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California Bankruptcies Shield Retirees, Not Bondholders

By Steven Greenhut
August 09, 2012 6:30 PM EDT

The recent war of words between the California Public Employees’ Retirement System and a Bermuda- based bond-insurance company called Assured Guaranty Ltd. (AGO) has made it clear that California officials would rather stiff bondholders than trim even the most generous pension benefits promised to public-sector workers.

The debate centers on Stockton, California, the largest city in the nation to declare bankruptcy. In its initial proposal to creditors, the city would fully fund its pension system while walking away from $124 million in debt from pension-obligation bonds it floated in 2007.

Stockton couldn’t meet its financial obligations to pay for enhanced pension benefits five years ago, so it borrowed the money. Rather than cut unsustainable benefit levels while it has the chance to do so now, officials there would rather default on the $103 million it owes Assured (AGO) Guaranty.

Stockton and other Californian cities have slashed public services, thus putting the demands of public employees above the concerns of taxpayers and residents who rely on public services. Now we see that even bondholders don’t stand a chance when their interests collide with those of public-sector unions.

It’s easier to take on an offshore firm than confront CalPers, which had threatened to wage a protracted court battle against another Californian city, Vallejo, if it decided to reduce pension promises after its 2008 bankruptcy. Stockton officials no doubt are aware of that threat.

Investor Warning

“Chapter 9 was not intended to be used as a sword to prefer one class of similarly situated creditor over another,” said Assured Guaranty in an Aug. 1 statement. “Stockton’s attempt to transfer the cost of lucrative, above-market employee wages and benefits granted when tax revenues were flush to capital markets creditors by haircutting bond principal is unprecedented, a contortion of the bankruptcy process and will foreclose Stockton’s access to the capital markets for the foreseeable future.”

CalPers’s general counsel, Peter Mixon, responded to Assured Guaranty, with bravado typical of the retirement fund: “The obligations owed to the public workers of the city have priority over those of general unsecured creditors including bondholders,” he said. “Unlike insurance companies, policemen, firefighters and other public employees are not in a position to evaluate credit risk of their employers. Assured Guaranty is in the business of evaluating these risks.”

Stockton City Manager Bob Deis also took aim at the company. He told the Stockton Record that Assured Guaranty is only interested in getting its money and didn’t care if anarchy reigned on Stockton streets, a reference to reports that 20 or more police officers were leaving or thinking of leaving an understaffed department. “Assured Guaranty wants more than that?” Deis said. “If that’s not bad faith and whining, I don’t know what is.”

Yet Assured Guaranty can’t be blamed for any anarchy on Stockton’s streets. That’s largely the fault of city officials there who have for years gone on a spending spree. Deis himself blasted the health plan the city approved in the mid-1990s that gave many city employees and their spouses “free” lifetime health care -- something that created a $417 million unfunded liability. Stockton officials also granted police and firefighters a 50 percent pension increase in the early 2000s, allowing them to retire at age 50 with 90 percent of their final year’s pay.

When real-estate prices were soaring as commuters headed east into the Central Valley to flee exorbitant Bay Area prices, Stockton officials spent every dime of the increasing tax revenue and more. They “invested” in taxpayer-funded arenas, a waterfront park complex and other dubious redevelopment structures now scattered throughout a downtown known mainly for its high crime and vacancy rates.

Buffett’s Pullback

Some Stockton officials blame the economic decline for their current mess. Housing prices have fallen almost 70 percent from the height of the market, leaving a wake of foreclosures and plummeting tax revenue. Had officials shown restraint during the good years, however, they wouldn’t need to slash a quarter of the police force and other services during these bad years.

Stockton’s and CalPers’s “tough luck” approach toward Assured Guaranty could have troubling long-term consequences. Writing in the Prop Zero blog, Joe Mathews noted that Warren Buffett’s Berkshire Hathaway Inc. -- which had played down concerns about municipal bankruptcies -- dramatically cut its municipal investments after the Stockton and San Bernardino bankruptcy news.

A report released by the Securities and Exchange Commission last month called for Congress to embrace new disclosure rules so that investors are better informed of the risks involved in municipal-bond investments. The insistence by CalPers that full pension payments come above even bondholders’ investments should provide impetus for those reforms, and could stoke SEC fears that the public will lose confidence in bond markets.

Fortunately, just because CalPers claims that pensions take precedence over everything else doesn’t resolve the issue. Marcia Fritz, the president of pension-reform group California Foundation for Fiscal Responsibility, claims this is the opening shot in a long legal battle. She says CalPers is misconstruing the state constitution, which requires agencies to make sure there is money to pay for its pension obligations, but it doesn’t mean pensions can’t be cut during a bankruptcy proceeding.

If the CalPers argument holds, then “nothing is safe anymore, except pension promises,” she said. “What Stockton is exposing is the vulnerability of bond insurers in the pension crisis. I’m concerned they may be undercapitalized to handle major bankruptcies like Los Angeles if judges rule that pension promises, no matter how outrageous, are senior to bond debt.” Bond debt, she said, will be more expensive to handle because of higher insurance premiums.

Offloading Costs

The unfolding battle reminds reformers that municipal bankruptcy is no panacea for a city’s woes. If elected officials don’t have the courage to confront existing pension obligations, then such bankruptcies will do little more than offload the costs onto bondholders and taxpayers.

Stockton reduced its overly generous retiree medical plan, but the pensions of current employees remain an enormous problem. If the courts allow Stockton to proceed on its current path, then instead of helping cities fix their fiscal woes, a coming wave of municipal bankruptcies might only encourage them to continue foisting their troubles on others. Bondholders aren’t the only ones who should be worried.

(Steven Greenhut is vice president of journalism at the Franklin Center for Government and Public Integrity. He is based in Sacramento, California. The opinions expressed are his own.)

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To contact the writer of this article: Steven Greenhut in Sacramento at steven.greenhut@franklincenterhq.org.

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.

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