The Shape of Things to Come

On August 1, the City of San Bernardino, California, filed for protection under Chapter 9 of the U.S. Bankruptcy Code. Chapter 9 is designed for municipalities and other local governments; the federal government can’t declare bankruptcy. At least that’s what most bankruptcy experts claim.

City officials gave media outlets the same explanations that CEOs of bankrupt companies often do: the mayor explained that the City would continue to meet its payroll and pay essential bills. He said that the main reason the City was seeking bankruptcy protection was to prevent lawsuits from being filed by a couple of angry creditors.

Asked to explain the cause of the crisis, San Bernardino officials passed the buck. They said that, because of budget shortfalls at the federal and state level, California Gov. Jerry Brown and the state legislature had made changes to vehicle tax money and redevelopment agencies that stripped local governments of hundreds of millions in state funding.

This was true. But not everyone accepted the official explanations as the whole truth. Some conspiracy-minded sorts hinted darkly about criminal wrongdoing in City offices. Others looked through San Bernardino’s filing and pointed to one of its largest creditors: the City owed the California Public Employee Retirement System (CalPERS) some $143 million in unfunded pension obligations.

For its part, CalPERS claimed that San Bernardino was using a misleading “actuarial” calculation of its obligation and actually owed something closer to $320 million.

Now, that was a fiscal emergency.

San Bernardino also drew media attention because it was the third California city in as many months to file for bankruptcy protection. In June, Stockton had sought bankruptcy protection because it couldn’t come to agreement with its employee unions on a plan to close the $26-million gap in its general fund; in July, the ski-resort town of Mammoth Lakes had filed bankruptcy (its story was slightly different, though; the Mammoth Lakes meltdown was triggered by a court judgment the town couldn't pay).

Welcome to the late stages of American statism. Government and quasi-governmental agencies battling in bankruptcy court. Political rhetoric piling high. Bureaucrats talking evasively about where tens or hundreds of millions of dollars have gone.

* * *

On July 26, San Bernardino’s Interim City Manager, Andrea Miller, and Director of Finance, Jason Simpson, delivered to the mayor and city council a report called the Budgetary Analysis and Recommendations for Budget Stabilization. The report lays out the City’s problems and various possible solutions — including several that might have avoided bankruptcy. It’s a dense and important document, a harbinger of trouble ahead for spendthrift municipalities and states.

At the start, the report notes:

The City of San Bernardino has been affected by the serious economic recession as have other cities and has taken steps over the last several years to reduce costs. Nevertheless, costs continue to outpace revenue due to increased operational expenses and significant rapid declines in property tax revenues as a result of a drop in property values and decline in sales tax revenue. Deficits of major proportions are projected in all five years of the forecast created as part of this project. To ensure basic operational service levels are maintained and anticipated cash flow requirements are met, steps will be needed immediately to reduce costs. . . . If these measures do not achieve immediate and substantial cost savings, then the City will have to explore other alternatives to deal with its fiscal crisis.

They didn’t. And, less than a week later, the city council decided to declare bankruptcy.

A quick side note: I’ve read Miller and Simpson’s report numerous times in the preparation of this piece; and, each time I read through it, I’m more impressed. It’s an honest assessment of how a municipal government (or, by extension, any government) can stumble into insolvency, despite the best intentions of several generations of leadership — including leadership that fancied itself reform-minded. Indeed, one of the most destructive qualities of statism is its tendency to turn good intentions into disastrous results. That tendency is on full display in the San Bernardino story.

While the report does take off on some tangents of bureaucratic jargon, most of its 49 pages are a fairly common-sense narrative of what happened. And what needs to be done to get the City back on an even financial footing.

This is how the report describes San Bernardino’s financial circumstances:

Reserves in the General Fund were exhausted years ago, reserves in the internal service funds were also depleted and the City has encumbered itself with various debt obligations and labor agreements putting additional and unnecessary risk on the General Fund.

The City has declared numerous fiscal emergencies based on fiscal circumstances and has negotiated and imposed concessions of $10 million per year and has reduced the workforce by 20% over the past 4 years. Yet, the City is still facing the possibility of insolvency due to a variety of issues including accounting errors, deficit spending, lack of revenue growth, and increases in pension and debt costs. . . .

Over the past several years, the City has utilized General Fund reserves, asset sales and one time revenues to maintain City services. To address the projected deficits in previous fiscal years, the City has reduced positions, negotiated compensation reductions, and implemented new revenue measures. Unfortunately, the decline in taxable sales and property values over the last several years has resulted in revenue losses of $10 to $16 million annually.

In other words, it had used the usual one-time, off-budget legerdemain and accounting gimmicks that spendthrift governments — and spendthrift people — instinctively employ when they expect some future windfall to make everything okay. In San Bernardino’s case, the one-time tricks had been played . . . and there was no windfall coming.

According to the report, for the 2012–13 fiscal year, the City’s expenditures would exceed revenues by $45 million. And that annual shortfall would only increase over time.

The report lays out some of the most critical financial weaknesses facing the City:

• Because the City has used reserve funds to balance previous budgets, there are no reserves in place to balance current and future budgets.
• Budget choices made in previous years have left the City with high capital lease balances for equipment — and no effective way to refinance or otherwise resolve those expenses.
• Because of the loss of federal and state redevelopment funds, the City has insufficient economic development programs in place to project stronger tax revenues in the future.
• Since the City has a current deficit in its General Fund, it does not have sufficient unrestricted cash available to pay its ongoing obligations.
• The City has an unemployment rate above state and county averages.
• The City has an unusually high ratio of public safety costs to overall General Fund revenues.
• The City’s expenses were over budget in FY 2011–12 and would be massively more so in 2012–13 and following.
• The City’s failure to complete its FY 2010–11 budget audit on time delayed necessary budget reductions, further depleting cash.
• The starting General Fund balance has been erroneously stated for each the previous two fiscal years.

In mid-July, the San Bernardino County sheriff’s office announced that it was involved in a multi-agency criminal investigation of the City government. The sheriff’s announcement didn’t indicate whether the investigation was related directly to the City’s bankruptcy filing. It referred to “allegations of criminal activity within departments of the San Bernardino city government” and confirmed that it would focus on those General Fund balances, which had been “erroneously stated.”

But the City’s financial problems aren’t (or aren’t entirely) the result of malfeasance. Many of its problems are structural. San Bernardino’s population is approximately 211,000; that number has been increasing rapidly since the 1970s. Because the City is a bedroom community and has never had a substantial commercial or industrial base, its population growth has outpaced growth of tax revenues needed to provide essential services.

According to the report, the largest employers in the City — in roughly descending order — are local government agencies, California State University San Bernardino, the San Manuel Band of Mission Indians, and San Bernardino Community Hospital. The common thread? There’re all either government agencies or government-dependent entities, relying directly or indirectly on public money for the majority of the revenues.

* * *

An important strategy for avoiding structural budget deficits is to adopt a budget philosophy that can serve as a meaningful framework for maintaining financial discipline.

This may sound elementary: Reporting on a government entity’s finances clearly and for public discussion is a way for the fiduciary responsibilities of elected officials and executive managers to be understood by the public and organization. But many government entities have become so decadent that they no longer look at financial reporting in that way.

The San Bernardino report describes some “best practices” in public-entity financial management:

• Structurally Balanced Budget. The annual budgets for all City funds should be structurally balanced throughout the budget process. Ongoing revenue should be equal to or exceed operating expenditures in both the proposed and adopted budgets. If a structural imbalance occurs, a plan should be developed and implemented to bring the budget back into structural balance.
• Multi-Year Financial Forecasting. To ensure that current budget decisions consider future financial implications, a five-year financial forecast should be utilized by the staff and Council. The annual General Fund proposed budget balancing plan should be presented and discussed in context of the five-year forecast. Any revisions to the proposed budget should include an analysis of the impact on the forecast out years.
• Use of One-Time Resources. One-time resources (e.g., revenue spikes, budget savings, sale of property, and similar nonrecurring revenue) should not be used for current or new ongoing operating expenses. Examples of appropriate uses of one-time resources include rebuilding reserves, retiring debt early, making capital expenditures (without significant operating and maintenance costs), and other nonrecurring expenditures.
• Established Reserves. San Bernardino has multiple funds, based on different revenue sources and requirements. Because there are risks (both known and unknown), it is important that reserve levels in all funds be maintained as a hedge against such risks. Without proper reserves, there can be major disruptions in services when unforeseen financial demands emerge, requiring immediate attention.
• Debt Issuance. A municipality should not issue long-term (over one year) debt to support ongoing operating costs (other than debt service) unless such debt issuance achieves net operating cost savings and such savings are verified by appropriate independent analysis. All debt issuances shall identify the method of repayment (or have a dedicated revenue source) without an impact to operations.
• Employee Compensation. Negotiations for employee compensation should continue to consider total compensation bargaining concepts and focus on all personnel services cost changes (e.g., step increases and the cost of benefit increases). Compensation costs should be included in the five-year financial forecast to ascertain affordability to the municipality, within context of expected revenues.

Summing up these points, the report concludes:

To resolve its structural budget deficit and prevent a recurrence in the future, the City needs to adopt a budget philosophy similar to the measures above to help elected and appointed officials maintain the financial discipline crucial to a growing community like San Bernardino.

And, then, the hardest truth: “It is atypical practice for cities to have adopted budget policies” like these.

That may be the biggest problem that the United States faces today.

* * *

For decades, the City of San Bernardino — like many of its residents — counted on rising real estate prices to subsidize the shortfalls in its day-to-day operations. For the City, these subsidies took the form of sharply increasing property tax revenues; the rising revenues allowed the City’s senior officials to grow sloppy.

Warren Buffett has a famous quote that’s relevant to this sloppiness (though it pains me some to quote such a chiseling crony capitalist): “It’s only when the tide goes outthat you discover who’s been swimming naked.” When the southern California real estate market collapsed, the tide went out. And San Bernardino was caught without its shorts.

The report takes a hard look at the City’s prospects for regaining some of the property revenues it lost to the collapsing California real estate bubble:

There are actually two bottoms for housing. The first is new home sales, housing starts and residential investment. The second is sale prices. Sometimes these can happen years apart.

Calculaterisk.com [an economics web site cited by one of the City’s property tax consultants] reports that the first housing bottom was spread over a few years from 2009 until 2011. They believe the second bottom, prices, hit in March 2012. This doesn’t mean prices will increase significantly any time soon. Usually, toward the end of a housing bust, normal prices mostly move sideways for a few more years. Real prices adjusted for inflation could even decline for another 2 or 3 years. . . .

Because we do not anticipate much growth with housing new starts or employment in the near future . . . we should assume construction-related permit activity will also be flat or possibly continue with its decline. Permit activity within most California cities has been very volatile with trends pointing to decreasing activity.

This is an interesting and useful discussion of cycles in the real estate market. But it hints at one of the many problems that come when a government agency tries to “time” a market. If San Bernardino’s consultants are right and a real estate market has a two-part bottom — and if those two parts occur years apart — predicting trends in property tax revenues at or near the bottoms is practically impossible.

In the end, all the report could conclude is: “The rate of revenue growth has not been sufficient to meet the contractual and debt obligations of the City.”

* * *

Every financial crisis — whether it involves a municipality, a company or a family — has two parts: expenses that are too high and revenues that are too low. The drop in property tax revenues was only half the reason for San Bernardino’s lurching deficit. The other half was the City’s expenses. And expenses are the thing bankrupt entities of any sort have to address first when they’re trying to emerge from their crises.

Here’s how the report describes San Bernardino’s expenses:

Roughly half of the annual deficit is attributed to unfunded liabilities in City Retiree Health, Workers’ Compensation and General Liability accounts.

The remaining half is attributed to increasing operational costs and the end of employee concessions. As early as FY 2009–10, expenditures exceeded revenues and the City had begun to utilize prior year fund balances to avoid service cuts or delays in projects. Because expenditures continue to exceed revenues, fund balances have been depleted and have reached a critical point in 2012–13 where the City will begin the year with an actual deficit and significant cash flow constraints.

Put into perspective, this projected deficit in 2012–2013 represents almost 38% of the General Fund budget for that year. The remaining fund balances cannot pay for ongoing operating costs and large sustained reductions will be required. Reducing ongoing expenses must largely come from ongoing reductions in personnel costs since these costs represent about 75% of total General Fund expenditures. Of the personnel costs in the General Fund about 78% are for public safety.

City of San Bernardino Public Safety and Fire expenditures consume the majority of the budget, some 73% of the General Fund in FY 2011–12. And personnel costs in total account for about 85% of the General Fund.

“Public Safety” is, of course, bureaucratese for “police.” The problem that San Bernardino and other bankrupt local governments face is that the most essential service they provide citizens is police and law enforcement. Everything else — education, parks, growth management plans, performing arts centers, and sports stadiums — pales in comparison to keeping cops on the streets. And crime to a minimum.

Here’s the report’s suggestion for cutting the cost of law enforcement in the City:

To substantially reduce costs in the public safety services, the City will need to reduce staffing, or seek out contract opportunities for the City’s Police Department to provide services to adjacent communities. In recent years, several municipal police departments have provided services to others under contracts for service. In fact, its common place for public safety departments to share dispatch services.

This is an important point to consider for the future of local governments. Cities, at least smaller ones, may not be the most efficient mechanism for financing law enforcement. As the report suggests, a regional law-enforcement infrastructure may be more cost-effective. This suggestion won’t sit well with many mayors and city councils, since their authority over the local constabulary is often their strongest source of political power.

But, when a bankrupt city like San Bernardino has three-quarters or more of its financially unsustainable budget dedicated to “public safety” expenses, it has abdicated the political power that comes with being the boss of the cops.

* * *

The San Bernardino report notes that “reductions to the expenditure side of the budget are not going to produce the level of savings that will be needed to balance the budget.” And, to boost revenues, it suggests increases in or additions of the following municipal taxes:

• Real Property Transfer Tax
• Utility User Tax
• Sales Tax
• Transient Occupancy Tax
• 911 Communications Fee
• Fees for Recovering Paramedic Costs

With bureaucratic resentment, the report notes that “all would require voter approval.”

In the meantime, the City has to find other, more immediate, ways to raise money. In this effort, the report circles back to an idea that it’s already admitted is bad for the City’s long-term fiscal health. Even though the report warns against paying for ongoing expenses with one-time transactions, the authors can’t ignore the quick money available from privatizing real estate:

Currently the City [owns] 294 parcels with total book value of $300 million and a likely sale estimate of less than $100 million dollars. Given the City’s 18% of the property assessment, the sale of these parcels would generate roughly $18 million dollars. The City may also wish to explore selling or leasing some of the parcels at below-market rates in order to incentivize developers and other business interests to spur additional economic development and development-related revenues.

Selling assets doesn’t improve the financial prospects of a city — or a business, or an individual — in the long-term. But insolvent entities don’t have the luxury of making the long term a priority. They need to survive the near term. So, they sell things.

The report tries to inject some wisdom into the breathless discussion of raising taxes and selling off real estate. On these matters, it concludes:

. . . the pursuit of new revenue sources and/or increasing existing revenues is a strategy that can no longer be ignored. However, seeking to increase revenues that are subject to large fluctuations should not be treated as a cure-all. As was the case with revenue received during the real estate boom, some increased revenue could be short-lived.

Therein lies the problem. Governments at any level are rarely able to see past the short-term. Even — or especially — when their press releases talk about the importance of long-term vision, statist entities rarely have it. Twenty years ago, hundreds of books and thousands of articles were written about the long-term vision of Japan’s mighty Ministry of International Trade and Industry. How the mighty have fallen. MITI doesn’t exist any more.

* * *

All of this discussion is really just a warm-up act for the 800-pound gorilla at the center of San Bernardino’s problems: the expanding amount of money required to maintain the pensions owed to retired City employees. Here’s how the report describes this issue:

. . . the City is faced with increasing pension costs, as CalPERS adjusted the investment returns increasing retirement costs to all its members starting in FY 2013.

The City’s costs for employee retirement have increased from $1 million in FY 2006/07 to nearly $1.9 million in FY 2011/12. By FY 2013/14 the annual cost will be over $2.2 million. To put this into perspective, the City was spending about 9% of its General Fund budget on retirement costs in FY 2006/07. In FY 2011/12 it will need to spend 13% of the budget on those costs, and by FY 2015/16 it will require 15% of the budget for retirement obligations. [This] is basically an overhead cost over which the City has little control over in the short term.

California law grants CalPERS extraordinary powers (essentially, taxing powers) by which it can demand payments from cities, counties, schools districts, etc, if it runs short of the money needed to meet its defined-benefit pension distributions. Kind of like a cash call to members of business partnership.

This creates a great deal of moral hazard. The San Bernardino report describes this in painful detail:

To address growing public safety pension obligations, the City issued pension obligation bonds (POBs) in 2005. This is a common strategy to reduce unfunded liabilities through the issuance of fixed-rate bonds. . . . the City’s annual pension costs were reduced by $2 million after the issuance of the bonds. However, at the time of the issuance of bonds and subsequent deposit of bond proceeds into the City’s public safety account, CalPERS lost a significant amount of its pension portfolio. The market losses have negatively impacted the City beyond the losses of its deposited funds and have completely reserved all the saving realized from the issuance of POBs.

So, CalPERS’s shoddy investments negated any advantage for the City in issuing pension bonds. The City is still responsible for paying back its bonds…and CalPERS can demand additional money from the City to make up for CalPERS’s bad investments.

It’s as if you refinance your home mortgage to get a lower interest rate. But, after agreeing to the refi, the bank reneges and raises your interest rate back to where it was before and then increases the principal amount of your loan because it lost money on an investment scheme involving Greek bonds.

CalPERS divides the payments that it demands — which it calls “rates” but which aren’t “rates” in any insurance or actuarial sense — into two parts: employee rates and employer rates. According to the San Bernardino report:

It has been a common practice for San Bernardino and many other agencies to pay both parts of the rates. However, recently the City was able to negotiate with the employee groups for all new hires after October 2011 to pay the full employee share. . . . The City could negotiate with current employees to pay all or a portion of the employee share. Further, the City could negotiate any level of sharing with its employees and is not limited to [traditional formulas]. Some cities are planning for [their employees to pay] a greater share of PERS costs than what has commonly been referred to as the “employee share.”

This is an overlooked point. CalPERS can raise the “rates” it demands from local governments as much as it needs to; and those local governments can simply pass CalPERS’s higher demands onto their workers. Or file bankruptcy.

In the years leading up to its bankruptcy filing, San Bernardino did what conventional wisdom suggested for getting its pension obligations in order. It negotiated a “two-tier” retirement benefit program wherein newly-hired employees receive a smaller retirement benefit than more senior employees. But the effects of these new deals are still years away. According to the report:

Savings under this program will build with workforce turnover, as employees under the current system retire and are replaced by employees at the new rate. Therefore, initial cost reductions are minimal but savings to the City in the long term will be significant.

Long-term solutions for near-term problems — the opposite of what a prudent financial manager should propose. In the meantime, the City was still desperate to cut costs. Immediately.

As California’s local governments downsize their employee bases, even slightly, a shrinking number of remaining employees end up paying CalPERS “rates” to support the pension demands of a growing number of retirees. This system is not sustainable. In fact, it’s a bubble . . . if not a Ponzi scheme.

Some senior elected officials in California — including, to his credit, Gov. Jerry Brown — have started to discuss “pension reform” as a pressing issue for the state. But their talk remains rather academic; in the real world, for San Bernardino, annual pension costs have grown from $1 million in FY 2006-07 to $2.2 million in FY 2012-13. That’s a shocking increase in a sunk cost — and one that’s not affected by anything the City does today, including layoffs, restructurings, assets sales, etc.

As the report notes: “costs are increasing at rapid rates significantly beyond increases in revenue and are no longer affordable to most public agencies.”

* * *

So, downsizing local government workforces is a Gordian knot.

The layoff program used by most local governments and public agencies in California is referred to as the “Golden Handshake,” made available under the California Public Employees Retirement Law (Gov. Code, 20903). The Golden Handshake, also as known as the “CalPERS Two Years Additional Service Credit” benefit, requires a local government to provide two additional years of service credit for the calculation of pension benefits to “employees who retire during a designated window period because of imminent demotions, mandatory transfers or layoffs.” While it can provide some short-term savings, this arrangement adds to a city’s future retirement costs and limits management flexibility. For example, the Golden Handshake requires an employer to establish a “window period of at least 90 days and no more than 180 days” to solicit early retirees.

This is a kind of madness. Cities on the verge of bankruptcy don’t have six months to wait for workers to come forward for early retirement. So CalPERS’s union rules end up being largely irrelevant in the circumstances where action is needed, like the ravings against “greedy corporations” of a 30-year-old graduate student at a bottom-tier university.

As the San Bernardino report notes:

The cost-effectiveness of these programs must be examined within the context of an aging workforce. . . . the program [must] be carefully managed to ensure that the option is only offered in instances where a financial justification exists. If that is not the case, the City could be put itself in a situation where additional layoffs are needed to pay for early retirements.

That last line reads like something out of George Orwell. Or: the beatings will continue until morale improves.

Out of this Orwellian muck, the City has to keep streets open and police on them. The essential elements, to most people, of the social contract. So, for the foreseeable future, local governments like San Bernardino will be faced with firing some workers . . . or firing more. Faced with an existential threat to the notion of “city” itself. As the report concludes:

The revenue forecast shows that significantly lower costs will be required for the foreseeable future. During this period of time, it has been noted the that Council, residents and businesses in the City expect and deserve a well well-maintained street network, nice manicured parks, cultural opportunities, well-maintained neighborhoods, in addition to fundamental public safety services. The challenge to the City will be to identify what it can afford and how that relates to the type of community services it wants to provide.

Indeed.

* * *

These problems are only going to get worse in the coming years. As the federal government reaches the limits of its borrowing capacity, it will be forced to cut back on block grants and other disbursements to the states. As the states have to deal with these cuts — and structural problems of their own — they’ll cut payments to cities and counties.

And the cities and counties will go bankrupt.

Even in bankruptcy, California’s cities and counties won’t be able to correct their economic models without restructuring the pensions that they promised public employees in more prosperous (or what seemed like more prosperous) times. According to a February 2012 Stanford Institute for Economic Policy Research report, public-employee pension spending in California grew an average of 11.4% a year between 1999 and 2010. That’s twice as fast as spending growth for essential budget items like public safety, health and sanitation.

These problems aren’t limited to California. As Reuters recently noted:

CalPERS has long argued that pension contributions cannot be touched even in a bankruptcy. But firms that insure municipal bonds have strenuously objected to the idea that pension payments should come ahead of bond payments. The outcome of how CalPERS and bondholders are treated as creditors . . . and whether CalPERS receives preferential treatment . . . will have broad implications for local governments around the country.

In the weeks since its bankruptcy filing, San Bernardino has slogged along. It made payroll in August and September. Miller and Simpson are still in their jobs, trying to keep things running in some semblance of order.

The City plans to layoff more employees and shut down libraries and has reduced its annual shortfall from about $45 million to $7 or $8 million. But this still isn’t sustainable.

The multi-agency criminal investigation hasn’t produced any results. Yet. Some locals say that it has more to do with political theater (specifically, a feud between San Bernardino’s mayor and city attorney) than any prosecutable crimes.

The real battle remains between San Bernardino and CalPERS. And this is a battle that neither side seems particularly interested in joining. The City, like many bankrupt debtors, seems to believe that the longer it delays a resolution of the money it owes CalPERS, the lower the final number will be. CalPERS, on the other hand, seems to be concerned that the San Bernardino bankruptcy will expose it as another of Warren Buffett’s naked swimmers. Or, more in line with its haughty history, an emperor with no clothes.

CalPERS lawyers can cite statute and weep well-rehearsed tears over pabulum like “fairness” and “austerity” but they can’t get blood — or $320 million — from a turnip.

And the City of San Bernardino is merely the first of many turnips ahead.

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