On Tuesday, San Bernardino, California, became the third California city in three weeks to announce its intention to seek bankruptcy protection. Does this mark the beginning of a significant trend toward bankruptcy, particularly in California? My colleague Guy Davidson examines the patterns.
The speed with which San Bernardino made its decision, the size of its announced budget shortfall, and the city’s claims of a long history of fraud are puzzling and alarming. It will be important for investors to understand both the cause of the announced $45 million shortfall and the charges of fraud. The more pressing issue, however, is whether more cities will follow it into bankruptcy. While we think a few more might, we don’t think it’s the beginning of a major trend.
State finances have steadily improved since the 2008 financial crisis, but local governments haven’t fared nearly as well. Preliminary data from the Rockefeller Institute indicate that states’ tax collections increased during the first quarter of 2012 for the ninth consecutive quarter. The primary sources of revenue for states are taxes on income, sales and corporations.
In contrast, local tax collections are heavily dependent on property taxes, which held up in the immediate aftermath of the recession, but have not kept up with inflation since the fourth quarter of 2010, as property values have continued to slide. April data offered some hope—the average home price rose 1.3%—but it’s too early to tell if the long decline has ended. Some local governments have increased other taxes in an effort to balance their budgets, but that’s not an option in California.
In response to lower revenues, many local governments have cut expenses to balance their budgets. Cost controls, particularly workforce reductions, have helped improve finances. According to the US Bureau of Labor Statistics, by June of 2012, local governments had shed 528,000 jobs, a drop of 3.6%.
Regardless of the economic environment, a tiny number of municipalities seek bankruptcy protection each year for one reason or another, and we expect this pattern to continue. There are nearly 90,000 units of state and local government in the US, yet in 2011, only 13 filed for bankruptcy. Virtually all the rest continue to meet their budget and legal obligations. So far this year, the number of filings has remained incredibly low—San Bernardino would be the sixth filing this year, by our count.
The municipalities filing for bankruptcy protection or defaulting on their debt can be roughly grouped into three categories: they are the victims of unique events, long-term economic decline, or extreme boom-and-bust cycles. (Pension costs certainly play a role in these municipal distress stories, but they are not the underlying cause of the financial stress.) We have recent examples in all three categories.
Some municipalities have had financial problems when a unique financial burden overwhelmed their budget. Only last week, Mammoth Lakes, California, filed for Chapter 9 bankruptcy protection after it lost a dispute with a developer and was ordered to pay a judgment nearly three times the size of its budget. An investor would hope that fundamental research would uncover such risks, but issuer diversification within a portfolio is the best defense.
A second group of seriously distressed municipalities consists of those that have experienced a long-term trend of economic deterioration. Detroit is a good example. Its considerably shrunken economic base no longer generates enough tax revenues to support operations. Fundamental research reduces the likelihood of investing in these distressed issuers.
Bankruptcies in Stockton and San Bernardino, California, represent the third category. Both went through a housing boom that generated strong revenue growth. Assuming the growth would continue, their governments quickly expanded budgets and services. Unfortunately, the housing boom was quickly followed by a deep local housing collapse, and the cities were unable or unwilling to cut expenses or raise revenues quickly enough. Diligent research and analysis of each issuer’s options and willingness to address problems is warranted.
Clearly, research on the impact of the housing cycle and municipalities’ fiscal response to it is critical to understanding today’s municipal market. And the housing crisis hit California particularly hard. One way to measure just how hard is to look at the percentage of home mortgages that are more than 90 days delinquent. When that percentage exceeds 10% of a county’s mortgages, a housing crisis has had a serious impact on that county’s economy. Of the 54 California counties tracked in the Federal Reserve database (four counties do not report the statistic at all), 10 have 90+ day delinquency rates exceeding that critical 10% level—including San Bernardino at 11.7%.
That means more filings are possible. However, the local government-related debt issued in these 10 counties is small, representing only about 1% of outstanding California municipal debt. In other words, the total amount of debt involved in potential filings should remain quite small—and does not mark the beginning of a significant trend.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, and Guy Davidson is Director of Municipal Investments, both at AllianceBernstein.