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March 18, 2015
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Nearing a Fiscal Precipice. Even as San Bernardino is struggling to try to catch up on its audits―a critical prerequisite to completing its plan of debt adjustment by the deadline imposed by U.S. Bankruptcy Judge Meredith Jury, the bankrupt city is beset by the endless federalism-Constitutional California battle between the California Public Employees’ Retirement System (CalPERS) and its other creditors. So even as the city is girding up for battle in Judge Jury’s federal courtroom, it is—simultaneously—defending its plan to fully repay its debts to CalPERS, asking in a separate federal bankruptcy court for dismissal of a lawsuit by creditors demanding equal treatment. The precursor of the municipal bankruptcy war likely to be waged in Judge Jury’s courtroom comes as the city’s auditor has revealed it might be impossible to finish auditing the city’s financial statements in time for them to be used in its plan of debt adjustment―potentially opening the city to crippling attacks by creditors. A partner at the city’s accounting firm has requested another $490,000 to finish the city’s audits for FY2012-13 and 2013-14, more than double the original cost estimate, and warned further delays might be encountered later. He advised the city the 2012-13 audit would probably be done by April 30th, giving the city a month upon which to construct accurate financial and fiscal data critical to completing its plan of debt adjustment. The FY2013-14 audit, however, appears unlikely to be ready by then. While that more recent audit, according to City Manager Allen Parker, is not necessarily required by the charter committee, he has concurred with council members who said it would allow the municipality’s creditors to attack it as unprepared and undeserving of federal bankruptcy protection―or, as City Attorney Gary Saenz warns, without that protection, creditors will be able to collect the millions they are owed, leaving too little for basic city services: “If you don’t approve (the contract increase), I can probably guarantee we won’t make (the court’s deadline)…That would be devastating for the city.” But, it appears, the delays in completing the audit might be only the tip of an iceberg: the new auditing firm laid out for Council, in a detailed explanation, a much gloomier assessment, beginning with its test of San Bernardino’s internal controls, reporting it found no such controls, meaning the new auditors had to instead go through a much more time-consuming process, called substantive testing, or as it testified: “We virtually had to start from scratch, start from zero, and go through, system by system, department by department.” The firm noted that while certain areas presented their own specific, sizeable problems, such as the San Bernardino Employment and Training Agency, which, the firm reported, was disrupted by the California Legislature’s dissolution of such agencies; the firm noted that many of the issues came because of a combination of limited record-keeping and the lack of current employees who were employed by the city when the decisions being audited were made—an issue created by staff turnover. But under the persistent Council questioning with regard to why fiscal information had not been provided by the city to its auditors, it also became clear that the problems were higher up: City Manager Parker told the Council that City Finance Director Scott Williams had told the auditor he needed to review information, holding onto it for weeks―despite instructions from Assistant City Manager Nita McKay. The refusal, apparently, triggered the city’s decision to put Mr. Williams on administrative leave, and then to dismiss him this month, just months after the city had hired him. The exchanges led Councilman John Valdivia to state that the city manager, Mr. Parker, should be held ultimately responsible for all the delays, stating: “Citizens hold me accountable for your inactivity…Get your act together, Allen.” In response, City Manager Parker replied that the city’s fiscal problems went back decades, and that there was no way they could be resolved in the two years since the council had hired him: “You can make me the scapegoat; that’s fine…(but) you have learned that our problems are systemic.” That led Councilmember Jim Mulvihill to say the gravity of the problems should be the citizens’ take-away: “The reality is the city is in a quagmire, and the audit is just symbolic of it, a little piece of it.”

The Resumption of the Federalism Challenge. Even as San Bernardino is struggling to finalize its plan of adjustment to file in a federal bankruptcy court in southern California, the city is in another U.S, bankruptcy court in Riverside, California, seeking dismissal of a suit filed against it by Ambac Assurance Corp., a New York bond insurer, and EEPK, a Luxembourg bank, in which the insurers claim San Bernardino should not be paying its CalPERS debt when it has not paid them a dime on debts totaling more than $59 million to them. Now San Bernardino has responded, claiming the creditors’ suit “transcends novelty” and is “made out of whole cloth.” The court has is set a hearing for May 11, just weeks short of U.S. Bankruptcy Judge Meredith Jury’s deadline for the city to file its plan of debt adjustment with her. While the city, ergo, has not detailed any plan with regard to how it would treat EEPK and Ambac’s debts, much less its other obligations, it seems beyond peradventure that San Bernardino’s plan of debt adjustment will not call for full repayment of those debts. Rather, as San Bernardino City Attorney Gary Saenz told Reuters last January, the city will propose a repayment plan that includes reductions to those creditors in “an amount that is fair and reasonable.” The challenge reflects San Bernardino officials’ insistence they would pay the city’s $24 million-a-year CalPERS bill in full—and the revelation the city had begun repaying millions of dollars in past-due obligations to CalPERS, debts that arose when San Bernardino halted payments to the pension fund for several months after filing for bankruptcy in 2012. Perhaps ironically, San Bernardino had indebted itself to the two firms to help pay its pension costs to CalPERS. Because of that, EEPK and Ambac said the bonds are part of a “single pension obligation”―the equivalent of the city’s relationship with CalPERS, so that, they claim, whatever payments San Bernardino makes to CalPERS, the municipality must make comparable payments to EEPK and Ambac. In response, San Bernardino has countered that cutting payments to CalPERS would trigger substantial reductions in pension payments to current and future retirees, driving many of its municipal employees to leave for jobs elsewhere, or, as City Attorney Saenz puts it: “You can’t have a workforce without pensions.” Nevertheless, in the wake of U.S. Bankruptcy Judge Christopher Klein’s ruling that it would have been legal for Stockton to reduce its pension plan, this bedeviling issue which pits state constitutions versus the federal chapter 9 municipal bankruptcy law show no sign of simply fading away.

Thirsty Motor City. Detroit’s water department this week plans to step up its enforcement of overdue business accounts in a renewed effort to collect tens of millions in lost revenue. Nevertheless, the department will not shut off residential water unless and until a proven safety net is in place. Although there are 26,000 residential accounts with outstanding balances, department officials have opted to target commercial accounts first, with the Detroit Water and Sewerage Department (DWSD) seeking compliance from 2,044 delinquent commercial accounts to avoid shut-offs: these customers owe DWSD about $20 million, according to Bill Nowling, now the spokesperson man for the new, post-municipal bankruptcy regional water authority, set to go into effect in July. In addition, DWSDD will also take action with regard to some 8,355 accounts that have been deemed illegal hookups — in which the water has been shut off at a meter, but is still showing water usage: water thefts that account for about $13.6 million—or, as Mr. Nowling reports: “We know where those properties are…We are going to start processing those.” On the residential side, a more sensitive issue on which now retired U.S. Bankruptcy Judge Steven Rhodes had previously opined, the authority is poised to consider how and when to resume shutting off water to delinquent residential accounts; however, Mr. Nowling said, the city wants to be certain all eligible residents know about — and take advantage of — payment assistance programs: “There’s no plan currently to go after the residential (accounts) until we have gotten a handle on whether the Detroit Water Fund assistance program is working…We think it is working, but we think it could work better.” The revised, or mayhap post-Rhodes chastened approach, will certainly be in stark contrast to the widespread residential shut-offs that raised such a storm a year ago―and which spurred former Detroit Emergency Manager (and now Gov. Chris Christie Atlantic City advisor to its emergency manager) Kevyn Orr to give Mayor Mike Duggan more control over the water department—in response to which Mayor Duggan vowed to help needy customers pay their water bills, while holding those who can afford to pay accountable. He implemented a temporary moratorium and assistance fund for low-income residents in a 10-point plan to educate and expand assistance options for those struggling with delinquency. Since last August, the city has enrolled some 25,464 residents in the Mayor’s plan, which offers a streamlined payment plan and includes the creation of the $2 million Detroit Water Fund to help low-income residents, administered by the United Way for Southeastern Michigan. To qualify, residents must have an outstanding balance of $300 to $1,000; maintain average water usage for household size; and have an income at or below 150 percent of the federal poverty level. Eligibility provides one year of assistance to residents and will account for about $700,000 of the money in the fund that officials believe is underutilized. Nevertheless, collecting lost municipal revenue is a priority as the water department transitions to the newly created Great Lakes Water Authority, set to go into effect next July 1. The authority, created as part of the city’s landmark bankruptcy, is designed to maintain Detroit’s ownership of the water system while giving suburbs more of a stake in its operations: under the agreement, the city will lease infrastructure to suburban communities for a 40-year, $50 million annual fee and an annual $4.5 million payment assistance fund. DWSD will still be responsible for Detroit billings, collections and debts. The authority will handle operations in outlying communities―with mediated discussions over the details of the lease agreement being overseen by U.S. District Judge Sean Cox. For the lease agreement to be completely operational, bondholders of DWSD have to approve the plan. “Making sure that DWSD itself in its current state is as sound fiscally as it can be is very important in the minds of creditors, which are ultimately going to approve a regional deal,” according to Mr. Nowling.

Putting Municipal Bankruptcy into Context. Last year, according to the Federal Reserve and the American Bankruptcy Institute, nearly one million Americans filed for bankruptcy—a significant decline from the number who used to seek federal bankruptcy protection before the law was made tougher a decade ago (see chart). Nevertheless, some fear this reform may have done more harm than good: The aim, after all, of the federal bankruptcy law is to give families—just like municipalities under chapter 9―relief from unpayable debts. Some two-thirds of individual bankruptcies are due to a lost job. Just like municipalities, many citizens and families need time to get back on their feet. In the mid-2000’s, federal Chapter 7 bankruptcy rules made it easier to forego such debts—an issue which upset credit-card firms, which claimed that spendthrifts abused the system. Ergo, in 2005 Congress toughened the law with the intent to shift people to a Chapter 13 bankruptcy, where they would have to repay some of the debt. The reform, it appears, had a significant impact. At least at first, Chapter 13 filings rose relative to Chapter 7 filings. A new paper, from Stefania Albanesi, of the prestigious New York Federal Reserve, and Jaromir Nosal, of Columbia University, has determined that the reform led to a permanent drop in the bankruptcy rate. Other recent research suggests, however, that this is not necessarily a good outcome. Will Dobbie, of Princeton University, and Jae Song, of the Social Security Administration, examined Chapter 13 bankruptcies before the reforms of 2005: they link half a million bankruptcy filings to tax records and employed a novel technique to analyze them. Because some U.S. bankruptcy judges are more lenient than others, people in similar straits may end up with different bankruptcy decisions. The dynamic duo argue that easier bankruptcy laws may have positive microeconomic effects: if a creditor may no longer claim large portions of a bankrupt individual or family’s income, that may increase her or his incentive to work—and decrease the incentive to slip out of town, change jobs, and shut down bank accounts: On average, those granted federal bankruptcy protection earned over $6,000 more in the subsequent year than similarly-placed plaintiffs who were rejected. In contrast, Michelle White of the University of California, San Diego and colleagues found that bankruptcy reform caused the default rate on prime mortgages to rise 23%. Figures released on earlier this month (March 6th) by the Federal Reserve show that consumer debt rose for the 41st straight month.

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