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The Varied and Diverse Predictors of Local Government Bankruptcy

By Marc Fudge

While the perception of the extent of local government bankruptcy may be greatly distorted, it remains an important topic in contemporary public budgeting and finance for several reasons. First, fiscal stress is commonplace across all levels of government and has greatly impaired the service delivery capabilities of many local governments. Even with the increased reliance upon information technology to improve administrative efficiency, delivering basic services have been compromised because of fiscal constraints. Some common examples are when municipalities shorten hours of operation or eliminate socially beneficial programs. Another reason why this topic is relevant today is because the increase in defaults and bankruptcies has made the public more aware and interested in local government financial management practices. Finally, the seemingly abundant number of municipal defaults and bankruptcies provides an entertaining headline for the mass media and for public consumption.

With increased emphasis and attention being placed on the topic of local government insolvency, it has become important to explore what factors have the greatest impact on local government defaults and bankruptcy. Many would agree that the recent economic recession played a prominent role in local government insolvency, but it was certainly not the sole reason. 

Historical and Legal Framework for Local Government Default and Bankruptcy 

bankruptIt has been widely stated that the recent economic recession precipitated the adverse fiscal conditions local governments continue to face. Prior to the recession, economic growth and development spurred many to believe that those rosy prospects would continue. Decades earlier, the optimism of economic growth preceded the largest fiscal crises up that point in time as well. During the early 1920’s, many local government units resorted to borrowing large sums of money to finance improvements, primarily for real estate development. By the end of the 1920’s, the effects of the Great Depression had an extremely adverse impact on property tax revenue, which were then, as they are now, the greatest source of income for local government units.

Socioeconomic & Political Factors Influencing Local Government Defaults and Bankruptcy 

Socioeconomic factors contributing to local government defaults and bankruptcy refer to the poor fiscal health of a community and are likely to include housing and commercial real estate busts, high unemployment, declining revenues and high pension and post-employment burdens. Other socioeconomic factors leading to local government defaults and bankruptcies can include an increase in employment costs and increased welfare expenses. The massive exodus of mid and upper-class residents from the city (referred to as suburbanization) also shrinks the tax base and leads to greater unemployment and migration of poorer populations.

In terms of the political factors impacting local government default and bankruptcy, state pension mandates and intergovernmental policies that determine how much a municipality can levy in sales taxes loom large. Another factor is “political fragmentation” which measures the degree to which the cost of a dollar to aggregate expenditure is internalized by the individual decision-maker in government. Finally, the impact of interest groups, depending on the size of the jurisdiction, may also play a role in local government fiscal uncertainty. In addition to socioeconomic and political factors leading to local government defaults and bankruptcies, elements unique to the organization, such as a lack of transparency and accountability, may also play a prominent role.

Below are some recent examples of U.S. local governments who have filed, or attempted to file, for bankruptcy.

Orange County, California

The case of Orange County, California, is unique because of the magnitude of the filing and because of the county’s affluence. Orange filed for bankruptcy in December 1994 on the basis of a portfolio loss in the amount of $1.7 billion. The bankruptcy was partly caused by a highly leveraged strategy of derivatives-based speculation.

Boise County, Idaho

Boise County, Idaho filed for bankruptcy protection in September 2011 in the amount of $5.4 million. The primary cause was that the county was unable to pay a multimillion dollar judgment awarded to a developer. Boise County placed restrictions on the developer who planned to build a residential treatment facility. As a result, the developer sued the county under the federal Fair Housing Act. The developer won a judgment of $4 million along with $1.4 million in attorney fees. The county felt the need to file for bankruptcy protection in large part because its operating budget was only $9.4 million. The U.S. Bankruptcy Court for the district of Idaho ultimately dismissed the county’s case because it failed to prove insolvency.

Jefferson County, Alabama

Jefferson County, Alabama filed for bankruptcy protection in November 2011 in the amount of $4.23 billion. The result of the subprime mortgage collapse was not their fault, nor unique to Jefferson County. However, a lack of transparency and accountability led to the county relying upon interest rate swaps to overcome poor financial management.

Vallejo, California

The city of Vallejo, California filed for bankruptcy in 2008 in the amount of approximately $50 million. The causes of Vallejo’s bankruptcy included its weak housing market, overly optimistic budget saving estimates, worse than expected transportation deficits, mandated pension increases and labor contracts created pension and wage obligations that could not be supported by city revenues.

Central Falls, Rhode Island

Central Falls filed for bankruptcy in August 2011 in the amount of $21 million. One of the leading causes of their bankruptcy filing was the fact that they were over $20 million in debt as a result of unfunded pension liabilities. 

Stockton, California

In February 2012, the city of Stockton, California voted to enter bankruptcy mediation. By June 2012, they had filed for bankruptcy protection. According to California Common Sense, three factors primarily led to the city’s financial problems: The housing and financial market collapse; unsustainable compensation promises, and; an ill-timed bond offering.

Harrisburg, Pennsylvania

A long-time decline in Harrisburg’s fiscal base along with a $282 million debt for an incinerator project led to the city filing for bankruptcy protection in the amount of $400 million in March 2012. Ultimately, Harrisburg’s bankruptcy filing was rejected. A federal bankruptcy court judge dismissed their claim citing that the filing was illegal. 

San Bernardino, California

In 2012, the city suspended a total of $6.8 million in bond payments prior to seeking court protection from creditors. In July 2012, the city council sought bankruptcy protection followed by declaring a fiscal emergency. This allowed the city to avoid state-required mediation with creditors and proceed directly to U.S. Bankruptcy Court. 

Detroit, Michigan

As of July 2013, the largest local government to file for bankruptcy protection was Detroit, Michigan. Detroit may be the poster-child for extremely poor fiscal management practices over an extended period of time. Dating back nearly 50 years, the city has essentially “kicked the can down the road,” thus exacerbating its financial woes.

The Complexity of Local Government Bankruptcy 

The reasons why local governments file for bankruptcy vary. Yet the common misconception is that there is a preponderance of them occurring. Despite public perception to the contrary, cases of municipal bankruptcy are extremely rare. In fact, of the 1,168 general-purpose governments in the U.S., .06 percent filed for bankruptcy protection since 2008. Further, over the course of 33 years (1976-2009) 40 general-purpose governments have filed for bankruptcy. Of those that filed, 30 were approved.

Many believe that defaults and bankruptcies are primarily caused by fiscal mismanagement. However, bankruptcy is typically not caused by reckless spending or mismanagement and might be due to deeper structural reasons. The snapshots of localities that have experienced fiscal crises demonstrate the complex nature of public finance. Furthermore, it should alert public administrators to the fact that sound financial management practices, across all areas of government, are paramount. As many local governments slowly move out of the fiscal abyss, the goal should not simply be to remain solvent but to be fiscally strong.

 

Author: Marc K. Fudge, Ph.D. is an assistant professor within the department of public administration at California State University San Bernardino. His research focuses on performance management, public budgeting and finance and e-government. He can be reached via email at [email protected]

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