Suppose you go on a spending spree, purchasing luxury items on credit such as a vacation home and new cars. Part of you knows the good times won’t last forever. Nevertheless, you decide to buy things you can’t afford, convincing yourself that you need and deserve them. In the process, you make some investments that don’t pan out. When ends don’t meet, you go to the bank and take out loans to pay off your older balances. Now deep in a financial hole, you hit upon a plan to climb out: simply default on your new loans by declaring bankruptcy and propose that the court let you do so without selling off most of those new toys you bought.

This is essentially the path taken over the past decade by the northern California city of Stockton, which filed for Chapter 9 bankruptcy protection last June. City officials ramped up spending on new public buildings and downtown entertainment venues and committed to lifetime medical care for city workers. The city structured its public-employee pensions in a way that guaranteed multimillion-dollar retirements for police officers and firefighters after a few decades on the job. California’s second-most-dangerous city, Stockton has been forced to lay off scores of public-safety employees to help pay for the profligacy.

When the city couldn’t meet its pension obligations in 2007, officials turned to lenders, including Lehman Brothers, and borrowed $125 million in pension-obligation bonds, the municipal-finance equivalent of taking out a new loan to pay ongoing mortgage expenses. The bonds bought the city some time, but the housing-market collapse dealt a devastating blow to Stockton’s rickety finances. Five years on, city property-tax revenues haven’t rebounded, and the inland port city in the agricultural San Joaquin Valley remains one of the most troubled real-estate markets in the country.

Stockton’s bankruptcy plan involves stiffing many of the creditors who provided the pension-obligation bonds in the first place. It’s tough to sympathize with any lender that would give pension-obligation bonds to a city as poorly run as Stockton. But it’s even tougher to disagree with a recent bankruptcy court filing by Assured Guaranty, the insurer underwriting those bonds. The company claims that Stockton is not really insolvent and that its bankruptcy filing, therefore, is a sham.

Assured’s attorneys objected to Stockton’s bankruptcy from day one. But the company alleges that new evidence from depositions and the discovery process, along with reports from independent experts, “all confirm that the City of Stockton cannot prove its insolvency under the law, has not satisfied the negotiation requirement required under the Bankruptcy Code, and has not filed its petition in ‘good faith.’” To what end? Assured argues that the city “hopes to use the Chapter 9 plan process to cram down a non-consensual plan on Capital Market Creditors in order to free up cash to fund above-market labor and pension costs, while refusing to consider—much less implement—additional sources of revenue and much-needed expenditure reductions.”

Needless to say, going the Chapter 9 route to keep pension benefits high wouldn’t be a legitimate exercise of bankruptcy law, which is supposed to be an option of last resort. Instead, Assured’s attorneys argue, Stockton is using bankruptcy as “an option of policy,” noting how the city proposed no tax or fee hikes before filing last year. Though tax and fee hikes are generally bad ideas, especially for badly managed cities like Stockton, the insurer is correct that such efforts would have demonstrated city officials’ willingness to increase revenues and pay down city debts.

Even more damning, Assured points out, is that Stockton officials never sought a “hardship exemption” from the California Public Employees’ Retirement System (CalPERS), which could have reduced the city’s payments to the state pension fund in the 2012–13 fiscal year by as much as $1.25 million. But public-sector unions, especially the police union, have undue influence in this blue-collar city. Officials did manage to eliminate the lifetime medical benefit, previously available in some cases to employees who had only worked in the city for a few months, but they refused to trim back pensions and perks for existing employees.

This goes to the heart of Assured Guaranty’s objection: Stockton utterly failed to confront its pension obligations. “The City has admitted that, for many years, it provided unsustainable and above-market wages and benefits to employees,” Assured’s attorneys explain in the filing. “The City’s recent short-term deals with labor do nothing to brighten the City’s long-term prospects, because the City refuses to tackle its most serious economic issue—rising pension costs under the CalPERS system.”

Stockton’s answer is to attack the bondholders. City Manager Bob Deis has suggested that Assured Guaranty and others don’t care about public safety. Over the summer, Deis warned that slashing pensions would cause a “mass exodus” of police officers—compounding the city’s public-safety problem, since the force has already been reduced. But that objection only reinforces Assured’s argument. The city could cut its costs, but it chooses not to. It has made a conscious decision to shortchange its creditors. Meantime, CalPERS’s general counsel, Peter Mixon, told the state fund’s board of administration in September that its power supersedes that of the federal bankruptcy court when it comes to municipal bankruptcies. CalPERS insists that cities must fund union pensions at the full promised amount, regardless of what that means for creditors or taxpayers reliant on policing and other public services.

Assured Guaranty is in the right here. CalPERS and bankrupt cities such as Stockton have decided to protect outsize public-employee pensions at all costs, insisting that a small group of beneficiaries should enjoy publicly funded luxuries while everyone else gets pummeled. Something will have to give, eventually. The episode proves that Stockton officials aren’t just fiscally bankrupt; they’re morally bankrupt, too.

Donate

City Journal is a publication of the Manhattan Institute for Policy Research (MI), a leading free-market think tank. Are you interested in supporting the magazine? As a 501(c)(3) nonprofit, donations in support of MI and City Journal are fully tax-deductible as provided by law (EIN #13-2912529).

Further Reading

Up Next