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California's Latest Earthquake: National Fault Lines?

Rick Roeder       April 15, 2009

Recent developments regarding the City of Vallejo’s financial distress have fault lines that extend far beyond the California border. These fault lines extend to New Jersey, Florida, Michigan and other distant realms where lucrative union deals have put governmental entities on precarious footing.

In May 2008, the City of Vallejo did what has infrequently been done for governmental entities since Chapter 9’s inception in the 1930’s – the City filed for bankruptcy under Chapter 9. City had been hit with a financial trifecta: the ongoing loss of income from closed shipyards, very generous Safety pay levels and plummeting property values. 74% of the City’s $80 million dollar general fund budget is for public safety salaries. Last month, bankruptcy judge Michael McManus affirmed that the City need only meet broad requirements which give discretion to break contracts. He affirmed that Congress did not impose limits on invalidation of union contracts under Chapter 9. McManus’ interpretation is interesting since the initial intent of Chapter 9 bankruptcy was to allow a municipal entity the ability to restructure debt. There will be a lively, ongoing debate as to whether collective bargaining agreements fall under Chapter 9’s domain.

Unless there are more legal and/or legislative roadblocks, expect many more governmental entities to make bankruptcy filings in the next few years. On April 7, Moody’s Investors Service did something it had never done before – it issued a negative outlook on a blanket basis on municipalities. And in the immortal words of Bachman-Turner Overdrive, “You Ain’t Seen Nothing Yet.” The stock market’s swan dive will have dire, but gradual, impacts on pension funding. The actuarial impact of the stock market decline on pension contributions is not immediate. Unexpected losses are spread over a period of years, typically five years or so.

Public pension plans were estimated to have almost 4 trillion in pension assets, or about $13,000 for each American, before the stock market tanked. Let’s guesstimate that there is average decline in aggregate portfolio values of 20% since the market slide. The “make up” needed in the form of added contributions has to cover both the 20% loss plus the 8% (or so) anticipated annual investment return that never materialized. Let’s assume a 28% shortfall that needs to be replenished by additional contributions.

28% of $4 trillion is roughly $1.1 trillion – or about $3,600 for each American. Like a mortgage payment, this shortfall does not need to be funded immediately but over a period of time. Let’s suppose that plans immediately reflect market value in their actuarial contribution calculations (which they do not). For example, if this shortfall is funded over 20 years, the resulting annual increase in contributions would initially be in the area of $80 billion using typical actuarial methodology (level percent of payroll financing), annually increasing by inflation for each and every year over the next generation. Granted, extra payments of this magnitude will not have to be made each year if the market partly or fully rebounds but how many are currently predicting such recovery in the near term? The reality is that the initial needed calculated contributions will be significantly less than the $80 billion dollar calculation, due to actuarial asset smoothing, but will rapidly ratchet upward in subsequent years.

This has numerous implications. First, potential buyers of municipal and state debt should both be more wary and ask for more in terms of coupon payments. This also makes the economic recovery a bit harder as governmental entities attempt to balance budgets with increased taxes. The state of California imposed a 1% increase in the already hefty state sales tax starting this month.

There are other implications. Numerous bankruptcy filings will have the impact of undermining the collective bargaining process – which supposedly is done in good faith. This feels as unsavory as if an obese person went on an eating binge in the week leading up to their gastric bypass surgery. Potential legislative responses from Washington D.C. could be hamstrung due to 10^th Amendment concerns (This is the states’ rights amendment).

While the McManus ruling is a clear defeat for the unions, do not expect public safety unions to go quietly into the night. Their union might dwarfs all others. I expect a bare knuckle, 3-5 year legal and political skirmish which will enrich lawyers and fascinate onlookers. Until then, exercise greater caution in buying governmental bonds. Realize that there is a delayed, but coming, drag on the road to long-term economic recovery.

As for the City of Vallejo, perhaps they should be thankful that new Yankee C.C. Sabathia is a native son. Given Sabathia’s $161 million free agent contract, maybe the City can ask him for a loan.

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