A rash of local bankruptcies is raising questions about the safety of tax-free bonds. By Kathy Kristof, Contributing Editor October 1, 2012 The tale of Stockton, Cal., is one of two cities: the gritty agricultural town of its roots and the cosmopolitan tourist destination that it aspired to become. But like American families who borrowed to finance a lifestyle they couldn’t afford, this northern California community is now paying a heavy price for its grand ambitions. Key city buildings are in foreclosure, and businesses have folded, leaving shuttered storefronts in their wake. Three years of municipal cost-cutting has drastically reduced services, including police and fire protection, and has helped propel the city’s per capita crime rate into the nation’s top ten. In June, Stockton became the largest U.S. city in history to file for protection from creditors under the nation’s bankruptcy laws. SEE ALSO: How to Buy Muni Bonds Safely Stockton has also become a cautionary tale for buyers of municipal bonds, who tend to be older, wealthier investors lured by the tax-free status of most munis. Investors, who once believed it was nearly impossible to lose money with bonds backed by the full faith and credit of a city government, are now being told that Stockton expects them to accept a loss on their investment. “Stockton makes it clear that general obligation bonds are no longer such a safe haven,” says Marilyn Cohen, president of Envision Capital Management, in Los Angeles. (General obligation bonds are those backed by an issuer’s taxing power. See our tips on how to avoid muni-bond land mines.) Two years ago, prominent analyst Meredith Whitney predicted that dozens of cities and counties would default on billions of dollars’ worth of municipal bonds. Although that worst case has failed to materialize, Stockton is beginning to look like one of many dominos. Within days of Stockton’s bankruptcy filing, the tiny California community of Mammoth Lakes followed suit, as did San Bernardino, a vast, economically troubled community east of Los Angeles. These cities are among dozens of communities across the country attempting to renegotiate their debts, within or outside of bankruptcy, as bondholders watch nervously. Advertisement To be sure, municipal bankruptcies are rare. Some states don’t even allow them. Defaults—instances in which a financially troubled entity fails to pay 100% of the principal and interest owed to investors—are rare, too. Less than one-half of 1% of the muni bonds outstanding fall into default in any given year, says Dick Larkin, director of credit analysis at HJ Sims, an investment firm in Fairfield, Conn. But a series of systemic problems have hiked the risk of default to levels unseen in this generation, says Doug Scott, managing director at Fitch Investors Service, which rates muni bonds. Few of these problems were created yesterday, and they are not likely to be solved tomorrow. Overly Generous Pensions Stockton’s woes, rooted in a string of historic missteps, are emblematic of the troubles besetting hundreds of similar communities nationwide, many of which issued municipal bonds to finance their growth. Former Stockton city manager Dwane Milnes says Stockton’s problems started with the booming stock market of the 1990s, which left public pension funds flush with cash. Money set aside in pension plans can’t be used for any other purpose. So when it came time to negotiate labor agreements with public employees, city officials agreed to boost promised retirement benefits-—which cost no cash upfront—-instead of providing rich raises. By the time the bargaining ended, the police and firefighters had landed agreements that allowed them to retire at age 50 with pensions that amounted to 3% of pay times their years of service. That was fairly typical in California, says Keith Brainard, research director at the National Association of State Retirement Administrators. After the legislature passed a law in 1999 that allowed public-safety officers to receive these enriched benefits, city after city approved the new formula, arguing that to do less would make it impossible to compete for police officers and firefighters. Nationwide, retirement formulas were also raised, although not quite as generously. Public-safety workers typically collect 2.5% of their pay for each year they work and are able to retire by age 55, Brainard says. Advertisement For Tony Delgado, a 53-year-old former Stockton patrolman, the enriched pension promise meant that when he retired in 2009 with 28 years of credited service, he walked away with 84% of his six-figure salary. His wife, a former probation officer who was injured after less than six years on the job, gets a pension of $2,500 a month, he says. Between them, they collect more than $100,000 annually in retirement. And because they both retired so early, they could be retired for far more years than they worked. Until the bankruptcy filing, the city was also paying for all of their medical insurance. Stockton officials have told former employees that the city intends to charge them for health policies this year and cancel retiree medical coverage by next year. Otherwise, city officials have said, retiree medical costs would exceed the cost of providing medical benefits for existing employees within a year. Overall, the cost of paying pension and health benefits to retirees now accounts for nearly 18% of the city’s budget; paying wages and benefits to existing employees accounts for 50.4% of the city’s budget. But generous pension and health benefits for retirees aren’t the only problems. Stockton, like many cities, also financed a building binge with municipal bonds at a time when it appeared that the government would be flush with cash indefinitely. SEE ALSO: How to Buy Muni Bonds Safely Cities earn revenue from four primary sources: property taxes, sales taxes, building-permit fees and business taxes. Like many communities on the outskirts of bigger towns, Stockton benefited briefly from soaring prices in neighboring big cities. Home buyers in San Francisco and Sacramento, for example, began to see the city as an affordable alternative. In the middle of the last decade, says Stockton resident Joni Anderson, she received unsolicited offers of $650,000 for her three-bedroom home, for which she had paid $220,000 just a few years before. Advertisement The resulting rise in revenues created a sense of walleyed optimism among city leaders. They spent $191 million on several projects, including a marina, a stadium and a sports arena; $40 million on a new city hall; and $32 million for parking garages. Although the bulk of these projects were financed with revenue bonds, which use the proceeds from the specific project to pay interest and principal, the city guaranteed repayment with general funds to hold down the bonds’ interest rates. “The city assumed the hyper-growth that was occurring in the housing sector would continue indefinitely, and that developer fees and property-tax growth would provide sufficient revenue to meet these new obligations,” the city said in papers accompanying its bankruptcy filing. Stockton isn’t the only place where construction of white elephants contributed to municipal ruin. In Scranton, Pa., city leaders point to an empty parking structure when explaining why they needed to default on municipal bonds in June. Mammoth Lakes leaders blame costs associated with expanding the town’s airport. Harrisburg, Pa., guaranteed a trash incinerator. Harrison, N.J., traces its financial woes to backing a soccer stadium. And the list goes on. Yet what most ails state and local governments is the tepid economy. With real estate prices in a holding pattern, nagging unemployment, and slow or no business growth, they’re like families forced to live with a long-term decline in pay. Cities across the country now face draconian budget cuts in order to pay the debts they incurred in better times. Ironically, increased risks would normally trash municipal-bond prices, causing their yields to jump. But investors are so desperate for any yield in today’s market that muni prices have barely budged, says Matt Fabian, a managing director at Municipal Market Advisors, a research firm. A triple-A-rated muni bond maturing in ten years currently yields 1.8%, roughly one-fourth more than a comparable Treasury bond. However, because interest earned on muni bonds is free of federal income taxes (and may be free of state income taxes as well), munis are actually more valuable to investors than their stated yields would suggest. Advertisement But the market’s relative calm could change, depending on what happens in Stockton. With the bankruptcy filing so fresh, it’s not clear yet whether investors will be forced to take a loss or the city will be forced to make them whole. If Stockton is able to cut investor principal—and other cities see that as a viable way out of their woes—it could deal the muni market a significant blow. That’s because investors can analyze economic risk, but it’s impossible to gauge accurately a city’s willingness to pay. “The direction in California is clearly a concern because cities have an influence on one another,” says Fabian. “The degeneration of governments’ willingness to pay has created the biggest risk in the muni market in a long time.” Kathy Kristof is a contributing editor to Kiplinger’s Personal Finance and author of the book Investing 101. Follow her on Twitter. Or email her at firstname.lastname@example.org. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!