensation for city employees, when employee services compose approximately three fourths of the city’s almost $200 million budget. For example, city employees receive a guaranteed salary increase from 2.5-7%, depending on General Fund revenue growth—even if the General Fund shrinks from the previous year. Meanwhile employee healthcare costs are also rising, growing at a rate of almost 10 percent over the past decade. Other post-employment benefits (OPEB), including pensions, are also rising steadily. The city now faces more than $800 million in unfunded liabilities for pensions and OPEB.

3. An ill-timed bond offering.

In 2007 the city sought to lower it’s pension costs, so policymakers undertook a bond offering to lower interest payments on roughly $125 million of its pension obligation. The proceeds of these pension obligation bonds were given to the California Public Employees’ Retirement System (CalPERS) to manage. California Common Sense found that CalPERS was overexposed to the real estate and stock markets, so it was unable to meet the expected returns. The original pension obligation bond money is now worth under $100 million while the city owes $248 million.

Increased debt payments, combined with multiple years of negative net annual activity, ultimately pushed Stockton over the edge. While bankruptcy will sort out the details of the city’s restructuring, it’s safe to say that employee services (namely police and fire) will be at-risk throughout the process. Public safety represents 80%, or almost $160 million, of the city’s nearly $200 million annual budget. Stay tuned to Reason Foundation’s Out of Control Policy Blog for more on Stockton in the days and weeks ahead.