In the Red

Stockton Goes Bust: California City Seeks Bankruptcy Protection

The former boomtown is the nation’s largest city to seek bankruptcy protection. Jamie Reno on what went wrong.

Justin Sullivan / Getty Images

History was made this week in California—but it’s not the kind of history chambers of commerce or tourist boards brag about. On Tuesday, Stockton, a city of nearly 300,000 located in California’s Central Valley, about 80 miles east of San Francisco, become the nation’s largest city to seek protection under the U.S. bankruptcy code.

Stockton, the seventh U.S. municipality to file this year and the first California city since Vallejo, which sought the same protection in 2008, simply stopped making bond payments and failed to reach financial agreements with creditors to address its $26 million budget deficit.

Stockton had been in negotiations with its creditors since late March under AB 506, a new California law requiring mediation before a municipality can file for reorganization of debt. On Tuesday night, after a heated five-hour meeting in which city employees expressed their concerns about losing their pensions, Stockton’s city council voted 6 to 1 to file for bankruptcy and to adopt the 2012–2013 budget, which proposes eliminating retirees’ medical benefits to help reduce the city’s deficit.

What happened in Stockton? In the mid-2000s, the city was hopping. The housing market was strong, and as a result tax revenues were flowing in. The city took out $190 million in bonds and loans to pay for a bunch of civic projects including a new city hall, a new multipurpose arena, and a baseball park.

But then the recession came, the housing bubble burst and, observers say, Stockton was hit even harder than most other California cities by the economic downturn. The city now has an unemployment rate of nearly 20 percent, and the foreclosure rate is one of the highest in the nation. It was ranked by Forbes magazine as America’s “Worst Place to Live” two of the last three years.

According to San Diego bankruptcy attorney Paul Staley, who lived in Stockton for 10 years, “Stockton had become a bedroom community for commuters to San Francisco and Oakland, and that drove overbuilding. When the economy imploded, commuters started disappearing, and the city saw a flight of home buyers. Property values in Stockton then plummeted, perhaps more than anywhere else in the state and nation, and the city could no longer sustain itself or pay the generous pensions to city workers.”

The city already has slashed the police force by one fourth and the fire department by one third, and cut 40 percent of other city employees, along with wages and medical benefits. Kathy Miller, a member of Stockton’s city council and its vice mayor, tells The Daily Beast that the city had no choice.

“We have to have a balanced budget by July 1, which is Sunday,” she says. “The only way to close the $26 million gap is either to negotiate complicated settlements with all our creditors, impose massive service cuts, or bankruptcy. The residents of Stockton have borne the brunt of our financial problems; this was the right thing to do.”

Miller says the problems in Stockton began with a series of decisions made in the 1990s based on the fact that, at the time, the city was doing well.

“It all started with the state, which in the early ’90s changed the formulas in Calpers (California’s public employee retirement system),” says Miller. “The state legislature decided that public employees could retire earlier and with higher pensions, and they gave huge benefits to the California Highway Patrol (CHP).”

After that, Miller says, the city couldn’t find any qualified police to hire because they all wanted to go to CHP. “So we decided to offer the same benefits that the state had given to CHP retirees,” she says. “That benefit was eventually granted to firefighters as well, and then every bargaining unit asked the city for more. This same type of thing happened in San Diego, San Jose, and cities all over the state.”

Miller says the city council responded as quickly as possible when the economy went south, “but with public employees, we were locked into labor agreements. We worked very hard in 2010, but some of the representatives (of the public employee unions) refused to negotiate, and some even demanded huge raises in salaries and benefits. That same year, we declared our first fiscal emergency.”

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The clincher, Miller suggests, is when the city agreed in the 1990s to grant a lifetime retirement medical benefit to all city employees: “This benefit provided retired employees and one dependent with medical coverage with no premium, no co-pay, and no deductible. The worst part of whole thing is that the city didn’t set aside the money to fund the medical benefit.”

The city’s money problems only worsened with what Miller says was a “borrowing binge in the early 2000s” to fund city projects that totaled approximately $300 million. “The projects were great,” she says, “but when the bubble burst, we could no longer generate tax revenue and we could not afford to pay for these projects.”

Miller says the council made the decision this week to eliminate the medical benefit which “is a luxurious benefit that a small group receives and which less than half of the cities in California provide. Nobody is being kicked off the city medical plan, but they will have to start paying for it. Taxpayers who live here will never have that benefit, but they are paying for it.”

But Joe Rose, an attorney who represents the Stockton City Employees Association, says the decision by the council this week to file for bankruptcy and eliminate the health-care benefit is “tragic.”

“It’s popular to beat up on public servants these days,” he says. “But this medical benefit is not as lavish as management describes, because the workers who get these benefits have small pensions, they are among the lowest paid of all city workers, and now they have to use a big portion of that pension to pay for health care.”

Rose says Stockton’s public employees, many of whom have worked for the city for decades, were promised by the city that they could get affordable health care when they retired. “Whose fault is it that the city didn’t fund a health-care plan, the city workers or management?” asks Rose. “Stockton is similar to other cities in California where public employers make promises about health care but don’t fund them. It’s not right.”

Rose adds, “This city has already made other health-care cuts too, including health-care cuts for active workers, for example. Some of them have a $5,000 deductible now.”

So what’s next for Stockton?

According to Staley, “A lot of people will be hit hard by this decision, especially people who are nearing retirement who will realize that now they have to resort to Plan B and that they can’t retire. But in other ways the city gets a clean slate like when a consumer files a Chapter 7 bankruptcy. There will be a lot of oversight by trustees and the court, but the city will be off the hook for many of its obligations. This will free up their cash flow.”

But, Staley adds, the city will have an enormous problem selling bonds in the future.

“This is a huge black mark on its credit rating, obviously,” he says. “But if the city takes decisive and effective action to reform its finances and balances its budget, things will improve. The city should slowly bounce back.”

Does the bankruptcy of Stockton, once a gold rush boomtown that drew fortune seekers west, portend a dire financial future for the nation’s most populous state? Vice Mayor Miller thinks so.

“What happened here could definitely happen in other cities in the state,” says Miller. “That’s the reason why public-employee unions in the state are trying to make municipal bankruptcy almost impossible, because it is a way to restructure completely unsustainable benefits. There are at least 10 other cities in this state that are half a step behind Stockton. They’re all watching us very carefully.”