The city of Stockton, CA has decided that it will file for bankruptcy protection under Chapter 9 of the Federal Bankruptcy Code. This announcement is likely to be a national news item that may catch the eye of many investors.
This call to bankruptcy was anticipated considering that Stockton had already defaulted on its debt and, for the last 90 days, had been in a mandatory mediation period in an attempt to negotiate concessions in labor costs and benefits, which are currently almost 70% of the city’s general fund. We do not believe this headline will be considered unexpected or that it will have a negative impact on the municipal bond market.
We also do not consider that this is the start of an epidemic among municipal entities to use default or bankruptcy strategies. Though there may be more smaller entities that will use this option going forward, we view this as more of a politically expedient approach versus a viable solution, which will generally be adopted by municipalities under financial stress.
Frankly, it is hard to understand after the Vallejo, CA experience that a municipal entity nearby would even consider the bankruptcy route. Vallejo spent many months initially having the bankruptcy proceeding approved (it is not as automatic as with corporations), spent three years in bankruptcy proceedings, spent $10 million in legal fees, and almost a year, after emerging from bankruptcy, is still struggling to meet the mandates that were dictated by the bankruptcy court. Considering that their tainted reputation has now effectively barred them from the capital markets, and that the ultimate concessions that they received in bankruptcy mirrored what likely would have been accomplished through diligent negotiations, they clearly have not established an attractive road map for others to follow.
It does reaffirm, however, that smaller municipal entities continue to be under stress and that clients should be very cautious in stretching for yield.