Politics & Policy

Stockton’s Rose-Colored Sunglasses

The California city faces a harsh reckoning for its unrealistic fiscal assumptions.

Yesterday, the city of Stockton, Calif. — population 292,000 — became the largest city in the United States ever to file for bankruptcy. After 90 days of forced mediation between the city and its largest creditors failed, Stockton had run out of options. The members of its town council, all Democrats, voted Tuesday, 6–1, to pursue Chapter 9. The town now has officially filed the papers.

Last year, Stockton made Forbes’s list of “Most Miserable Cities” because of its staggering levels of unemployment (near 20 percent) and crime (it’s the tenth-most-dangerous city in terms of violent crime). And over the last three years, Stockton saw 25 percent of its police officers, 30 percent of its firefighting staff, and 43 percent of its other public employees let go as the city scrambled to cut $90 million from its budget.

But for the residents of Stockton, the harshest days may still lie ahead. Even after gutting public safety, Stockton finds itself with its cash reserves entirely depleted, a $26 million fiscal deficit, and $830 million in unfunded retirement liabilities for public workers.

How did Stockton find itself in such fiscal disorder? While some of the factors behind its downfall are unique, others are troublingly common: Increasingly, municipalities are dreaming big but planning small.

According to Douglas Johnson of Claremont McKenna College’s Rose Institute, Stockton has been “clobbered by all three” of the major factors hitting California cities: 1) a vicious housing crash, 2) overly generous compensation for city employees, and 3) a huge bump in retiree pensions (which in Stockton were renegotiated in 2000). There is a common thread among all three troubles: the blindly optimistic belief that the good times would continue indefinitely.

For Stockton, the biggest of these problems is its deal with public employees. For current employees, Stockton guarantees a wage increase of 2.5 to 7 percent every year, regardless of how the city’s general fund performs. Stockton also provides a rather generous set of post-employment benefits, including lifetime free medical insurance to all retirees and spouses, which has added over $1.3 billion to the city’s long-term debt.

The city’s pension program is another albatross. On the recommendation of the California Public Employees Retirement System (CalPERS), the organization that manages most of California’s pension funds, Stockton increased pension benefits nearly 50 percent in 2000 and all but stopped making direct payments into the fund. CalPERS assured municipalities that high returns on existing investments would cover the additional benefits.

CalPERS — then under the watchful eye of Governor Gray Davis — assigned the interest rates, made the projections, and drew up the recommendations that eventually sunk Stockton. In typical Californian fiscal fashion, there was a catch: For Davis’s investment estimates to work, the Dow Jones Industrials would have needed to reach 25,000 by 2009 (it didn’t reach half that) and nearly 13,000,000 come 2050. CalPERS’s approximations extrapolated from the height of the Internet boom, conveniently validating luxurious public-sector contracts.

This dynamic, says Stockton city manager Bob Deis, amounted to a “nasty partnership” where both parties were “negligent.” “If the city staff was doing their homework, they would have asked what [CalPERS’s] assumptions were,” Deis says. “There were lots of hidden items in the labor contracts that were not common. . . . The city staff did not understand the various assumptions that CalPERS used.”

But it would take a number of years for the impact of these contracts to be felt. After the 2001 recession, Stockton entered a period of rapid growth, fueled mostly by the real-estate market. From 2000 to 2006, the median home price in Stockton rose from $110,000 to $400,000, and tax revenue soared.

During this period, says Harris Kenny of the Reason Foundation, Stockton became prone to a “dreamer mentality” — it’s not uncommon for small cities to get “huge visions when the coffers fill out.” In 2007, this mentality came with a price tag of $129 million in public projects to revitalize the city’s downtown area. Stockton’s annual budget is roughly $200 million.

But the price tag was not a concern for Stockton — economic growth would simply continue at its 2007 pace, according to budget estimates. On this assumption, Stockton secured funding for its building projects — including a new stadium, a million-dollar appearance by Neil Diamond at the venue’s grand opening, a subsidized luxury restaurant and hotel, and a refurbished marina — by offering municipal bonds at high rates of return. These bonds will ultimately cost the city $248 million to pay back. (Chapter 9 bankruptcy does not discharge a municipality’s debts; it just keeps interest from spiraling out of control and establishes a manageable payment plan.)

Then the real-estate bubble burst. “Their housing market totally imploded. . . . If you want an example of how bad a place could get hit, that’s Stockton,” Kenny says. Stockton was left with a demolished housing sector and a budget that literally banked on that sector’s flourishing.

Looking back on the city’s decisions, Deis, who took office two years ago, expresses concern with their logic: “Given the modest income of most of our citizens, some of the dreams were greater than what the community could pay for or what they found acceptable.”

By 2010, the city had practically run out of cash reserves and was on the brink of insolvency. Stockton responded by taking on more debt. This temporary solution became another long-term problem as debt payments jumped from $3 million in 2007 to $17.5 million for 2012.

As a recent study from the nonprofit group California Common Sense reports, “Even if Stockton entirely cut its Administration, Public Works, Community Services, Entertainment Venues, and Debt Service programs, it would still have had a budget shortfall.” Stockton needs a fundamental restructuring, focusing on the two largest elements of the budget: fire and police services. No plan is possible without addressing these costs.

With this harsh reality in mind, Deis has proposed a “Pendency Plan” that would suspend over $10 million in debt payments and cut spending on employee compensation and retirement benefits by $11 million. By law, a balanced budget must be submitted on July 1.

“This is not where any of us wanted to be, but, absent restructuring agreements with our creditors, any other options would decimate the city,” said Deis in a press release. “The Pendency Plan allows us to operate until we can get a long-term Plan of Adjustment negotiated and approved through bankruptcy.”

The city has 18 major creditors, all of whom will be at the table during the bankruptcy proceedings. Meanwhile, the unions, equipped with clearly worded contracts and regular memorandums of understanding, have a strong case if they choose to challenge contract alterations in court, as some (particularly the police union) are expected fiercely to do.

While all of this may be disconcerting to Stockton officials, there is some hope in the form of neighboring Vallejo. The city filed for bankruptcy in 2008 after its finances were hit hard by the national economic crash. During the three years that followed, Vallejo was able to renegotiate its union contracts, and the city is widely seen to be recovering, albeit slowly, from its crisis. Deis has publicly leaned on this example: “Vallejo is leaner, smarter, and they’ve got the confidence of their citizenry. I think Stockton will be doing the same.”

Stockton’s struggles, though, are far from unique. The city’s failure, while the largest to date, is part of a bigger trend, as Douglas Johnson warns: “A lot of cities will face a very similar situation in the next ten years.”

Stockton is a stark reminder of the harsh realities that underlie too many state and local budgets. When a city of 292,000 needs to cut 100 police officers despite suffering 76 murders, just to kick the fiscal can down the road, it is a sobering reminder that the horrors of Greece and Spain may not be too far away.

— Harry Graver is an editorial intern for National Review.

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