These higher operating costs are often attributed to the rising pension costs of employees in addition to adding services throughout their jurisdictions. Furthermore, when there is a financial downturn, similar to the one in 2008, it can impair the main revenue sources for local governments. If a local government isn’t thinking long term by either building reserve funds or fostering strategic growth, its financial unpreparedness and structural issues can lead the city into insolvency, which brings us to the case of San Bernardino’s bankruptcy.

In this article, we will take a look at the municipal bankruptcy of the City of San Bernardino and what led to the Chapter 9 filings.

To learn more about the provisions under Chapter 9, click here.

Understanding the San Bernardino Bankruptcy

Before the 2008 property crisis, most cities became accustomed to high property values that generated higher property tax revenues. On top of that, healthy consumer spending generated high sales tax revenues. When pension fund portfolios looked healthy and credit market conditions were favorable, cities could borrow money relatively easily. As a result, several new projects were approved. However, when the bubble burst, all of those positives turned into negatives: property values, tax revenues and pension fund assets fell, while labor and pension costs continued to rise. This also led to budget shortfalls and underfunded pension liabilities while a tightening credit market reduced access to borrowing.

In the report titled “A Guide to Municipal Bankruptcy for City Attorneys” the authors highlight that the City of San Bernardino was hit particularly hard by the national collapse of the housing market. The city’s population grew during the real estate boom leading to more public services and, consequently, more city employees. After the collapse, the city’s property and sales tax revenues declined steeply, but personnel costs continued to rise. The city offered more generous retirement benefits than most California cities, including higher employer pension contributions and a city charter that set police officer and firefighter salaries by formulas.

These and other factors left San Bernardino with high labor costs, comprising approximately 75% of annual general fund expenditures and little room to generate savings. Worse of all, the city did not realize the true urgency of its problems until it was on the verge of running out of cash leading to an emergency bankruptcy filing.

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The City’s Leadership and Turnover

Although the City Council and other elected bodies decide on the direction of the local government, all of their directives are carried out by the department heads and staff throughout the city. In the case of San Bernardino, it faced some serious leadership turnover in the years leading up to the bankruptcy and had the hardest time retaining the leadership bodies to run the city’s affairs.

Between 2004-2014, the city cycled through five city managers, five police chiefs, four finance directors and five public works directors. In a research paper titled “Exuberance & Municipal Bankruptcy: A Case Study of San Bernardino” the authors state that the City of San Bernardino staff leads were appointed by the political body but had to report to the city manager or vice versa. That kind of systematic indirection and entanglement takes its toll, and apparently its professional environment was an increasingly unpleasant place to work. Right at the time the city was desperate for stable, responsible leadership, it alienated more policy professionals than it could retain.

High Cost of Essential Services Employees: Police and Fire

Prior to bankruptcy, over 70% of the city’s budget was allocated toward police and fire services. The assessment of whether a locality is overconsuming fire and police services relative to what it can afford is particularly salient in San Bernardino.

For generations prior to the bankruptcy, a city-charter provision had mandated that police and firefighters be paid the average of salaries in ten other like-sized cities (population from 100,000 to 250,000). Most comparison cities were in a far better position fiscally to pay those salaries, however. Post the city’s bankruptcy, a citizen commission advised that the city will need to end the average salaries provision for its police and fire employees which mandated that these two unit employees are paid average salaries to other comparable cities based on population. The recommendation also advised this mandate to be replaced by collective bargaining.

Plan of Adjustment – City of San Bernardino

When filing for protection under Chapter 9, the municipality is obligated to craft a plan to reorganize its debts and present this plan to the bankruptcy court for its approval before it can be enacted and followed by the municipality. The court reviews and confirms a plan if the pertinent conditions set forward under the Chapter 9 code are met, such as:

• All amounts to be paid by the debtor related to the plan have been fully disclosed and are reasonable;

• The debtor is not prohibited by law from taking any action necessary to carry out the plan except to the extent that the holder of a particular claim has agreed to a different treatment of such claim, the plan provides that on the effective date of the plan, each holder of a claim of a kind specified in section 507(a)(1) will receive, on account of such claim, cash equal to the allowed amount of such claim;

• Any regulatory or electoral approval necessary under applicable non-bankruptcy law in order to carry out any provision of the plan has been obtained, or such provision is expressly conditioned on such approval; and

• The plan is in the best interest of creditors and is feasible.

In the case of San Bernardino, debt secured by a designated revenue source was not impaired, however, all the general fund-backed debt was impaired as shown below:

• 1996 Refunding Bonds Claims (Impaired/Voting)

• 1999 Refunding Certificates of Participation Claims (Impaired/Voting)

• Secured Claims: CIEDB Harriman Project Claims (Unimpaired/Nonvoting)

• Secured Claims: CIEDB Pavement Project Claims (Unimpaired/Nonvoting)

A complete listing of the City of San Bernardino debt portfolio can be found on their Plan of Adjustment document here.

Don’t forget to check out the municipal bond screener here to find bonds meeting your specific investment criteria.

The Bottom Line

The entire process of Chapter 9 bankruptcy can take years before a plan of adjustment is approved, enacted and followed by the municipalities. This process took almost five years for the City of San Bernardino and it finally exited bankruptcy in 2017.

The municipal debt investors must carefully analyze the structure of their holdings and understand how this structure will be treated in the event of municipal insolvency.

The recent bankruptcies of well-known American municipalities should admonish investors who may think that municipal debt is immune to financial downturns.

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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.