Four of the five largest municipal bankruptcies in American history have occurred since the Great Recession. Many other cities today teeter on the precipice of insolvency. Yet we lack good policy tools for dealing with cities in severe fiscal distress.
Recent experience confirms many analysts’ view that federal municipal bankruptcy law (Chapter 9) is ineffective. And state intervention, usually seen as the alternative, hasn’t fared well either.
The best way forward is to combine the two; what we call “intervention bankruptcy.” States, who must approve any municipality’s petition for bankruptcy in federal court, should pass laws specifying the appointment of a receiver who will craft the plan of debt adjustment and work hand-in-glove with the federal judge throughout the bankruptcy process. States that have taken this approach (Michigan and Rhode Island) have seen solid results in their bankrupt cities (Detroit and Central Falls).
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The key is for states to prevent any municipal bankruptcy from being directed by local officials. Mayors and city council members are under pressure from public sector unions and other stakeholders, which often renders them unable to make the tough decisions required. The result is that cities emerge from bankruptcy in little better shape than they entered it. This has been the experience of the three California cities (Vallejo, Stockton and San Bernardino) that went through bankruptcy in the last decade. The workout only modestly improved their fiscal condition. Falling back into insolvency remains a real possibility.
Large municipal bankruptcies are rare events. States don’t want any of their cities to declare bankruptcy because it negatively affects the credit ratings of their other cities. Cities don’t want to do it because the process is costly and time-consuming, with the outcome uncertain. For instance, Vallejo spent $10.6 million on lawyers’ fees alone, and San Bernardino was in bankruptcy proceedings for more than four years.
Nonetheless, bankruptcy may be necessary for more cities today than at any time since the Great Depression. Why? For three reasons: First, cities’ debt levels are at all-time highs, which include both bonded debt and pension obligations. As a share of GDP, local government debt is now over nearly 12 percent, up from about 8 percent in the late 1970s. State and local pension debt is up to almost 10 percent of GDP compared to about 4 percent in the late 1970s.
Second, cities have less room to cut costs. Payroll is the biggest slice of any city’s budget. However, cities slashed jobs during the last recession and those worker headcounts haven’t recovered. There are still 300,000 fewer local public workers today than in 2008. If a city cannot reduce its workforce, either through layoffs of attrition, it is very hard to significantly reduce operating costs.
Third, many larger American cities (population in excess of 100,000) have long struggled with concentrated poverty. Such cities struggle to attract new residents and many continue to experience population declines. Concentrated poverty increases the demand for government services while simultaneously rendering an increase in local taxes and fees to pay for them is impossible. The result is less fiscal flexibility.
Put these trends together and more cities may need access to bankruptcy to break contracts. These include collectively bargained agreements with labor unions, bond covenants and pension obligations. Such things can only happen in a federal court.
For bankruptcy to be useful, however, the states and the federal government must work together. The intervention bankruptcy approach we advocate combines things only the federal government can do, such as reduce debt by breaking contracts, with the oversight powers of state government. States have incentives to see that their cities succeed and state-appointed receivers are more likely to do the right thing than local officials. Because that insight has been borne out by recent experience, states should take notice.