What Happens When Cities Go Broke?

By Jonas Elmerraji | June 25, 2010 AAA
What Happens When Cities Go Broke?

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.

In Pictures: 9 Ways To Go Bankrupt

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.

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.

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