Stockton, Calif., is Largest City to File for Bankruptcy

Update: Stockton, Calif., officially filed for bankruptcy Thursday.

Stockton, Calif., is poised to become the largest U.S. municipality to file for bankruptcy now that the city's leaders have declared there is no way for them to close a $26 million budget gap in their general fund.

The City Council voted Tuesday in favor of enacting a "pendency plan," a sort of emergency budget that coincides with their expected bankruptcy filing later this week.

The issue came to a head this week since Friday is the final business day of the fiscal year. The plan assumes the city will file for bankruptcy imminently.

City leaders were unable to renegotiate millions in debt owed to creditors in the months leading up to the decision, and they were unable to pass a balanced budget, as required by law. Local officials believe bankruptcy protection will allow them to craft a budget that allows the city to continue functioning and avoid a collapse in public services.

The root of the situation in Stockton is unusual when compared to other municipalities that have taken similar steps. In Harrisburg, Pa., an unsuccessful attempt at bankruptcy was driven largely by debt from a boondoggle incinerator project. Boise County, Idaho, filed for bankruptcy (but was denied the status) in 2011 after losing a sizable judgment. And Jefferson County, Ala.’s filing was due in part to a bad deal on utility system debt.

In documents provided to the City Council, City Manager Bob Deis -- drawing on the words of former Federal Reserve Chairman Alan Greenspan -- attributed the city’s fiscal woes to the “irrational exuberance” during the era of the housing boom that left it with millions of obligations once the market crashed.

Over the last three fiscal years, the city has closed nearly $90 million in budget deficits, and just over a year ago, the city declared a state of emergency requiring a quarterly review of its financial conditions. Today, Deis writes, the city is insolvent. Reductions in staffing levels, employee compensation and city services haven’t been enough to solve the problem; the city has tapped its resources and it doesn’t have any more left to solve the problem. The only way to fix it is through restructuring, which would reduce the city's debts and employee benefits to more sustainable levels. Without restructuring of debt, the city’s deficit could mount to $40 million annually within just three years, according to Deis.

"Your council is not responsible for the financial situation that we face today, but you have been left with the responsibility for dealing with it," Deis wrote to City Council members. All but one of Stockton's City Council members began their terms in 2009 or later.

Earlier this year, the state controller's office launched an investigation of the city's financial reporting practices discovering discrepancies in the city's financial reports.

The city plans to fix its financial problems by reducing its debt load by about $12 million and reducing employee compensation and benefits by about $11.2 million by eventually phasing out retiree medical benefits starting in the 2014 fiscal year, among other changes. It’s unclear exactly how much the city can comb from retiree pensions, though that’s likely to be a contentious issue throughout the bankruptcy proceedings. Any plan would ultimately have to be approved by a federal bankruptcy judge.

Chicago-based attorney James Spiotto, an expert on municipal bankruptcy, says that while Chapter 9 bankruptcy protection could help the city stop the bleeding, it won’t solve its financial problems. “They have an economy issue,” Spiotto says. “Obviously, if you can attract more business, you can solve some of that. But Chapter 9 isn’t going to change that.”

The only way the city will bounce back in the long-term, Spiotto said, is if it develops a long-term recovery plan that addresses how it can become an attractive destination for businesses and residents. “If you don’t have that second piece,” Spiotto says, “you’re just putting on a Band-Aid.”

Stockton’s problem now is that its property tax, sales tax and business tax revenues are on the decline, and its financial woes won’t make it an attractive place for businesses to relocate. Of particular concern is crime, which makes the city unattractive to outsiders. Stockton has the second-highest murder rate in California, and last year, the city’s 58 homicides were an all-time record. This year, it’s on pace to break that record.

Essentially, it's stuck in a cycle; a common trait among  financially distressed cities.