What Happens When Cities Go Broke?

What Happens When Cities Go Broke?

June 25, 2010

Investopedia - In today's shaky economic environment, bankruptcy has become a dreaded -- yet not all that uncommon -- phenomenon. But what happens when it's not a person or company going broke, but an entire city? With added emphasis on government finances in 2010, it's a question that more and more citizens are beginning to ask themselves.

Municipal and state bonds are investments that touch a huge percentage of the investing public. And as we're seeing right now in Europe, there's no limit to the size to which government budget problems can grow.

Here's a look at what it means for a city -- or a county or state -- to go bankrupt, including the fallout for its citizens and stakeholders.

New Kid on the Block

Bankrupt cities are a relatively new phenomenon. Until the 1930s, it was legally impossible for U.S. cities to declare bankruptcy due to the absence of any municipal bankruptcy legislation. That changed in 1934 when the Bankruptcy Act was modified to include municipalities, a change made in response to the growing number of insolvent towns in the U.S. during the Great Depression.

After a number of evolutions and changes, the rule emerged as today's Chapter 9 of the U.S. Bankruptcy Code. Chapter 9 bankruptcies are available exclusively to municipalities. But there are some significant differences between a city's Chapter 9 bankruptcy and the much more common personal and business bankruptcies that take place on a daily basis.

Chapter 9 bankruptcies aren't designed to extinguish excessive debts. Instead, their purpose is to aid in reorganization by allowing a city to break untenable contracts and obtain more attractive financing. That's a good thing for a city's bond holders, who would typically see their assets at risk in a corporate bankruptcy.

Causes of a City Bankruptcy

The causes of a city's bankruptcy shouldn't be surprising -- it's basically a case of sustained budget deficits. As cities spend more than they take in, they have to rely on debt to finance their operations. While that's a common practice in the short term, it's a scenario that can quickly spiral out of control -- particularly when economic headwinds are factored into the equation.

Common causes of municipal bankruptcies include the loss of key tax revenues or mounting expenses from pensions, lawsuits or debt maturities.

One of the biggest municipal bankruptcies in U.S. history took place in 1994 in Orange County, California, home to some of the country's most affluent communities.That bankruptcy occurred following significant losses on the county's highly leveraged investment funds.

A more recent example took place in Vallejo, California, where excessive salaries and pension expenses drove the city to insolvency. Public employees in the city were drawing above-average salaries and benefits to match thanks to well-funded union groups with city council's ear. In 2008, Vallejo became the largest city in California to declare Chapter 9 -- a tool that officials used to renegotiate contracts with its highly paid civil servants (see story below).

It Could Happen To You

While there have been around 500 municipal bankruptcies in the U.S., there have been some serious close calls with some of the biggest cities in the country -- in fact, U.S. bankruptcy code was changed in 1976 in response to New York City's major financial troubles.

Other cities that came close to bankruptcy include San Diego, Miami and Cleveland. The Rock 'n Roll Capital even defaulted on a number of short-term loans in 1978, but avoided filing Chapter 9 through difficult financial wrangling.

So, what does it mean when your city goes bankrupt? Normally, very little.

In the past, cities have managed to maintain their necessary services to citizens while they navigated their bankruptcies. Bankruptcies are a bigger concern for bond holders; while bankruptcy won't absolve a city of its financial obligations, it can lead to early cancellation of municipal bonds as well as the potential for more serious issues like default. (For more on this type of investment, read The Basics Of Municipal Bonds.)

While municipal bonds have long been a favorite investment thanks to their tax advantages and government status, it's essential to remember that defaults aren't unheard of for municipalities, particularly when times are tough.

That said, because municipalities have the power to collect taxes on a captive audience -- homeowners -- they typically don't have too much difficulty figuring out new financing solutions with lenders.

The Bottom Line

As the economy continues to churn in 2010, there's little question that we'll hear more about the possibility that more U.S. cities will go bankrupt. But even if your town does succumb to Chapter 9, it's unlikely that it'll turn to anarchy. And, unless you're a municipal bond holder, life is likely to go on as usual.

What Happens When City Hall Goes Bankrupt?

Originally Published on February 28, 2008

Free Republic - ... Why do cities and towns declare bankruptcy?

For the same reason that individuals and corporations do. They're broke and can't pay their debts. This might be because of an unexpected expense — say, a costly lawsuit — or a sudden shortfall in revenue, due to falling property values, for instance. Either way, declaring bankruptcy protects cities and towns from their creditors, just as it does for individuals and corporations. (In Vallejo's case, bankruptcy offers another benefit: It would allow the city to renegotiate costly labor contracts with public-safety employees, which reportedly account for about 80 percent of the city's general fund budget.)

The one main difference: Municipalities can't liquidate assets to pay off their creditors — the mayor can't sell the town fire engine to pay the bank.

Have municipalities always been able to declare bankruptcy?

No. For most of U.S. history, cities and towns were not eligible for bankruptcy protection. But during the Great Depression, more than 2,000 municipalities defaulted on their debt, and they pleaded with President Roosevelt for a federal bailout.

"All they got was sympathy," reported Time magazine in 1933.

Instead, Roosevelt pushed through changes to the bankruptcy laws that allow towns and cities to file for bankruptcy. They even got their own section of the bankruptcy code: Chapter Nine.

How many municipalities have sought bankruptcy protection?

Since 1980, 32 cities and towns have declared bankruptcy, according to James Spiotta, a leading municipal bankruptcy lawyer. Most notable of these were Bridgeport, Conn., population 140,000, which declared bankruptcy in 1991. And, in the nation's biggest municipal bankruptcy, Orange County, Calif., sought protection from its creditors in 1994 after city officials made a series of bad investments.

What is life like in a "bankrupt" city or town?

In one sense, life goes on as usual. Police and fire departments still respond to 911 calls; the garbage is still collected. But don't expect that new bridge or school to be built. For a bankrupt city, all new projects must be approved by a majority of creditors. The biggest hit, though, is to the city's image. Bankruptcy carries a much greater stigma for a city than for a corporation, which is why officials go to great lengths to avoid Chapter Nine.

If a city or town declares bankruptcy, does it affect others nearby?

Yes. Surrounding cities and towns can find it harder to borrow money for new projects because investors — who buy and sell bonds — will question their financial viability. That's why states often intervene to prop up a faltering municipality and avoid the sting of bankruptcy. Sometimes all it takes for a town or city to get help from the state capital is the mere threat of bankruptcy. "It's an instrument of getting attention and getting others to help you," Spiotta says.

What about New York City? Didn't it declare bankruptcy in the 1970s?

No, but it came close. The city was teetering on the edge of bankruptcy in 1975 when it appealed to Washington for a bailout. President Ford balked, prompting the famous Daily News headline "Ford to City: Drop Dead." (Ford never actually uttered those exact words.) In the end, Congress did pony up some money for New York, and the city formed the Municipal Assistance Corp. — a quasi-government body that, in effect, allowed New York to lend money to itself. Other big cities — Philadelphia, Pittsburg, Miami — have flirted with bankruptcy in recent decades but not actually declared it.

Are we likely to see more towns and cities declare bankruptcy in the future?

That's difficult to say, but some experts believe the warning signs are clear: unfunded pension liabilities, an anemic economy, costly infrastructure repairs and falling property values.

"All of the ingredients are there," Spiotta says. "I wouldn't be surprised if we start to see more bankruptcies."