A Case Study in Municipal Bankruptcy

June 27, 2012

Stockton, California will surpass the city of Vallejo California as one of the largest U.S. cities to file for bankruptcy.  The city has 300,000 residents and is $700 million in debt. Unable to close a $26 million deficit due to debt obligations and labor costs, city leaders decided bankruptcy was the best option going forward, but all things considered, do the benefits indeed outweigh the costs?

Stockton faces a decline in property-tax revenues and high unemployment while general fund debt from downtown revitalization projects and high labor costs have put pressures on the city’s ability to pay its bills. The biggest problem—retiree health care costs. Stockton’s city manager, Bob Deis, said Stockton was obligated to pay $600,000 to $1 million in city retirees’ health-care costs and has not saved any money for this obligation.

The NextStep

Faced with mounting pressures, City Mayor Ann Johnston chose bankruptcy commenting, “I see no other solution to this.” The city council moved forward to approve a special budget that plugs the budget deficit by “defaulting on $10.2 million in debt payments and cutting $11.2 million in employee pay and benefits under union contracts.” The city will then be expected to file for bankruptcy between now and July 1 and begin a restructuring process that could cost the city up to $3.5 million in legal fees, according to Deis.

Bloomberg explains, “Chapter 9 of the U.S. Bankruptcy Code is reserved for cities, counties and quasi-governmental bodies, such as special water or tax districts. It offers more protection from creditors than Chapter 11, which is used by companies and wealthy individuals.” The city will then be permitted to break contracts it has made with lenders without the threat of lawsuits. Deis views bankruptcy as a “pause” telling the city council, “It provides you a breather to adopt a budget and maintain services during this next year. It doesn’t guarantee success in the long term. That’s going to require some negotiating and some give-and-take.”


City council member Dale Fritchen was the only dissenting opinion in Stockton’s vote for bankruptcy. Fritchen reacted saying, “I think it’s going to hurt Stockton more than it will help Stockton. For heaven’s sake, I hope I’m wrong.” The cost to the city is not only observed in short-term legal fees but also in long-term costs to the city’s ability to borrow and attract residents and business.

Birmingham, Alabama is a prime example of the fall out that comes when a municipality files for bankruptcy. Jefferson County, the county in which Birmingham is housed, filed the largest bankruptcy to “restructure $4.2 billion in debt, most of which is tied to sewer bond deals tainted by corruption.” Now, Birmingham, a city with low unemployment, cash reserves, and a good credit rating, may face higher borrowing costs when it goes to the market to fund needed infrastructure projects.

Detroit, Michigan is also an example of a city faced with high debt and retiree health care costs. With decreased revenues and no major spending cuts to services or to city employees, Detroit continues to suffer. A lawsuit with the state also threatens the city’s precarious financial situation with the state threatening to withdraw $80 million in interim financing.

Providence, Rhode Island faces a $22.5 million deficit largely fueled by unfunded pension liabilities. But in a recent success, city leaders and employee unions reached a deal to suspend automatic cost-of-living pension increases to help keep the city out of bankruptcy  by saving $18.5 million for the next fiscal year. Paul Doughty, head of the local firefighters union called the agreement “a bitter pill to swallow” but better than bankruptcy.

Lesson Learned

Municipalities across the country are facing tough decisions on how to match revenues with increasing expenses. Some are choosing the fiscally responsible path by addressing unfunded pension liabilities, rising health care costs, and excessive government spending. Others have failed to make the tough decisions necessary to restore financial stability choosing instead to subject the city to the negative consequences that come with bankruptcy. We can only hope that Stockton will be the final wake-up call for local government leaders to stop putting off what can be done today to improve their cities financial situation.

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