What Can Be Learned from Past Fiscal Disasters?


March 9, 2015
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Stepping into the Fiscal Future. In commencing his first State of the City speech, San Bernardino Mayor Carey Davis refrained a message from the first nine public speakers at city hall: “I am San Bernardino.” So, Mayor Davis began with the line: “You are San Bernardino.” But the mayor used a format different than most cities; he mixed in other leaders, so that what residents and taxpayers were treated to was a program of leaders focusing on their efforts and partnerships with the city—clearly Mayor Davis’ theme as the bankruptcy city enters its home stretch in putting together its plan of debt adjustment for U.S. Bankruptcy Judge Meredith Jury, telling his audience: “Together, we are building a community and we are developing a series of strategic plans that will propel the city forward.” For San Bernardino taxpayers, it is hard to imagine a more diametrically opposite message than the last State of the City address, when former Mayor Pat Morris, a year and change ago, told the city’s citizens they were confronted by a “nightmare” and an urgent need to outsource services—including fire—and shutter some fire stations. Instead, Mayor Davis told them: “I come to you with a different message. In one year’s time, we have heeded these warnings…Our city is not paralyzed by bankruptcy. There are many things that are happening that are raising the quality of life for our residents.” Advising the audience that its federal bankruptcy protection had ensured its ability to balance its budget, he warned that hard choices lie ahead: a frank (no pun) assessment of the city’s fiscal condition and sustainability and public participation. He said he understood that choices city leaders had made, such as cuts to fire services, have garnered significant opposition; he noted that harder choices—choices he warned which would engender citizen resistance and hard choices lie ahead: “We have challenges and hard work ahead of us, but if we change our focus and concentrate on how to achieve our destiny, we can succeed…We are not where we want to be, but we will get there.”

State Interceptor Programs. As we have noted from North Carolina, Rhode Island, and Michigan; proactive state fiscal interception programs can be critical to avoiding severe fiscal distress or municipal bankruptcy—or vital to recovery. But state audits too can offer valuable fiscal lessons important to municipal, fiscal sustainability. Of course, we have also noted the tendency of states—and the federal government—to exercise a double standard: where a fiscal municipal crisis is caused by a severe storm disaster (in this case a tornado) a state—and the federal government—tends to respond physically and fiscally. In contrast, if the tornado is a fiscal rather than physical disaster, the response—or non-response—can be quite different. But in Indiana, Moody’s analyst Dan Seymour helps us to understand that a recent default by an Indiana school district can highlight the importance of underlying state credit analysis when bonds are enhanced with a post-default school intercept program. The issue here involves Indiana’s Joplin School District—in the wake of the fiscal woes it suffered following a 2011 tornado. According to a Hoosier state audit, which was critical of the school district for using the same firm as advisor and underwriter on its post-tornado borrowings ($62 million from a voter-approved referendum) to finance insurance reimbursements, and repair its buildings; the tornado damaged or destroyed 10 schools; it killed 161. In addition to the district’s damage, more than 8,000 homes and businesses were destroyed, along with St. John’s Regional Medical Center. It was one of the nation’s deadliest tornados on record.

But the municipality learned that trying to juggle the regular budget, fierce storm destruction, and promised debt payments can be a bridge too far: Munster missed two bond payments last January—misses and the ensuing default for which it made up by borrowing from a local bank. It was as if a fiscal tornado followed a physically devastating tornado. Mr. Seymour and other analysts thus note that the school district’s default demonstrates the importance of closely examining both underlying credit fundamentals and the mechanics of a state intercept program—especially noting the distinction between pre- and post-default interceptions—or, as Mr. Seymour wrote: “Unlike pre-default intercepts, a post-default intercept generally cures deficiencies only after a default has already taken place, meaning it does not necessarily reduce the probability of default…Therefore, for post-default-enhanced credits, the probability of default is primarily based on the underlying credit quality, and the enhanced rating starts with an analysis of the underlying obligor.” He helpfully adds that Moody’s bases its ratings on municipal bonds covered by pre-default intercept programs more on the state itself as opposed to the underlying credit.

Indiana’s state audit, released last week, of the Joplin School District found that the financial condition of the district’s general fund has been struck by its own fiscal storm—dropping nearly 75% from $16 million to $4.6 million; its capital projects fund has declined even more: to $5 million from $29 million in 2011, declines, according to the state audit, “due in large part to the impact of the May 22, 2011, tornado and atypical disaster related expenditures…Decreased property values and a tax increment financing agreement entered into between the city, master developer, and the district has also affected local funding.” The decline in the project’s fund will require additional financing to pay for construction expenditures until the district receives final federal and state disaster funding, according to the report. In its audit, the state audit criticized the school district for its use of the same firm to serve as both financial advisor and bond underwriter for all bond and lease participation certificate sales, noting: “Using the same provider to act in the dual capacity of underwriter and financial advisor for a bond issue creates an inherent conflict of interest.” The state audit was also critical of the Joplin School District for utilizing a negotiated sale rather than a competitive bid process, noting that in past general audits, it had determined that municipalities paid higher rates through negotiated sales than if they competitively bid their transactions.