City Journal Summer 2014

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Summer 2014
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California

Steven Greenhut
Deadbeat City
Unions win, bondholders lose in round one of Stockton’s bankruptcy trial.
5 April 2013

California public-sector unions, the City of Stockton, and the California Public Employees Retirement System (CalPERS) gloated Monday after U.S. bankruptcy judge Christopher Klein ruled that the beleaguered city could proceed with its bankruptcy plan. For the unions, the judge’s decision was nothing less than a triumph of public workers over the hated 1 percent who rule from Wall Street. Responding to the decision, California School Employees Association spokesman Dave Low served up a red herring: “This ruling once again shows that greed is driving the large Wall Street corporations who in this case sought to further slash retirement security for police and other public employees to better their bottom lines.” Stockton officials have long blamed greedy bondholders—the same bondholders who bailed out the city in 2007 by providing pension-obligation bonds—for demanding drastic cutbacks in city services. A carefully worded statement from CalPERS mostly recapitulated the gist of Judge Klein’s ruling: that Stockton’s bondholders hadn’t negotiated with the city in good faith and, therefore, the city could proceed with its workout plan.

It’s clear why the unions are thrilled with Klein’s ruling. At least for now, the judge has prevented the scenario described by bankruptcy attorney Michael Sweet: “The fear is that there is going to be a run on the bank. Everyone is going to be cutting CalPERS payments if Stockton is allowed to do it.” Stockton owes CalPERS $900 million. As more California cities face fiscal crises and even bankruptcy, they could unload their CalPERS debt. The world of six-figure, “3 percent at 50” pensions could collapse into a cascade of bankruptcies.

For California’s taxpayers, meanwhile, the Stockton bankruptcy fight is really about the efforts of city officials, CalPERS, and unions to protect the lush pension deals that government workers have won in recent years, even as city finances hit the wall. Somehow, Judge Klein found that it was Stockton’s creditors who had acted in bad faith—even though it was the city that was stiffing its underwriters and refusing to consider the steps San Bernardino officials have taken, deferring payments to CalPERS to help make payroll. Klein also dismissed creditors’ claims that Stockton isn’t really bankrupt, but is merely using bankruptcy strategically to unload debts the city doesn’t want to pay. It’s noteworthy that following the Stockton decision, San Bernardino officials decided to start making their payments to CalPERS once again.

Some pension-reform advocates, however, took encouragement from the judge’s delaying of a decision on whether the city could reduce its payments to CalPERS. Reformers probably shouldn’t get their hopes up. True, Klein said that the key question revolves around whether the city is discriminating against its capital-markets creditors by refusing to repay its debts while protecting CalPERS. “The city is going to have a difficult time confirming a plan over an objection and claim of unfair discrimination without being able to explain that problem away,” the judge said in his ruling. “And that problem is probably going to require me to get down into the nitty-gritty of the CalPERS situation.” But even though the door isn’t closed, Klein’s ruling could just as easily create a replay of the story in Vallejo, which emerged from bankruptcy last year with a plan that left existing pension promises in place.

In Stockton, the lenders were essentially right. After two decades of free spending, during which Stockton’s political leaders dramatically boosted compensation for public employees and spent lavishly on new arenas and other redevelopment projects, little remained in the treasury to maintain the city properly. Stockton’s lovely old downtown is largely vacant. Abandoned shopping carts litter even the most charming tree-lined neighborhoods. Residents joke that calling the police is pointless unless blood is in the street. Stockton’s incompetence and misuse of resources—retired police often earn $200,000 annually while street cops get laid off—are underlying causes of its urban decay.

City officials could have tried to reduce its pension debt or rein in out-of-control costs for the city’s employees. But that would have required courage. Instead, they tinkered around the edges of the problem. As trial testimony revealed, prior to its bankruptcy filing, Stockton compensated its city workers at roughly 125 percent of the average across California. Since then, the city’s salaries are about on par with the state average. Stockton officials also pared back what one city councilmember called a “Lamborghini” medical benefit that required no copays or employee contributions and allowed city workers to choose any doctor and any name-brand prescription—all courtesy of Stockton’s taxpayers. The city also trimmed some of the add-on benefit categories, such as extra pay for the firefighters who drive the fire trucks. Yet it made no deep cuts in the excessively high compensation levels or those unaffordable pension guarantees.

Stockton’s city manager, Bob Deis, argued that the city couldn’t tackle pensions, because reducing them would make it difficult to recruit top-flight managers and police officers—an absurd argument, given city workers’ high pay and benefits even now. At issue is a state law that effectively requires bankrupt cities to make pension payments a priority over all other debt obligations. That legislation conflicts, however, with federal bankruptcy law, which prioritizes obligations to bondholders. The judge said he was unclear on how that could be resolved.

Some commentators, myself included, believed that municipal bankruptcy would be a useful tool in enabling cities to get out from under their crushing union contracts. Others took a more skeptical view. As the Manhattan Institute’s E. J. McMahon foresaw, bankruptcy has indeed become a tool to prop up pensions on the backs of bondholders. Bond issuers will raise the cost of borrowing, and all will return to “normal”—at least until there is no one left for cities to stiff. Sooner or later, the bill will come due.

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