A California court’s approval this week of the city of Stockton’s bankruptcy protection sets up a battle between Wall Street investors and the state’s pension giant, CalPERS, over whether pensions of municipal workers must share the pain.
Stockton, California’s 13th largest city, has so far not planned on reducing pension contributions, which CalPERS argues is barred by state law.
But bond insurers and investors such as the Franklin California High Yield Municipal Fund, who will be forced to take a haircut, argue that federal bankruptcy laws trump state laws and that CalPERS and city employees must share in the plan to resolve Stockton’s debts.
How much protection the law affords pensioners remains to be seen as the case advances through the court system. But for a broader look at the municipal finance crisis affecting California and the nation, AdvisorOne spoke with Bill Watkins, a veteran economic forecaster specializing in the U.S., California and Oregon economies, and executive director of the Center for Economic Research and Forecasting (CERF). The institution is based at California Lutheran University in Thousand Oaks, Calif.
AdvisorOne: What has caused Stockton’s crisis?
Watkins: The proximate cause was the crash of the housing market and fall-off of revenue. That was preceded by aggressive spending by the city and the pension problems that most cities across California face.
Are pension payouts indeed contractual and unalterable?
It looks like CalPERS won the first round. [Editor’s note: The federal bankruptcy judge ruled a decision on that matter would come at a later phase of the city’s bankruptcy administration.]
I’d expect the other creditors to push for having CalPERS take a share in the loss. You’d have to talk with a bankruptcy lawyer, but it seems there are all sorts of contracts that are annulled in bankruptcy court.
You can’t be elected to be a city councilman without the support of police and fire. Police and fire [crews] often have attractive contracts.
What other California municipalities are vulnerable to bankruptcy?
San Bernardino, of course. Fresno is also a possibility. A year ago, even Los Angeles city officials were talking about bankruptcy but stopped doing so before last month’s municipal elections.
Every major city in California has challenges, partly because of pensions, and partly because ever since Prop 13 when the state took over redistributing property tax revenues, the state has managed to shove a large part of that to local governments—cities, counties and special districts.
Local governments have seen the biggest decrease in government employees, and this is where most government services are actually delivered.
Are there any positives for California’s economy?
California’s tech sector is an amazing thing. Right now, if you compare the jobs we have today with what we had before the recession, San Francisco and San Mateo counties have more jobs than before the recession.
The state has 96% of the jobs it had before the recession; its job strength is mostly derived from the tech sector.
Also, I’m a little bit impressed that California’s Gov. Jerry Brown has gotten us to a place where we have a state surplus. That’s a big improvement from a few years ago.
Your center also makes national economic forecasts. How’s the U.S. economy been doing?
Over the past four years, we’ve been among the least optimistic about the United States and we’ve been mostly right. In 2008, when Lehman Brothers collapsed, much of the debate concerned whether there’d be a V-shaped recovery [and when that would take place]. We said right away, this is a regime shift—like a bank run. Just a rumor of a [large-scale] bank run is enough to crash the economy.
We saw a bank run on the whole financial system. We lost a huge amount of net worth, but the liabilities didn’t change. I think the recovery is still slower than it needs to be.
Part of it is that the regulatory environment has been increasingly onerous and that biases the economy toward big business against small business. Small-business people own a lot of real estate compared to the average American, so their balance sheet has been more affected than the average American.
Home ownership at 69% before the recession was too high. The government, by fighting foreclosures, was slowing down the process [of correction].
Should bond investors be shunning California municipal bonds?
It depends on a person’s risk-return profile. We’re going to see more cities have trouble. There are going to be more defaults.
What are the chances of a large-scale crisis of the sort foreseen by Meredith Whitney?
I wouldn’t say it’s the most probable, but [such an eventuality] would probably be associated with the Eurozone. The possibility exists.
What’s the connection between the Eurozone and California?
Because the financial system in the world has gone through one big shock [from which] we’ve not recovered. Another big shock is going to [destabilize] the world financial system. California is already weak, and a [Eurozone crisis] would cause a big recession again.
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