Bankruptcy Loses its Taboo for California's Cities

Agenda-Setting Financial Insight.
July 11 2012 4:54 PM

Bankruptcy Loses its Taboo for California's Cities

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San Bernardino has just become the third Golden State municipality in two weeks to fail.

Photo by David McNew/Getty Images

Bankruptcy is no longer taboo among California’s struggling cities. San Bernardino has just become the third Golden State municipality in two weeks to fail - ending a four-year hiatus since fellow California town Vallejo began its costly and protracted court battle against creditors. So far, though, investors seem pretty sanguine. 

Granted, the three cities, which also include Stockton and Mammoth Lakes, are hardly bustling metropolises - each has a population of less than 300,000. But California, home to the glamorous Silicon Valley and Los Angeles, has the high taxes, big government and heavy regulation that are characteristic of major metropolitan areas. 

That makes it especially tough for cities in the state’s heartland that can’t attract the glitterati. They have also been hammered by the housing market bust. Throw in rising pension costs and terrible governance and it’s likely that other towns will turn to the courts to remedy their woeful finances. 

Yet municipal bond yields on lower-rated debt actually fell 0.06 percentage point to just 3.71 percent in the days after Stockton and Mammoth Lakes turned to the courts. Compare that to the height of muni madness two years ago, when investors feared a wave of defaults would rip through the $3 trillion market. Yields then topped 5 percent. 

So what gives? First, the hysteria in 2010 was overblown. Bankruptcy is, and should be, the last resort for cities and counties who have exhausted all other options. As San Diego and San Jose have shown this year, governments can deploy more creative initiatives to plug budget shortfalls. 

That said, investors can’t afford to be too blasé either. Aggressive court tactics could sting them. Stockton officials, for example, have called for bondholders to share the pain doled out to creditors - a departure for a market accustomed to being paid in full in the rare case of default. Additional filings could also make investors more skittish about lending to other municipalities pinched by depressed revenue and escalating pension costs. At the very least, that would mean rising borrowing costs. 

Three small bankruptcies are no reason for bondholders to lose perspective. But they shouldn’t trust their life savings either, at least not to California’s municipalities. 

Read more at Reuters Breakingviews.

Agnes T. Crane is a Reuters Breakingviews columnist, based in New York, where she covers capital markets and Latin America. She joined from Dow Jones Newswires, where she was an award-winning journalist who led a team of reporters covering the credit crisis.

Martin Hutchinson covers emerging markets and economic policy, drawing on 25 years of experience as an international merchant banker. He ran derivatives platforms for two European banks.

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