Judge Keeps Pensions Out of Stockton Bankruptcy Deals

Today Christopher Klein, a U.S. bankruptcy judge, approved the city of Stockton’s plans to exit bankruptcy – ensuring that the pensions of Stockton’s retired public workers will not be subject to a tug of war among the city’s creditors.

“Judge Klein’s decision reinforces the confidence we had in our plan from the beginning,” Stockton City Councilmember Elbert Holman told Capital & Main by phone. Holman, along with Paul Canepa and Kathy Miller, voted to file for Chapter 9 bankruptcy; all three remain in office.

The judge’s Thursday decision had not been a foregone conclusion. On October 1, Klein had ruled that the federal bankruptcy code could trump the state’s retirement law that protects public employees’ defined-benefit pensions – and thus expose these retirement plans for “impairment,” or cuts. This prompted the Sacramento Bee’s political columnist, Dan Walters, to cite a Wall Street source’s favorable response: “Moody’s Investors Service underscored that effect by declaring that Klein’s ruling is ‘welcome news for investors’ in municipal debt.”

Stockton’s experience with bankruptcy – and the shadowy role of Wall Street credit-rating firms — is a cautionary story for cities still grappling with the effects of the Great Recession. The background to Klein’s decision is one familiar to many such cities.

Before the recession, Stockton’s leaders had agreed to issue seven bonds totaling $155.5 million – money borrowed for “new public facilities and downtown improvement” to be carried out between 2003 and 2009. The expectation was that “hyper growth” of real estate prices would never end, said Bob Deis, then Stockton’s city manager, in a June 5, 2012, memo to the mayor and city council. Further, “developer fees and property tax growth would provide sufficient revenue to meet these new obligations.”

As they did across the U.S., until real estate prices crashed nationwide, contributing to a recession that lasted from December 2007 to June 2009 — the worst economic downturn since the Great Depression. In Stockton, the city’s budget gap grew as property tax revenue contracted—$37 million in 2007-08 to an estimated $33 million in 2008-09. A downward trend of reduced property tax revenue continued for city operations.

Despite the recession, Stockton’s seventh and last bond was issued in 2009 in the amount of $35 million from Franklin Templeton Investment (FTI), an unsecured creditor of Stockton. Standard & Poor’s Ratings Services assigned an underlying rating of “A” to this 2009 bond.

In the Stockton bankruptcy proceedings, the city reached repayment agreements with all of its creditors, except for Franklin Templeton Investment. FTI was the lone creditor that refused to accept the city’s terms for repayment, calling them unfair. Judge Klein’s October 1 ruling indicated agreement with FTI that a fair plan to exit bankruptcy could require Stockton’s pensions to be treated as a liability subject to adjustment (like FTI’s 2009 bond).

Since the housing crash, Stockton workers have endured layoffs, pay and benefit cuts (including to retirees’ health care) to slow a yawning budget deficit. The California Public Employees’ Retirement System-contracted pensions of the city’s employees did not cause the cash-flow crisis in Stockton and its move for bankruptcy protection. The fount of the city’s red ink lies elsewhere: the real estate crash and sharp drop of property tax revenue.

One big question hangs over Stockton’s financial crisis: How does the Standard & Poor’s rating of “A” to the $35 million bond from Franklin Templeton Investment in 2009 fit into the city’s Chapter 9 filing? Standard & Poor’s is one of the credit-rating agencies that fraudulently rated risky mortgage-backed bonds during the last decade, pumping up the housing bubble in Stockton and scores of other communities in and out of the Golden State before it burst. What made such mortgages so risky is clear. Borrowers lacked the means to qualify as home buyers. Lending standards went out the window. A term to describe such unqualified borrowers was NINJA (no income, no job or assets).

In his 2010 book Zombie Economics, economics professor John Quiggin explained Wall Street’s part in that real estate boom-and-bust cycle. During the last decade’s speculative mania, rating agencies such as Moody’s and Standard & Poor’s “offered AAA ratings to assets that turned out to be worthless, on the basis of models that assumed that house prices could never fall.”

Bob Deis, Stockton’s former city manager, wrote as much in his 2012 memo to city leaders. Was such an over-inflated rating the smoking gun for Wall Street’s role in Stockton’s bankruptcy filing?