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U.S. municipal bankruptcy is ‘trendy’ but likely not catching

San Bernardino Mayor Pat Morris ponders a question Wednesday, July 11, 2012, regarding the Tuesday city council vote authorizing a bankruptcy filing outside San Bernardino City Hall in San Bernardino, Calif. City officials have said San Bernardino "has an immediate cash flow issue" and may not be able to make payroll with a budget shortfall of more than $45 million in the next fiscal year.

Rick Sforza/AP

Is there a budget bubble in the United States? In the last few weeks, three California cities have declared bankruptcy in the face of overwhelming budget deficits.

The latest was San Bernardino, a city of 209,000, which earlier this month sought protection from creditors. It followed in the footsteps of Stockton and Mammoth Lakes.

Municipal bankruptcy in the U.S., as The Sacramento Bee sardonically declared last week, is "trendy." But it may not be catching.

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Only about 650 municipalities have filed for bankruptcy since the mid-1930s, when it first became an option, according to John Mikesell, an expert in municipal finance at Indiana University.

There are about 89,000 municipalities in the U.S., and municipal bond watchers are bullish that the news out of California is not a signal of a rush of filings to come. "They are so rare that analysts haven't paid much attention to them," said Prof. Mikesell.

And the cities that have sought credit protection faced some extreme circumstances – a $43-million (U.S.) legal judgment related to a development dispute, in the case of Mammoth Lakes – and share a number of unflattering habits.

Why it's not an epidemic

Accusations of gross mismanagement and dysfunctional politics have been laid against the municipal governments of the bankrupt California cities, which reportedly overspent on salaries and pensions and didn't heed repeated warnings of impending doom.

In San Bernardino, for example, the city charter pegged police and firefighter pay to wages offered by other California cities, an obligation that became untenable as the unemployment rate surged to 15 per cent.

But most city managers and politicians will try to make major changes before bankruptcy is a possibility. If not, they will pay the price, said Daniel Bergstresser, an associate professor at Brandeis University International Business School. "If you tell your creditors today that you're not going to pay them, it affects the terms on which you're going to borrow tomorrow," he said. "If you decide you want to build a new high school, the cost of financing that is certain to be higher and might be prohibitively high."

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It's not a get out of jail free card

Bankruptcy, or Chapter 9 protection, shields financially distressed municipalities from their creditors while developing a plan to adjust their debt. But it is unlikely to be the next big thing in urban government: it doesn't make a city's problems disappear.

The city of Vallejo, Calif., declared bankruptcy in 2008. Since then, things have not exactly improved. Bankrupt cities are still required to balance their budgets, pay their legal bills and deal with "outstanding liabilities" – that is, employee pensions. Vallejo had $382-million in outstanding liabilities and was hit with more than 1,000 lawsuits.

In the aftermath of such a drastic step, roads will not be repaired, and police and fire services will likely be cut, as they were in Vallejo, resulting in longer response times.

What are the alternatives to bankruptcy?

California has enacted a law requiring municipalities to pursue mediation or declare a fiscal emergency before seeking bankruptcy. Elsewhere in the U.S., cities have hired consultants to help them restore order to their book and sold off assets like office buildings and parking infrastructure.

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But the best way to avoid bankruptcy, experts say, is responsible financial management. "If you don't have the money, do not try to spend it. Do not kick the costs of current services off to some future date," said Prof. Mikesell. "Do not promise lucrative retirement benefits to employees unless you, at the same time, put aside money now to cover the ultimate cost."

Another option is state receivership, where the municipal government is relieved of its responsibilities, services are slashed and an interim body attempts to return the operation to a sustainable basis.

"I prefer that model to bankruptcy," said Prof. Mikesell. "That can do a better job of putting the burden on the people to blame for the problem."

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