Breaking a Californian taboo

IN ONE corner stands San Bernardino, a bankrupt city of 210,000 souls. Squaring up to this six-stone weakling is a super-heavyweight: the California Public Employees’ Retirement System (CalPERS), the world’s sixth-largest pension fund, with assets worth around $245 billion and a reputation for getting its own way. Wall Street, legal experts and other troubled cities are watching this ill-matched contest closely. Some observers think it could go all the way to the Supreme Court.

CalPERS manages the pension schemes for 450 Californian cities (and thousands of other public bodies). Member cities are obliged to make regular contributions. Few have dared renege on these when trouble hits. As part of their bankruptcy arrangements, Vallejo, an old port town near San Francisco, and Stockton, in the Central Valley, slashed workers’ pay and stiffed bondholders but made good on their CalPERS payments. In September Compton, a struggling city south of Los Angeles, did fall behind on its obligations; it was quickly brought into line by a lawsuit.

San Bernardino has proved less of a pushover. An unlovely, crime-ridden city at the heart of the Inland Empire, the suburban sprawl east of Los Angeles, it followed Stockton into bankruptcy this summer. The city’s particular troubles go back decades, but much of its story followed familiar contours: overbearing unions, political dysfunction and financial commitments made during good times that could not be met in bad. In one respect, though, its behaviour has been strikingly original. Since its declaration in August, San Bernardino has not paid CalPERS its full dues.

Pat Morris, the city’s affable mayor, dislikes talk of confrontation. The problem is simply that CalPERS is, by some distance, San Bernardino’s biggest creditor, and the city cannot cut services any further without jeopardising basic safety. The fund, like all creditors, will eventually receive what it is owed, the mayor adds, but the city needs breathing space. (It wants to resume payments in 2013-14.) On November 30th it filed a proposed emergency budget with a bankruptcy court. Among the cuts and deferrals were $13m-worth of payments to CalPERS. This, the plan noted dryly, “assumes repayment at some future date to be negotiated with the creditor”.

The creditor, though, is not in a negotiating mood. A day after San Bernardino’s councillors approved the plan CalPERS said it would sue to reclaim $6.9m in missed payments, and filed an aggressive motion seeking removal of the restriction on lawsuits that normally applies to cities entering bankruptcy. Asked if CalPERS could take the drastic action of terminating its contract with San Bernardino, leaving the city to look after its own, a tight-lipped spokeswoman says the fund “reserves the option”. The bankruptcy court will take up the case on December 21st.

Ultimately California’s cities may be bystanders in the real battle: between CalPERS and municipal investors. Holders of municipal debt ask why CalPERS should automatically take priority over them in the repayment queue. They want a ruling that treats CalPERS like any other unsecured creditor. In a separate case that will not reach court until next year, two bond insurers are challenging Stockton’s eligibility for bankruptcy precisely because it makes no effort to tackle pensions.

Californian state law is clear that cities must meet their CalPERS obligations. But bankruptcy is a federal matter, and so CalPERS’s opponents may find themselves resting their argument on the supremacy clause of the constitution, which asserts the primacy of federal over state law in the instance of a clash. Municipal bankruptcies are so rare that there is little legal precedent. “I don’t think we know how this ends,” says Eric Hoffmann, an analyst at Moody’s, a ratings agency.

A ruling against CalPERS’s claim to seniority would, of course, satisfy the city of San Bernardino and its other creditors, as well as holders of municipal debt elsewhere in the state. It would increase the pressure on Stockton to revisit its bankruptcy arrangements. But it might also make bankruptcy look more attractive to the many other weak cities in California labouring under heavy pension burdens.

A finding in favour of CalPERS, on the other hand, could have sweeping effects on the market for municipal debt, says Matt Fabian at Municipal Market Advisors, a research firm. By in effect creating a class of subordinated bonds, the court would set in train a series of events that could lead to widespread credit downgrades and a market withdrawal by some lenders. For California’s cities, many of which have yet to recover from the housing crash, that would be a serious blow indeed.