City Journal

Nicole Gelinas
What to Do When You’re Broke
New York’s insolvent municipalities could learn from California’s bankrupt ones.
Summer 2013
Stockton, California, hopes to lighten a crushing debt load through bankruptcy.
Ben Margot/AP Photo
Stockton, California, hopes to lighten a crushing debt load through bankruptcy.

In mid-May, New York governor Andrew Cuomo acknowledged a “long-festering” problem: many of the state’s cities, towns, and counties were virtually broke. “In the private sector, a company goes into bankruptcy court, gets restructured, and comes out in a relatively short period of time,” Cuomo said. “There is no governmental equivalent.” The closest that New York localities came to bankruptcy, he pointed out, was the “financial control board,” an instrument that the state could use to take over insolvent local governments. But those boards interceded only “after the locality really was financially bankrupt for a long period of time”—an unacceptable wait. The governor’s solution, approved by lawmakers in June, was a statewide “financial restructuring board.” Yet this new creation won’t solve the fiscal woes of cash-strapped cities, towns, and counties because Cuomo designed it to be impotent. In particular, it lacks the power to take on the main forces that drive up costs for localities: public-sector unions and the politicians who covet their support.

But there is a way for municipalities to tackle insolvency. Contrary to Cuomo’s assertion, local governments in America can declare bankruptcy—and they’ve been doing so more frequently since the 2008 financial crisis began. Last year alone, four public-sector entities that bondholders had previously considered “investment-grade” fell into default—as many as in the previous eight years combined, according to the Standard & Poor’s bond-rating agency. Two of those entities, Stockton and San Bernardino, were California cities; a third California city, Vallejo, had entered bankruptcy earlier, in 2008. These cities have much to teach New York. If Cuomo fails to heed their lesson and reform his new board accordingly, distressed New York cities might heed it—by declaring bankruptcy.

New York’s control-board process works as follows. When a local government gets into so much trouble that it can’t pay its bills, it goes to Albany for financial help: usually, the power to borrow under a state guarantee. In return, Albany installs the control board, which assumes the municipality’s budgeting authority and can impose emergency cost-cutting measures.

A control board served New York City well in the 1970s. After two decades of skyrocketing welfare and social-services spending, the city faced a 17.4 percent budget deficit in 1975. In the past, Gotham had papered over similar deficits with short-term debt. But banks, growing nervous, now turned off the credit tap, preventing the city from paying its day-to-day expenses, which included repaying short-term bondholders. So the state (and eventually the feds) stepped in, guaranteeing new long-term debt to pay off those bondholders. Governor Hugh Carey imposed strict conditions, however. A control board would take over the city’s budgeting, “mandating a new level of austerity,” as the New York Times put it. Among the board’s powers were approving or rejecting new labor and construction contracts and freezing wages on old ones. The control board proved successful because New York City’s problems involved immediate costs—salaries, social services, and incessantly maturing debt. Freezing those salaries and restructuring that debt could therefore help.

But today, New York State’s distressed cities and towns have a different kind of problem: they can’t afford to pay their future obligations. Many localities have promised to pay pensions to their workers or to cover their health-care costs, once they retire—but haven’t put enough money aside to keep those promises. Freezing wages today does nothing to curb these already unaffordable future costs. Think of New York City in the 1970s as a person who temporarily loses a job and persuades his landlord not to hike his rent. Today’s distressed municipalities are more like someone who has incurred a mountain of consumer debt for cars, clothes, and electronics: a rent freeze will do little to help her pay it off.

One of those distressed municipalities is Long Island’s Nassau County. Nassau is the 13th-richest county in America and the richest in New York, with a median household income of $91,162 in 2011—81 percent higher than the national average. The county’s 7 percent poverty rate is less than half the 15.9 percent rate nationwide. Yet it’s in so much financial trouble that a state control board has overseen it since 2000. You don’t have to be poor to be broke.

The county’s woes are more than 20 years old. Back in 1992, it narrowly avoided a control-board takeover. As Newsday, the local newspaper, chronicled, the state let Nassau avoid deep budget cuts by raising taxes and borrowing $65 million for short-term expenses. Newsday bitterly complained that “a bipartisan corps of cowards has sold out Nassau County taxpayers” by “mortgaging the future to avoid cutting costs.” But the county continued to mortgage the future, borrowing long-term to repay property owners for perennial property-tax overcharges. Since the extra property-tax revenue had already been spent on operating costs by the time the county repaid the property owners, the procedure amounted to borrowing long-term to pay short-term expenses—a fiscal no-no. This sleight of hand constituted more than one-third of the long-term debt that the county assumed between 1992 and 2000.

The reason for the county’s extravagant borrowing was prosaic: Nassau was spending far more than it took in. The county’s major taxes—property and sales—exactly tracked inflation between 1992 and 2000. But spending grew 13 percent after inflation, saddling the county’s $2.5 billion budget with chronic nine-figure deficits, including a deficit in 2000 that was nearly 7 percent of spending. The public-safety budget, for example, increased from $355 million in 1992 to $555 million, thanks to ballooning compensation costs. (Noting that the average cop’s salary had broken through the six-figure mark, Long Island Business News commented that “Nassau has more police officers who work fewer hours for higher pay than any other comparable department in the nation.”) Compensation costs in other departments, too, were rising. Raises and cost-of-living increases for public workers “pursuant to various collective bargaining agreements” were weighing the budget down, the county reported. Retroactive pay agreements, early-retirement costs, and health-care expenses were all becoming unaffordable.

In the summer of 2000, after months of downgrades and warnings from bond analysts, Nassau could no longer finance its deficits. In response, Governor George Pataki and Albany lawmakers created the Nassau County Interim Finance Authority, or NIFA. This state-run control board, modeled on the one that had rescued New York City a quarter-century earlier, would issue debt for the county to help it raise money. In return, NIFA would oversee Nassau County’s budget, and it would have the power to step in and impose emergency measures, such as freezing wages and regulating borrowing, if the county continued to behave irresponsibly.

But to avoid angering the powerful public-sector unions, Pataki and his successors, with the assent of county and local politicians, severely constrained NIFA’s capabilities. Above all, the board couldn’t alter existing union contracts. Even when contracts expired, a state law called the Triborough Amendment dictated that their provisions, including inefficient work rules and overly generous sick and vacation pay, had to remain in place until the parties could agree on a new contract. If uniformed workers couldn’t agree to new contracts, state law also required that the impasse go to “binding arbitration”—with arbitrators who usually ruled in favor of the unions. This arrangement gave unions no incentive to give anything up. As E. J. McMahon of the Empire Center for New York State Policy says, New York State’s biggest problem is its “outmoded, inflexible statutory framework for collective bargaining.”

As a result, NIFA failed to rescue Nassau. Between 2000 and 2011, the county’s tax revenues rose in real terms—especially its property taxes, which are now the nation’s second-highest, at more than $9,000 per household annually. But despite this bounty, Nassau’s finances were worse off in 2011 than they had been a decade previously. The county faced an 8 percent budget deficit that amounted to $260 million. Spending on pensions had more than quadrupled since 2000 (to $114 million), and spending on health care for public workers and retirees had more than doubled (to $272 million). Though police officers’ ranks had shrunk 4 percent, spending on cops was up 43 percent because the county, under NIFA’s eye, had signed multiyear, above-inflation pay increases for its police force and given away new perks in return for the tiniest changes to work rules. Even the labor-friendly New York Times took note of “strange perks” for uniformed officers, “like paid time off for giving blood.”

Further, the county’s outstanding debt had increased 47 percent since 2000—to $4.3 billion. In addition to that debt load, Nassau owed $4.6 billion in payments for health insurance for current and future retirees—but the county still charged union employees and retirees nothing for health care. The only spending item in the budget to decline was payments on debt, thanks to lower interest rates. But that wasn’t a good thing: the lower interest rates were simply the result of lenders’ confidence that NIFA would repay them. (Indeed, Nassau informed its investors explicitly that the control board’s purpose was “to reduce the cost of borrowing.”) NIFA had become a gimmick that enabled Nassau to borrow cheaply and keep ignoring its problems. NIFA had also become a bailout of previous bondholders, since much of the county’s new debt was used to refinance old obligations. “NIFA kept us from lowering the county to junk,” a Standard & Poor’s analyst told Newsday in 2000.

In 2011, NIFA gave up waiting for the county to do the right thing and used its powers to decree an emergency. At long last, the control board imposed some useful measures. It froze wages. It cut the county’s borrowing budget by 30 percent last year. It killed Nassau’s attempt to sell its sewer system to plug operating deficits.

But because NIFA still allows the county to borrow cheaply, Nassau can continue to avoid making tough decisions. In late 2011, County Executive Ed Mangano tried (unsuccessfully) to persuade taxpayers to vote themselves a tax hike—to pay for a stadium. Public-sector unions have sued in federal court over the wage freeze and won a lower-court victory. Earlier this year, supposedly neutral labor arbitrators struck another blow against the wage freeze by awarding the county’s courtroom investigators (many of them pensioned retirees from other state and local jobs) a retroactive raise from $86,000 to $121,000. Nassau has floated a proposal to ease the wage freeze for cops in return for the right to force new employees to pay health-care premiums, a measure that won’t go nearly far enough to save the county’s finances. Nassau has also sued NIFA, asserting that the board can’t prevent it from borrowing to refund tax overcharges—and can’t even prevent it from hiring lobbyists to lobby the state. Newsday’s apt conclusion: “This is nuts.”

Nassau County isn’t the only New York locality being overseen by an ineffective control board. As Syracuse mayor Stephanie Miner points out, the state has “one of the wealthiest counties under a control board and one of the poorest cities.” She’s referring to Buffalo, whose median household income is a third of Nassau County’s. Buffalo lost control to a state board in 2003. Under oversight, says John Faso, a former Republican gubernatorial candidate who served on the board until 2006, Buffalo did benefit from some useful measures. “We were able to freeze salaries and freeze step raises,” he remembers, referring to the automatic raises that workers get under state law when their contracts with localities expire.

But in Buffalo, just as in Nassau County, state law kept the control board from being effective. According to the law, Buffalo lacked the power to alter its pension obligations, since local governments in New York don’t decide the age at which their workers retire and what benefits those workers will get; Albany makes those decisions and sends the localities the bill. Nor could the board force workers to pay more for health care. Once again, the Triborough Amendment stated that provisions in expired contracts had to remain until new contracts were agreed upon.

Partly because of these constraints, spending in Buffalo has risen 45 percent since 2003, mostly in the last few years. Benefits costs have doubled. The city has closed three police stations and cut the police force by 17 percent, yet police spending is up. Despite a population decline of 8 percent, debt has increased by 2.5 percent. Just as in Nassau, the only thing that’s gone down is the cost of debt, with interest payments falling by 7 percent since the state insulated its ward from market pressures.

New York municipalities in fiscal trouble could benefit from something closer to California’s freewheeling approach to its own cash-strapped cities. True, California’s three large municipal bankruptcies since 2008 have been messy, unpredictable, and expensive. And bankruptcy is no magic wand: like a control board, it can’t balance a budget without political will. Still, the managers of two of the three bankrupt cities say that they wouldn’t have preferred a control board. A close look at the municipal bankruptcy process shows why.

Start with Vallejo, a city of 120,000 about 40 minutes by car from San Francisco. Between 2000 and the peak of the housing bubble in 2006 and 2007, the city’s property-tax collections doubled. When the bubble burst, those taxes cratered, precipitating a depression-level revenue decline of 20 percent almost overnight. The city couldn’t cut spending that quickly. Annual pension costs, for example, had risen precipitously, but California law states that localities must make payments to the state pension fund before anything else. Public-safety costs, too, had risen by nearly a third over half a decade, partly because in 2006, Vallejo had agreed to 24 percent wage hikes for uniformed officers over four years. The city began to cope by cutting one-third of the public-safety workforce. But it couldn’t simply wait for its costly contracts to expire; local voters had approved a binding-arbitration procedure in the city’s charter, so expired contracts would go to an arbitrator who might rule against the city. Vallejo also faced a staggering $130 million liability for future retiree health-care benefits.

Dan Keen, the city’s manager, wasn’t in charge when Vallejo declared bankruptcy. “If you can find a way to avoid it, you should,” he says—but adds that he doesn’t see how the city could have avoided it. Bankruptcy brought Vallejo the supreme advantage of “being able to reject its collective bargaining agreements,” as bond analysts at Standard & Poor’s note. They calculate that after legal costs, bankruptcy saved the city about $22 million in the short term. It also chopped about $54 million off Vallejo’s retiree health-care obligations. The city is currently opening one of two fire stations that it had closed, and it’s using money from a new sales tax not to pay health benefits but to pave roads. Keen acknowledges that bankruptcy fixed only some of the city’s problems. Vallejo still faces a 4 percent budget deficit, largely because of those pension costs: even bankruptcy doesn’t erase a city’s pension obligations, according to state law. But he doubts that a control board could have done better.

Stockton, too, went bankrupt because of obligations to its employees. Between 2002 and 2006, its population rose 17 percent, but property-tax revenues tripled, and spending increased nearly 67 percent. When the bubble burst, revenues fell 21 percent, and the city, like Vallejo, found itself broke. Pension costs now totaled $23 million a year, not the $6 million of a decade ago. Stockton slashed the police force by more than a fifth, even though it’s the nation’s tenth most violent city and has the nation’s second-fewest cops per capita. But it wasn’t enough. One problem was binding arbitration, just as in Vallejo. Though voters had eliminated it in 2010, it still applied to existing firefighter contracts.

As Stockton debated what to do, it benefited in a surprising way from the earlier Vallejo bankruptcy. When Stockton decided to take advantage of a new California state law that allowed it to undergo mediation with its creditors, who were largely unions, the results were big savings. The city cut compensation by 23 percent; achieved lower pension and health-care benefits for future workers; reduced vacation, sick, and longevity pay; and eliminated cash payouts for unused sick leave. It’s hard to believe that the unions would have agreed to all this if they hadn’t remembered Vallejo and feared that bankruptcy would bring still harsher consequences.

Nevertheless, the bankruptcy arrived in 2012. City manager Robert Deis says that there was no alternative; Stockton “couldn’t cut more without endangering people.” Indeed, murders have risen from 35 in 2009 to 71 in 2012, with fewer police able to keep gang members from killing one another. Though the concessions from current workers were useful, Deis says, the city believed that bankruptcy was the only legal way that it could reduce health benefits to retirees and payments to bondholders. After the filing, the city sent a stark notice to its retirees, informing them that “effective July 1, 2013, all retiree medical benefits will be eliminated.” Those older than 65 would buy Medicare; the rest would have to purchase private insurance. Like Vallejo, Stockton is leaving untouched its pension promises to current workers and retirees. Still, “bankruptcy provided the muscle to save the city $2 billion over the next 30 years,” Deis says.

Vallejo’s bankruptcy hurt its retirees much more than its bondholders; Stockton, by contrast, wants its bondholders to take big hits. But Stockton has little fear that future lenders to the city, fearing a repetition of the city’s insolvency, will insist on high interest rates. That’s because Stockton intends to repay debt if the asset securing that debt—a firehouse, say—is essential. If the asset isn’t essential (a parking lot, for example), the city will probably decline to repay the creditors and let them seize the asset. This specificity should mean that Stockton’s bankruptcy won’t penalize it in bond markets. Bondholders will probably continue to buy bonds backed by sewer revenues; indeed, the city has already borrowed easily in bankruptcy to buy fire engines. Though Deis agrees with his Vallejo counterpart that bankruptcy is no fun, “I think people should be very careful about turning off self-governance” and turning to a state control board, he says.

San Bernardino is like the other two cities, only poorer and broker. Last year, just before filing for bankruptcy, it faced a $46 million deficit on a $166 million budget—or a whopping 28 percent. Bankruptcy lets San Bernardino do what the other cities have done: reduce health-care benefits for current workers, eliminate them for retirees, and cut pay. But it’s going a step further: since last summer, the city hasn’t made its required payments to the state pension fund, despite California law. “This decision was not taken lightly,” interim city manager Andrea Travis-Miller said last summer, adding that it was necessary “to allow the city to keep providing the most basic and critical services.” Some observers regard the move as a bid for state aid; others see a simpler motive. “San Bernardino just has no money,” says one.

If California-style bankruptcy is radical surgery, Governor Cuomo’s new “financial restructuring board” looks like a Band-Aid. It will help a distressed town employ “shared services,” merging one department’s administrative task with another department’s or with another town’s. The board will also encourage towns to reduce the number of elected officials to eliminate overlaps. It will decide labor disputes for uniformed officers’ unions—but only if the unions agree. “It’s in everyone’s interest to make the kinds of reforms that we need, . . . obviously for the elected officials and also for the unions who represent the workers,” Cuomo said. But that’s not true; it’s not in unions’ interest to give up free health care. Why should they agree to submit to a board that might take it away? It’s telling, moreover, that the governor himself won’t serve on the board; his budget director will stand in, indicating a lack of heft.

If Cuomo wants to prevent New York cities from going bankrupt—and they can, according to state law—he should learn from California’s bankrupt cities. Those cities have been able to do something that New York’s similarly distressed municipalities haven’t: reduce retiree health-care liabilities and get out of bad contracts. To grant New York cities the same power, the governor and state legislature should repeal the Triborough Amendment. Coupled with political will at the local level, that measure would help healthier cities and towns before it’s too late.

But what about places like Nassau and Buffalo, where it is too late? There, Cuomo should take a page from the playbook of Michigan, which installed an emergency manager in its largest city, Detroit, earlier this year. The manager has the power to alter existing union contracts and to negotiate with financial creditors. Cuomo should ask lawmakers to invest New York control boards with similar powers. To make the process more democratic, he could always appoint a locality’s mayor to head the board overseeing that locality’s finances.

Cuomo should also imitate Detroit’s emergency manager in making clear that the state will no longer bail out municipalities by letting them borrow cheaply. Indeed, the state should charge struggling municipalities a penalty interest rate on any debt that it issues on their behalf. Further, that debt shouldn’t go toward refinancing existing debt, as it has in Nassau County; the bondholders who assumed the old debt should be stuck with the risks they took.

If Cuomo refuses to take these steps, the result might well be municipal bankruptcies, once his financial restructuring board fails to fix struggling cities’ finances. Those bankruptcies could have absurd consequences. For example, a county could probably use bankruptcy to cancel troublesome labor contracts—but once out of bankruptcy, it would resume living under the Triborough Amendment and might have to readopt those contracts, depending on whether state or federal law prevailed in court. But that could hardly be a more absurd situation than the one that New York’s insolvent cities are in today.

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