Investors throughout the U.S. and around the world were fearful for the future of their own holdings in the private sector, and the words of Sir John Templeton were more relevant than ever, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Throughout all the chaos, investors weren’t really concerned about the world of municipal debt. For an ordinary investor, the municipal government is just as secure as the federal government and their investments in municipal debt are almost recession-proof. The commonly held belief amongst many investors is that if the government is struggling to make payments on its obligations, the elected officials will simply increase the taxes to bring back the revenue or any potential shortfalls – until Detroit and Stockton happened. These two municipal bankruptcies were a wake-up call for many investors around the world that municipal debt isn’t recession-proof and that every municipality is different in how it manages its operations and debt.

In this article, we will take a look at the municipal bankruptcy of the City of Stockton and what led to the Chapter 9 filings.

To learn more about the provisions under Chapter 9, click here.

When a local government is struggling with its crippling debts and unable to meet its financial obligations, it can seek protection under Chapter 9 bankruptcy from its creditors while developing a comprehensive plan to put forward for adjusting its debts.

This plan mainly includes a way to reorganize the municipality’s debts and potentially extend the maturities to lower its debt service payments and/or possibly refinance its debt obligations to lessen the financial burden. At an individual level, this may sound similar to a mortgage loan refinancing or loan modification that will prolong the term of the loans, which, in turn, decreases the monthly payments. However, unlike bankruptcy laws reserved for individuals, there is no provision under the Chapter 9 bankruptcy code that warrants the liquidation of assets of the municipality and distribution of the proceeds to investors or creditors.

Under the Chapter 9 bankruptcy protection, the municipality files for a petition, drafts a plan of debt adjustments and follows this plan. All these stages are approved by the bankruptcy court and require monitoring to ensure proper adherence to the plan of adjustment. Again, these stipulations and laws can be very different for every state.

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Municipal bankruptcy is often the end result of a decade-long financial mismanagement, lack of financial preparedness and/or political decision-making at the local government level – Stockton was no different.

In the early 2000s, things looked very different for all local governments throughout the U.S.

• Stock market was booming, enabling local governments to earn high returns on their pension portfolios (CalPERS in Stockton’s case)

• Real estate market was hot, increasing the property tax revenues

• Consumer sentiment was at an all-time high, brining significant growth to the sales tax revenues

During these times, the City made some decisions and took up obligations that they weren’t able to meet during the recession and had to file for municipal bankruptcy.

• In the late ’90s, the City of Stockton decided to give life-time healthcare to all its retirees, which resulted in a $417 million liability for the City a decade later. During the City’s chapter 9 filing, the City manager called the life-time healthcare to be a “Ponzi Scheme.”

• In its quest to revamp the downtown and marina areas, Stockton approved spending on large projects and issued significant public debt to fund these initiatives. One of those initiatives was a $47 million dollar debt issuance to construct a concert and sports arena. These debt issuances were primarily backed by the property tax revenues on the super-inflated house prices in California during that time.

• During the 2008 crash, Stockton became the foreclosure capital and its general fund revenues were slashed substantially. These revenues were committed for different purposes like public safety, debt service, community services, etc., and all these areas had to suffer significantly along with the City defaulting on its debt.

• The same goes for other revenue sources like sales tax, which suffered tremendously; high unemployment rates brought low consumer spending causing a significant blow to the City’s sales tax revenues.

• As the stock market crashed, cities throughout California started to feel the strain of unfunded pension liabilities with CalPERS. This persists even today for many local governments.

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The treatment of municipal debt obligations is different based on their type and the revenue structures; for example, the municipalities are generally not required to make payments on their general obligation (GO) debt during the bankruptcy. This entails both principal and/or interest payments. All debt obligations secured under GO debt are subject to negotiations and possible restructuring under the code. However, any special revenue-backed debt will be serviced during the bankruptcy based on the pledged revenue sources.

This difference in treatment of GO debt and special revenue-backed debt has taken center stage in the financial restructuring of Puerto Rican debt, where there has been an emergence of disputes between GO and revenue-backed debt.

To learn more about this dispute, click here.

In any municipal bankruptcy, the bankruptcy court approves a Plan of Adjustment and it includes the treatment of all outstanding debt for the municipal government. Furthermore, if the general fund debt contains a bond insurer, the City will typically enter into an agreement with the bond insurance company.

In the City of Stockton’s case, the following happened.

• The Retiree Health Benefit that created an almost $545 million liability for the City was settled by paying an aggregate amount of $5.1 million to the retirees;

• All debt secured by special assessment or backed by other revenues were not affected by the bankruptcy. The special tax obligations that were secured by special and restricted sources of revenues, consisting of specific levies on real property within certain financing districts created by the City, were not payable from the General Fund;

• Assured Guaranty provided the bond insurance for the City’s Pension Obligation Bonds. Under the bankruptcy Plan of Adjustment, the City agreed to make non-contingent payments on the Pension Obligation bonds set forth in the Assured Guaranty Term Sheet. The City also agreed to make contingent payments to Assured Guaranty in accordance with the City’s Contingent Payment Model, which stated that if the City exceeded its baseline financial projections only then would Assured Guaranty be entitled to these contingent payments;

• In the case of 2004 Arena bonds, the City entered into an “Arena Settlement” with NPFG (Bond Insurer) and agreed to a modification of payment under the settlement agreement.

Investors can read more about the treatment of other debt instruments in the City’s Plan of Adjustment here.

The City of Stockton’s bankruptcy showed that political decision-making during the “good times” should be carefully vetted with the worst-case scenarios. It also served as a prime example, contrary to the pre-recession investor sentiment, that municipal debt is recession-proof and government can simply raise taxes to ward off any fiscal deficits.

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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.