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Rick Roeder, FSA       August 2012

California's fiscal crisis is reaching the point of no return for an increasing number of municipalities. In the past two months, three cities have filed for bankruptcy: Stockton, San Bernardino and Mammoth Lakes. Our April 15, 2009 Ramble (Latest California Earthquake: National Fault Lines) had previously reported on the City of Vallejo's bankruptcy filing and predicted that the handling of the Vallejo mess would have long-term ramifications on the actions of other municipalities.

The unions' response to Vallejo was to attempt to make a bankruptcy filing more difficult. The unions tried to pass a bill which made it impossible to file for bankruptcy without first getting approval in Sacramento. Perhaps a more extreme solution of eliminating the possibility of a bankruptcy filing was also contemplated. In 22 states, municipal entities do not have the option of a bankruptcy filing. CalPERS' response to Vallejo's crisis was to promise a legal battle royale if the City attempted to cut pensions for existing employees. The spectre of CalPERS' deep pockets was one of the reasons that Vallejo did not seriously pursue the course of pension reduction. The passage of Assembly Bill 506 has been the legislature's recent response to bankruptcy filings. The Bill requires ninety days of mediation with creditors after filing.

None of California's recent bankruptcy filings included a proposal to reduce pensions that are accrued or will be earned in future years by current employees. This view has treated pension benefits as a vested, contractual benefit under California's constitution which cannot be impaired by the federal bankruptcy process. More on this later.

As the Sacramento Bankruptcy Court sifts through these issues, a potentially game-changing grenade has just been lobbed by two insurance companies. The Assured Guaranty Corporation stands to lose $103 million if the City of Stockton's proposal goes through in current form. The National Public Finance Corporation will also be out many millions. In other words, enough money to hire some high-priced lawyers to challenge one of the sacred cows of California law: pension benefits.

The core of the insurers' arguments is that no credible bankruptcy agreement can exclude paring pension expenditures because of their magnitude. Their point is that no reasonable bankruptcy process can exclude the largest creditor, in this case, CalPERS, from the discussion. Currently, Stockton pays CalPERS roughly $29 million per year.

CalPERS has been staunch in its support of existing pension levels: “The obligations owed to the public workers of the city take precedence over general unsecured creditors, including bondholders,” said CalPERS general counsel, Peter Mixon.

Two of the spokesmen for pension maintenance do so on a basis of half-truths that ignore the possibility of a middle-ground solution. Tom Dresslar, a spokesman for the California Treasurer's office, has been quoted, “What these (financial) analysts are saying is that the state needs to somehow make sure that public sector workers get screwed so that bondholders and other creditors get made whole. The state has problems of its own. The idea that cities have made some bad financial decisions and the state should rescue them with pots of money makes no sense. We don't have any money.”

Dresslar's comment conveniently ignores several critical points. First, the importance of treating bondholders in an even-handed manner falls under the category of “don't bite the hand that feeds you.” Bondholders are vital in the financing of our state's governmental entities. Second, the idea that the state can wash its hands of local woes is ludicrous given the large spectre of mandates Sacramento has placed on the shoulders of local entities. Last, and definitely not least, is the state's far-reaching decision to pass SB-400 in 2000. The magnitude of those pension increases set the bar for the highest level of pensions in California history. The state's setting of this bar, coupled with its 500-pound gorilla status, made it very difficult from a political standpoint to keep cities and counties from following suit.

CalPERS indirectly fueled the notion that increased benefits were affordable with terminology that would make some actuaries roll over in their graves. During the go-go 1990s, CalPERS formally designated a number of its clients as “super funded.” I have never read an actuarial text that uses or defines “super funded.” This term may well be a CalPERS creation. Perhaps the decision makers of CalPERS' clients should have been a mite suspicious of any term involving “super” since even Superman has proven vulnerability to Kryptonite and Lois Lane - not always in that order. However, this environment of touted financial invincibility too often carried the day.

More deflection of the impact of pensions comes from the president of CalPERS' Board of Administration, Rob Feckner. Feckner opined, “The real culprit (of the state's fiscal crisis) is the economy and the housing market.” This self-serving view ignores the simple fact that entities are typically paying much higher percents of payroll for pension funding than a decade ago - typically by a factor of 2-4.

The Legislature's budget analyst, Mac Taylor, has opined that contracts and retiree health benefits can be overturned but has been silent on the issue of reducing pension benefits.

Proponents of existing pension levels point out that Stockton was a victim of its own excesses as it granted large pay raises and took out significant loans to beautify the City that some deemed unnecessary. In other words, Stockton is being portrayed as an outlier not representative of the herd. For those of you who have been to Stockton, one might have lots of sympathy for the purpose of such loans! Regardless, Stockton's significant layoffs of safety and fire personnel should set off alarms that new efforts should be made to prevent this from recurring elsewhere.

The state's fiscal morass has created a crippling, ripple effect. When Jerry Brown decided to eliminate agency funds, previously available for local redevelopment, San Bernardino cited the elimination of such monies as a key element in their decision to file. The state's raid on redevelopment funds has also had the unfortunate impact of being the catalyst ballot measures to raise local taxes in half-dozen cities this November.

How the bankruptcy filings play out will have a significant impact on future bond issues in California. To date, the demand for such bonds has remained strong. No matter what jokes the Republicans are making about California's fiscal solvency, the lure to a Californian of paying no state or federal taxes on bond interest will likely remain vibrant unless the roof caves in.

My view is that entities should make every possible effort to maintain negotiated pension levels. To do otherwise undermines credibility in future negotiations, fosters undesirable employee cynicism and guarantees a protracted legal brouhaha. However, if the bankruptcy court decides that some restructuring of pensions is necessary, I recommend the following two elements:

  • Reverting to pension formulas of the 1990s for all future years of service. Such benefits were reasonable and generally affordable.

  • Make sure the final average compensation period is at least three years. The numerous spiking situations give the state's pension system an unnecessary black eye.

My biggest suggestion is for all parties to be flexible and look for a middle-ground solution. One of the biggest reasons for gridlock in both Sacramento and Washington DC is the maddening inability to deviate from the “doctrinaire” party line view. For those who have deviated from such lockstep, there have often and needlessly been professional and political consequences. Personally, I still carry some battle scars in this regard! However, it has never been clearer that both cool heads and some reasonable compromises will be needed for California to regain its former financial vitality.

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