What Is the State Role in Severe Municipal Fiscal Distress?

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April 22, 2015
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Balancing Municipal Sustainability vs. Municipal Bondholders’ Interests. Fitch Ratings is warning that Illinois Gov. Bruce Rauner’s support for making municipal bankruptcy more available to the state’s larger municipalities and school systems might have corrosive impacts on those larger municipalities’ bondholders. In a special report, Fitch warned that recent developments in Illinois and New Jersey could reduce the chances of state intervention—intervention that, according to the rating agency, could result in better outcomes for the respective municipal bondholders than allowing distress to lead to municipal bankruptcy: “We believe efforts to resolve looming budget deficits and ensure the affordability of long-term obligations would be more productive than focusing on easing laws or practices to allow bankruptcy.” The special report comes as Illinois Governor Bruce Rauner has recently proposed amending Illinois laws to grant authority to larger municipalities to file for federal bankruptcy protection, and, because of his growing apprehension about the credit quality of Chicago Public Schools (CPS), Governor Rauner this week said he is apprehensive CPS may need authority to file for bankruptcy as a solution to its large budget imbalance. According to CPS analysis, the system’s reserves will likely be fully depleted by the end of FY2016. (Giving a sense of a system beset by apprehensions with regard to its fiscal solvency and its leadership, the Chicago Board of Education yesterday sold $300 million in municipal bonds with a 25 year maturity—but at a top, prohibitive interest rate of 5.63%–a severe fiscal penalty.)

With regard to New Jersey, the agency noted that the recent appointment of corporate restructuring experts—including Kevyn Orr, who served as the Emergency Manager overseeing Detroit’s largest municipal bankruptcy in U.S. history―to assist Atlantic City in addressing the seaside city’s fiscal crisis appears at odds with New Jersey’s “strong history of aiding local governments to prevent the type of stress that could lead to bankruptcy,” noting: “Of US states, New Jersey has historically provided among the strongest levels of early intervention to local governments with financial strain, [but] recent developments in Illinois and New Jersey are lessening the chances of state intervention that could result in better outcomes for bondholders than allowing distress to lead to bankruptcy…We believe efforts to resolve looming budget deficits and ensure the affordability of long-term obligations would be more productive than focusing on easing laws or practices to allow bankruptcy.” The April 20th Fitch report comes on the heels of Gov. Bruce Rauner’s recent proposal to add a Chapter 9 provision to state statutes as part of his Illinois turnaround agenda—a proposal which has incurred strong opposition in the legislature from unions, who have charged that the Governor is using the threat of municipal bankruptcy to give local governments greater leverage in negotiations on pensions, benefits, and wages. The rating agency noted that the Governor’s apprehensions follow in the wake of the increasingly failing fiscal grades of the Chicago Public Schools district, which has been slammed by a steep credit rating slide as it confronts a $1.1 billion deficit and some $9.5 billion of unfunded pension obligations—and mounting public pension debts for Chicago’s police and fire retirees, where public safety pension payments are set to achieve an unaffordable trajectory next year under a state mandate to stabilize those funds. Fitch’s perspective is that while state fiscal intervention mechanisms vary from state to state, the majority focus on helping local governments recover from distress, rather than preventing it, with authors Managing Director Amy Laskey and Senior Director Rob Rowan noting that restrictions on states’ ability to impact some union collective bargaining agreements, including pension obligations, “limits their ability to remediate financial distress.” The special report appears as the prestigious Chicago Civic Federation is pressing Illinois’ legislature to consider a measure developed by the incomparable municipal restructuring expert Jim Spiotto to create an authority designed to intervene before a government’s fiscal strains reach crisis stage.

The State Role in Municipal Fiscal Distress. In our studies, states have played singularly disparate roles with regard to severe municipal fiscal distress—with the State of Alabama becoming a precipitator of Jefferson County’s then largest municipal bankruptcy in history, California playing an agnostic-to-negative role in its triple set of recent municipal bankruptcies, but both Rhode Island and Michigan evolving into constructive roles—roles which could be significant factors in the long-term fiscal sustainability of post-bankrupt Detroit and Central Falls. New Jersey, however, appears to leaning away from its previous record of strong support. Now Illinois is debating whether it ought to change its role. Part of the issue relates to whether a state does or does not even allow a municipality to file for federal bankruptcy protection (12 states do specifically; 12 do conditionally; three provide limited such authority; two specifically prohibit; and the remainder are silent.). Now as New Jersey and Illinois debate changing their respective state policies and maybe statutes, Fitch Ratings frets that recent developments in the two states are reducing the chances of state intervention to help municipalities in severe fiscal distress, writing that: “We believe efforts to resolve looming budget deficits and ensure the affordability of long-term obligations would be more productive than focusing on easing laws or practices to allow bankruptcy.” The new views come as Illinois Governor Bruce Rauner has recently proposed granting authority to local governments to file for federal municipal bankruptcy protection (current Illinois law bars municipalities with populations over 25,000 from filing a Chapter 9 petition.), and New Jersey continues to debate whether the state ought to force Atlantic City into municipal bankruptcy. In its recent views, Fitch noted it believes the needs of a distressed municipality are a better indication of the possibility of bankruptcy than whether current state law allows it, writing: “In New Jersey, the recent appointment of corporate restructuring experts to assist Atlantic City in resolving the city’s fiscal crisis appears at odds with the state’s strong history of aiding local governments to prevent the type of stress that could lead to bankruptcy. Of U.S. states, New Jersey has historically provided among the strongest levels of early intervention to local governments with financial strain.” With regard to the Windy City, Fitch notes the increasing failing fiscal grade of the credit quality of the Chicago Public Schools (CPS), noting that Governor Rauner this week said that he fears the district may need municipal bankruptcy as a solution to its large budget imbalance, adding that, according to the school system’s own analysis, their reserves will likely be fully depleted by the end of FY2016. The dichotomy Fitch likens almost to a teeter-totter: “Fiscal intervention mechanisms vary by state. Most focus on helping local governments recover from distress, rather than preventing it. Many can approve or reject financial plans, budgets, and certain government contracts under state control. Their powers, however, are constrained by laws governing labor contracts, benefits including pension obligations, and service provision. Fitch believes this limits their ability to remediate financial distress.”

The Challenge of Communicating about Municipal Bankruptcy. In a corporate bankruptcy, the company or corporation usually simply ceases to exist; in a municipal bankruptcy, the municipal corporation seeks federal court protection to ensure its continuity—and, of course, the city remains open and operating. In states which authorize municipalities to file for chapter 9 protection, there are significant variations—with some, such as Michigan and Rhode Island, for instance, authorizing the state to appoint an emergency manager or receiver, an individual who effectively displaces any and all elected officials—and who bears little onus or responsibility to communicate to the city’s citizens. But in others, such as Alabama and California, the elected municipal leaders remain in office—and retain significant responsibilities to communicate to citizens and taxpayers what is happening in or to their city or county—an especially vital role under a federal-state-local situation intended to ensure continuity and the provision of essential public services. Thus, after significant struggle, San Bernardino last evening selected Monica Lagos to serve as the voice of the city. Ms. Lagos, who since last October served as a senior account executive at Westbound Communications, was appointed in the wake of a 6-1 vote, but only after an extended and sometimes heated discussion. Her task is to “tell the city’s story” as it struggles to cobble together its plan of debt adjustment by the end of next month’s federally-set deadline by U.S. Bankruptcy Judge Meredith Jury. As San Bernardino City Manager Allen Parker, in seeking to justify the diversion of virtually non-existent fiscal resources for such a new position, put it to the Mayor and Council before the vote: “Transparency, transparency, transparency…I am looking less at image-making than I am at telling a story that gets us through the bankruptcy.” Prior to the Council’s vote, Ms. Lagos said the specifics of her approach to the city’s municipal bankruptcy would need to be worked out after she was hired: “I think we all know that it’s extremely important for the city, and it’s been a long time coming…Honestly, for me in particular, it’s a position that will help connect each of the departments, help connect what the city’s efforts are currently with the public’s need to know this information.” Prior to the vote, City Attorney Gary Saenz advised the Council that Judge Jury had said it is important for the public to be informed and involved in the city’s Plan of Adjustment, noting: “This is not a plan of adjustment that is just something that happens at City Hall…It’s something we get the whole community engaged in, and they have to be a part of getting San Bernardino out of bankruptcy…It needs to be a consistent message that informs the public exactly where we are, particularly with regard to the bankruptcy.” The lone dissenter, Councilman John Valdivia, said he agreed with residents that the focus should be directly fixing problems in the city rather than “image.”

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