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Jul 22

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Bankruptcy: coming soon to a city near you

Three California cities have declared bankruptcy in a month. The most recent California city to declare bankruptcy is San Bernadino, following declarations by Stockton and Mammoth Lakes. According to the Los Angeles Times, San Bernardino’s budget is short $45 million, about ⅓ of its annual general fund budget, and may not make payroll in August.

Other California cities are on the brink. Despite widely-circulated rumors, the new city manager in Compton claims that “(bankruptcy is) a dirty word that the city should not be using at this time.” You might want to cover your ears, because my guess is that with a $43 million general fund deficit and with more bills due than cash on hand to pay, “bankruptcy” and a few other dirty words might be uttered around Compton city hall in coming days.

Like any other bankruptcy experienced by an individual or a business, these cities have declared or will likely soon declare bankruptcy because they face financial obligations without means to pay. While cities get into the mess the same way that individuals and businesses do — spending more than they bring in — the way out is a little different for cities.

An individual, for instance, can walk away from the debt entirely, leaving creditors with the house or the car or whatever asset might have backed the loan, if any. Cities lack that option.

When a business goes bankrupt, the business might cease operations, sell off its assets, and satisfy a portion of its debt obligations with the proceeds. Alternatively, a business might use bankruptcy protection to renegotiate its debt obligations on terms that allow the business to continue and for the creditors to be paid back, at least in part. That business’s creditors, equity investors, suppliers, and purchasers all face risk when the business goes bankrupt.

Cities are somewhat different. A city does not really have the option of closing down, satisfying whatever obligations it may, and then disappearing completely. Furthermore, businesses and residents do not suddenly gather their belongings and relocate. Instead they remain where they are, generally speaking, and continue to generate tax revenues for the city. Since the city’s revenue source remains in place, creditors can be more confident that they will eventually be paid. This is different than a business where, for example, revenues can dry up completely, leaving only the business’s existing assets for repayment. It is highly unlikely that these bankrupt cities will start selling off assets — parks, fire engines, and manhole covers — in order to satisfy its creditors.

Municipalities must file under Chapter 9 bankruptcy, a chapter of U.S. bankruptcy code prepared specifically and exclusively for municipalities. This filing effectively allows the city to renegotiate contracts. Contracts involving labor unions tend to be the primary focus since salaries and pensions associated with these contracts eat up relatively large portions of a city’s budget. Further, creditors may face having to renegotiate the terms of their contracts.

Because of the credit problems that a bankruptcy filing reveals, the city also faces some immediate effects. One is that vendors will become much less likely to extend credit. Further, city employees might become nervous about their paycheck and upset when it fails show up and consider employment elsewhere. Residents and businesses that observe the city’s financial problems may choose to locate in other cities. But roads, stop lights, and stop signs all remain more or less functional and, for most of a city’s residents, life generally continues as it always has.

So while bankruptcy might soon be coming to a city near you — or to your own city — there is probably no need to worry that your city is about to disappear. In the meantime, however, the bankruptcy declarations do make for interesting news and nervous politicians.

About the author

Eric Madsen

Mr. Madsen is a Chartered Financial Analyst (CFA) charterholder and a Manager at Fulcrum Inquiry, a finance and economics consulting firm that performs economic damages analysis involving commercial litigation, financial investigations, business valuations, and forensic accounting. He also holds an MBA from the UCLA Anderson School of Management and a B.S. in Economics. He conducts expert analysis in finance and economics. Mr. Madsen may be contacted at 213.787.4122 or at emadsen@fulcrum.com.

Permanent link to this article: http://betweenthenumbers.net/2012/07/bankruptcy-coming-soon-to-a-city-near-you/

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