Wednesday, June 24, 2009

More Municipalities Likely to Face Chapter 9: Is a Perfect Storm Brewing?

Municipal bankruptcies1 are quite rare. In fact, they are barely a drop in the bucket when compared to consumer filings under the Bankruptcy Code. From 1995 until the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), consumer bankruptcy filings soared from 874,642 to 2 million,2 and after a post-BAPCPA drop,3 filing rates are on the rise4 with expectations that the trend will continue.5 From 1938-2007 there were approximately 579 municipal bankruptcies in the United States.6 Despite the rarity, the importance of municipal bankruptcy is significant in light of the impact it has on the citizenry, surrounding governments and the state government.7 Recognizing the magnitude of the financial crisis that is experienced with any municipal bankruptcy filing, whether it be a large municipality (such as Orange County, Calif.8) or a small municipality (such as Greene County, Ala.9), reinforces the importance chapter 9 bankruptcy.

This article offers a brief examination of the filing trends and the common causal factors of prior municipal bankruptcies. Then we'll examine how the current economic conditions and other factors point toward a likelihood of more municipalities teetering on the edge, and possibly into, chapter 9. This proposition is supported, anecdotally, by a brief discussion of the recent distress of several municipalities, including Jefferson County, Ala.-potentially the largest municipal bankruptcy in U.S. history.10

Major Causal Factors of Municipal Bankruptcies

The primary method of studying the causal factors leading to municipal bankruptcy are case studies due to the limited number of filings. Out of the case studies conducted since 1985 until present, a host of causal factors emerge:13 (1) problems with financial management14 (including mismanagement, lack of controls and oversight, and lack of strategic plan); (2) reliance on risky revenue sources15 (such as gambling or an amusement park); (3) declining population coupled with rising per capita costs;16 (4) changes to the economic base;17 (5) natural/manmade disasters;18 (6) political factors (both internal and external to the municipality);19 and (7) ineffective leadership.20 Other factors can be included, but most can be categorized as falling within the scope of one or more of the enumerated causal factors.

It is important to note that, perhaps, the single most important factor leading to a municipal bankruptcy is ineffective leadership, because every other factor could either be avoided, minimized and/or handled if there was effective leadership in place. Whether it be Orange County with the risky investment pool, Greene County with a dog track, or any other municipal bankruptcy, the underlying problems may not have been avoided, but with proactive engaged leadership, the impact of the financial crisis could have been greatly curtailed. Municipalities that have faced serious financial crisis and avoided municipal bankruptcy have had effective leadership, both from a fiscal and political perspective.

Is a Perfect Storm Brewing?

A few financial analysts have forecasted that municipality bankruptcies will continue to occur given that many municipalities are one step away from insolvency and "have underfunded pensions as well as healthcare liabilities they can't afford."21 In recent years, large municipalities such as Pittsburgh and San Diego have been in a state of fiscal stress.22 Also, in the wake of Hurricane Katrina, many analysts expect that the cities affected by the hurricane, as well as cities that received the influx of displaced residents, may find themselves in financial distress for years to come.23 Other national disasters might have a similar impact on local government financial health. And obviously, the current economic crisis is pervading the national, state and local governments alike with diminishing tax revenues and/or increasing demand and costs for public services.

Furthermore, there has been a dramatic increase in state and local government per capita expenditures over the last four decades. Increasingly both state and local governments absorb rising costs of often-expanded services. In 1960, state and local governments combined were spending approximately $1,410 per resident. In 2004 estimates of the average per capita expenditure topped $6,600, approximately a 370 percent increase in costs over the previous amount.24 The costs of public services are not expected to slow down in the coming years. Rather, governments at all levels are facing soaring health care and pension costs, increases in services to the aging, mandated public safety expenditures, and infrastructure replacement and maintenance.25 Furthermore, Fitch Ratings, a bond credit rating agency, recognized that the "expense pressures facing governments, particularly in health care, energy and cost of capital," will be a concern to all government managers in maintaining their finances, as well as to the investors investing in the government credit issuances.26 Additionally, because of the "continuing economic effects of September 11, 2001, compliance with mandatory Department of Homeland Security directives, and reduced tax revenues coupled with increased costs for delivery of service," local government finance could easily experience extreme fiscal stress.27