The Great Municipal Bond Heist?

April 9th, 2013

by Eric Schaefer

On Monday April 1st, bankruptcy Judge Christopher Klein of the Eastern District of California accepted the city of Stockton's petition to enter bankruptcy under Chapter 9 of the U.S. Code. The judge's decision was something of an anticlimax to the city's filing on June 28th, 2012. Most observers to the proceedings expected the city's petition to be granted despite opposition from several quarters.

While the road from petition (for bankruptcy relief) to its grant may strike some as long and torturous, it is nothing compared to the ordeals to come as the court grapples with the conflicting claims of priority over the city's revenues. In one corner sits CalPERS (the California Public Employees Retirement System) which manages the pension obligations for Stockton's current and retired workers. Squaring off against CalPERS in the other corner, is the assorted purchasers of the city's municipal debt. One bond issue in particular will dominate the proceedings. It is the $125.3 Million in pension obligation bonds raised in April 2007, to plug an already large gap between the city's pension fund assets and its commitments under its several plans.

The sticking point is the opinion of whether vested pension benefits are a contractual obligation or whether they are a promise which can subsequently be modified by statute. The relevant case law on the subject is mixed. Pension defenders point to Article 1, Sec. 9 of the California state constitution which forbids the passage of any legislation impairing the obligations of contracts. Not so fast. Others contend that as with any contract, relief is permitted if fulfillment results in the unintended destruction or impoverishment of one of the parties to a contract. Fiscal ruination certainly seems to fall within that category.

But in its retort, CalPERS points to Article 16, Sec.17 as justification for its hard-line in the proceedings affecting not just Stockton but San Bernardino as well. The California constitution requires public pension plan administrators (such as CalPERS) to act in the beneficiaries' best interest. The challenge here is to find a balance between the interests of the plan's beneficiaries and ultimately Stockton's taxpayers. The question before the court is simply, Is it fair to the latter to be saddled with rising taxes or ever ending cuts in basic and essential services so pensioners may continue to collect benefits?

Consider the consequences of a decision in favor of pensioners over bond holders. In the plans proposed, bond holders would receive nickels and dimes for lending money to Stockton so it could improve the funding of its pension plans. In other words, the court's decision would create a precedent (where few or none exist) involuntarily subordinating investors to pensioners. The ruling would effectively shut down the pension benefit obligation bond market. And, in the broader market for debt issued for other purposes, considered seen most at risk of bankruptcy or default.

Now, contemplate the other outcome in which the court essentially rules the pain must be shared. This will give a green light to other fiscally beleaguered municipalities to take their chance in bankruptcy court in an effort to lighten the weight of their pension obligations. Within California alone there are a number of cities for which Chapter 9 may become more attractive if it provides an avenue to reduce pension commitments. What was once a backwater of the federal bankruptcy court system will suddenly be thrust into the limelight.

We do not envy Judge Klein's position. There is little or no precedent for the dispute he must referee. As the Stockton bankruptcy proceedings wend their way to some resolution, the heat and rhetoric is bound to escalate. Both bond holders and pensioners will cry theft if the other side prevails; or, even if the pain is shared. Given what is at stake — not just for Stockton or California, but for the whole nation — we only hope Judge Klein is endowed with the wisdom of Solomon.

Notes on Sources and Methods:

Budget estimates are from the 2012/2013 budget issued by the city of Stockton. This is the city's last budget before seeking Chapter 9 protection.

Retirement related expenses consist of annual projected pension contributions plus healthcare related expenses incurred by retirees. Debt service consists of payments on all debt including Stockton's pension obligation bonds. Personnel spending consists of all non-pension related costs associated with the city's workers. Other spending is the difference between the total budgeted amount for the cycle less personnel, retirement and debt service expenses.

(Sources: City of Stockton; AIFS estimates.)

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