When Cities Struggle, Workers Punished -- But Bondholders Spared

NEW YORK -- As cities across the nation struggle to balance their budgets, a chorus of experts has told investors to take cover. Economists, analysts and financiers have given speeches, released reports or made the television rounds arguing that cash-strapped municipalities will default on many billions of dollars in debt.

But local governments have other options, which often come first. They can lay off workers. They can skip pension contributions. They can close libraries. They can stop filling potholes.

Cities spend the vast majority of their financial resources on payroll and services. And as recent history has shown, local governments have the ability to slice these expenditures to the bone. While cuts may strain residents and imperil the local economy, a default often means a municipality will see its debt costs skyrocket, threatening funding for bridges, roads and other projects.

This political calculus pits the interests of residents against those of the owners of a municipality's bonds.

"It isn't that the government finance officers have a soft spot for bondholders," said James Spiotto, a veteran bankruptcy attorney and head of the bankruptcy practice at Chapman and Cutler, a Chicago law firm. "They have a soft spot for money at a cheap rate. They're just doing their cost-benefit analysis."

Despite fears, bond investors may actually be the best-protected of all a city's creditors. A bond default, experts say, is often more trouble than it's worth. It tarnishes a city's credit rating, making borrowing more expensive. It could even shut off a city's access to bond markets altogether.

"The penalty of default is severe," said David Kotok, chairman and chief investment officer of Cumberland Advisors, an asset management firm that specializes in state and local government bonds and oversees more than $1.5 billion. Without market access, Kotok said, a municipality often "can't get new financing for a school, or a fire hall, or a water utility."

Cities and states face difficult financial straits. As home values sink and consumers lose wealth, government revenue from property and sales taxes has fallen. With 9 percent of the workforce unemployed, the tax base is weakened further. In Vallejo, Calif., a city currently trying to exit bankruptcy, property tax collection has fallen by a third since its peak. In Newark, N.J., which recently laid off 13 percent of its police force, special tax collection, which includes revenue from hotel, payroll and parking taxes, has also dropped by a third since the financial crisis struck.

In a report last fall from the National League of Cities, finance officers estimated that city revenue for 2010 would be down 3.2 percent, the biggest drop in the 25-year history of the survey. Eighty-seven percent of those officers said their cities were worse off than in the previous year.

Given the grim climate, experts have predicted that municipalities will miss payments owed to investors. In September, analyst Meredith Whitney, who shot to fame after predicting Citigroup's 2008 dividend cut the previous year, said in a report that municipalities, contending with lower tax revenue and diminished aid from states, will default in large numbers, precipitating the next financial crisis. Whitney predicted "50 to 100 sizable defaults," worth "hundreds of billions of dollars" when she appeared on "60 Minutes" late last year. That would represent a significant portion of the roughly $2.9 trillion state and local government bond market.

Whitney's prediction has been sharply criticized, but she isn't the only one to voice such concerns. In November, analyst Christopher Whalen, managing director of Institutional Risk Analytics, said the state of California will default on its debt. In January, JPMorgan Chase chief executive Jamie Dimon said more municipalities will file for bankruptcy. This week, Roubini Global Economics, the consulting firm co-founded by economist Nouriel Roubini, predicted $100 billion of municipal defaults over the next five years.

"If you are an investor in municipals you should be very, very careful," Dimon said, according to Bloomberg News.

Investors have moved money from municipal bonds and yields have risen, signaling that those bonds are perceived as especially risky. Yields on 20-year state and local government debt broke 5.4 percent in January, the highest level since the dark days of late 2008, according to Federal Reserve data. The difference, or "spread," between those bonds and ultra-safe U.S. Treasury bonds was a full percentage point in January, the biggest gap since the worst of the financial crisis.

But while municipal financial troubles have evidently made investors nervous, it's not clear that cities would choose default as a way out. When local governments look to cut costs, bond payments fall near the bottom of the list.

"Cities simply don't walk away from debt," said Matt Fabian, managing director of Municipal Market Advisors, a Concord, Mass.-based research firm. "They haven't walked away from debt since before the Depression. Even in the Depression, bondholders were ultimately paid back."

Instead, cities have mined payrolls for savings. Since August 2008, state and local governments have eliminated 426,000 jobs, according to a recent report from the Center on Budget and Policy Priorities.

Even in the most statistically dangerous cities, governments have eliminated some of their most valuable employees. Camden, N.J., the country's second most dangerous city according to an analysis of FBI statistics, laid off half of its police force in January. East St. Louis, Ill., just across the river from the nation's single most dangerous city by analysis of FBI data, laid off more than one-quarter of its police that same month. When union contracts make layoffs difficult, cities have negotiated concessions, such as furloughs or reduced benefits.

Vallejo, which has been in bankruptcy since 2008, set its sights on payroll cuts. Over the last five years, salaries and benefits have constituted about 90 percent of its general fund expenditures, the city's financial records show, making them a particularly juicy target. Debt payments, by comparison, were minuscule. In 2007, before the bankruptcy, debt service and related payments made up less than 4 percent of general fund expenditures.

Since declaring bankruptcy, Vallejo has imposed deep pay cuts on employees and ratcheted up worker contributions to health coverage, effectively cutting wages further. Workers and retirees say Vallejo owes them this money, but under the city's latest plan to emerge from bankruptcy, these "unsecured creditors" could be paid as little as five cents on the dollar. Essentially, the city is leaning on its employees and retirees for savings.

"I don't blame unions for saying, 'Wait a second, you made stupid decisions, why should I pay for it?'" said Marc Levinson, the lead bankruptcy lawyer representing Vallejo. "Everybody felt pain, and the residents certainly have felt pain."

Even in Vallejo, the only major municipality currently in bankruptcy, bond investors have done remarkably well. Under the exit plan, these investors would get their principal repaid in full. The city is withholding a portion of the interest payment -- which constitutes a default -- but because the bonds are insured, it's the insurer, not the investors, who has taken a hit.

"I think that the very loud hand-wringing over the prospects for major municipal bond defaults is entirely misplaced," said Mark Zandi chief economist for Moody's Analytics, according to Bloomberg News.

In 2010, the Standard & Poor's/Investortools Municipal Bond Index, which includes $1.27 trillion of municipal debt outstanding, logged just $2.65 billion in bond defaults, according to a January report from Standard & Poor's. That marked an 8.6 percent decline from 2009, which saw $2.9 billion of bond defaults.

Still, some municipal defaults will likely persist. Even if a default doesn't make financial sense, political pressures could necessitate one. As budget shortfalls continue to plague municipalities, some are attempting to reorganize obligations without taking the drastic step of bankruptcy. In those negotiations, a bond default can be used as a bargaining chip.

"There's the finance reality, and there's also the political reality," said David Johnson, a partner at the Chicago-based ACM Partners, a boutique financial firm that advises municipalities. "Organized labor is going to be able to say, 'Hey, look, you're skinning us, but these bondholders aren't taking any pain?' They're not going to allow that. And vice versa."

Voters, Johnson added, are likely to favor a default over a cut to services.

"As much as bondholders might want to believe otherwise, the purpose of a municipality is not to service bond debt," he said. "It's to provide government services."