Stockton to enter bankruptcy. What happens next?

Stockton, Calif., will be the largest US municipality to enter bankruptcy. The question, Gordon writes, is: Who will be left holding the bag?

Kevin Bartram/Reuters/File
Crumbling sidewalks and shuttered businesses line a downtown street in Stockton, Calif. It will take some time to parse through the Stockton bankruptcy ruling, Gordon writes, and determine who will pay.

A few years ago, it was fashionable to compare California, Illinois, or whatever U.S. state was struggling financially to the troubled island nation of Greece.  Now, with Stockton, California the largest U.S. municipality to enter bankruptcy, it may be tempting to make another Mediterranean comparison – this time to the troubled island nation of Cyprus.

In Cyprus as well as Stockton (plus San Bernardino, California and Jefferson County, Alabama), the question is:  Who will be left holding the bag?  A common theme is “haircuts,” or possible losses for investors (bank depositors in Cyprus; bondholders in California) to spare wider pain to taxpayers, pensioners, public employees, and other local stakeholders.

One problem with haircuts is that they can impair future market access:  the government in question may have to pay higher borrowing costs to regain investor confidence.  A wider concern is contagion:  If investors fear they won’t get their money back, they might demand higher interest rates from the sector as a whole.  Moody’s Investors Service publicly worried about such contagion last summer, in a report critical of U.S. municipalities and what the organization viewed as changing norms toward bankruptcy.

But there are a few reasons to be skeptical about the contagion scenario applied to munis.  First, although broad (worth about $3.7 trillion in 2012), the municipal bond market is not very deep.  On the supply side, a few large issuers like California, New York, and Texas dominate.  On the demand side, most investors are households or institutions representing households such as money market mutual funds.  

Because of its traditional mom-and-pop structure, muni bonds don’t trade very often and the market is not transparent.  When bonds do trade, different buyers may pay different prices for the same issue, and prices can rise faster than they fall (the “rockets and feathers” phenomenon). Economists have rightly criticized these features as inefficient.  However, some market participants counter that proposed cures might be worse than the disease.

A silver lining of less-than-perfect information and higher transaction costs in muni markets may be that shocks are transmitted slowly through the system.  More educated institutional investors are probably able to sort good apples from bad; other investors simply “buy and hold.”  A recent IMF working paper confirms these predictions:  after a bad credit event, investors apparently shift their money from places like California and the City of New York to safer issuers.  Rather than suffering from Stockton’s misfortune, other states and municipalities will probably benefit, much like U.S. Treasuries after the 2008 financial crisis.

Interestingly, the IMF authors did detect some evidence of contagion, or bad news spreading, but in an unexpected direction from munis to U.S. Treasuries.  One explanation is that investors looked at an Illinois or California and worried about prospects for a federal bailout, analogous to Cyprus and the rest of the Eurozone.  Still, measured effects were small and took time to surface.  The U.S. also has a long history of steadfastly refusing requests for local aid.

In any event, it will take some time to parse through yesterday’s Stockton ruling.  Its most significant effects may be felt within California – where many municipalities pay into the state’s CalPERS pension fund.  The judge ruled that CalPERS was just another creditor, but we still don’t know who will be left holding the bag.

You've read  of  free articles. Subscribe to continue.

Dear Reader,

About a year ago, I happened upon this statement about the Monitor in the Harvard Business Review – under the charming heading of “do things that don’t interest you”:

“Many things that end up” being meaningful, writes social scientist Joseph Grenny, “have come from conference workshops, articles, or online videos that began as a chore and ended with an insight. My work in Kenya, for example, was heavily influenced by a Christian Science Monitor article I had forced myself to read 10 years earlier. Sometimes, we call things ‘boring’ simply because they lie outside the box we are currently in.”

If you were to come up with a punchline to a joke about the Monitor, that would probably be it. We’re seen as being global, fair, insightful, and perhaps a bit too earnest. We’re the bran muffin of journalism.

But you know what? We change lives. And I’m going to argue that we change lives precisely because we force open that too-small box that most human beings think they live in.

The Monitor is a peculiar little publication that’s hard for the world to figure out. We’re run by a church, but we’re not only for church members and we’re not about converting people. We’re known as being fair even as the world becomes as polarized as at any time since the newspaper’s founding in 1908.

We have a mission beyond circulation, we want to bridge divides. We’re about kicking down the door of thought everywhere and saying, “You are bigger and more capable than you realize. And we can prove it.”

If you’re looking for bran muffin journalism, you can subscribe to the Monitor for $15. You’ll get the Monitor Weekly magazine, the Monitor Daily email, and unlimited access to CSMonitor.com.