Fool’s Gold 2: Los Angeles

In a January blog, I discussed the fact that despite the conventional wisdom about the “safety” of municipal bond investments, the immediate future could see a significant number of municipal defaults.  So, it shouldn’t have come as a shock to our readers when Los Angeles’ Controller Wendy Greuel recently warned that the city’s general fund could run out of money by May 5^th.  She reported that the city’s budget gap was $222.4 million for the current fiscal year which ends June 30.  Is the current budget issue in Los Angeles a tipping point?

Recently, elected officials of the city and the Los Angeles Department of Water and Power squared off over periodic payments ($73.5 million) the utility is supposed to make to the city in lieu of taxes and franchise fees.  The utility, the nation’s largest ($4.2 billion annual budget and 8,600 employees) stopped making payments when the LA City Council voted not to allow rate increases.  Utility officials claimed such increases were necessary to cover the costs of investing in renewable energy projects mandated by the state.  On April 12^th, the utility’s general manager, David Freeman, wrote to the Controller, “There is no surplus money to transfer at this time”.  Ms. Greuel ordered an immediate audit of the utility.

While the $73.5 million payment would help the city’s budget, it does not appear to be enough money to change the city’s plight.  The deficit has forced the city to dip into its reserves to cover the short fall.  The city started the fiscal year with a reserve fund of about $207 million.  With the $73.5 million from the utility, it is estimated that the reserve would end the fiscal year with $39 million, or .9% of the annual city budget, far below the targeted level of 5% of budget.  There is no doubt that something will have to be done, and soon, as budget projections show a $500 million short fall for the next fiscal year.  Given the California State budget woes, it is unlikely that help will come from that source.  Los Angeles Mayor Villaraigosa has suggested cutting the work force but has run into resistance from the City Council that must approve such cuts.

Given the city’s precarious position, it isn’t any wonder that Moody’s cut the rating on some $3.2 billion of Los Angeles’ general obligation bonds citing “continued erosion of the city’s historical better-than-average willingness and ability to quickly rebalance its budget mid-year”.  A recent quote from LA Times Reporter Tim Rutten sums up the situation.

The crux of the city’s crisis is this: Los Angeles has suffered a catastrophic decline in tax and fee revenues… the city’s public employee pension funds underwent an equally devastating collapse…  city payrolls were allowed to grow heedlessly in recent years…  The truth is that everyone knows the way out of this crisis – and that involves reopening and renegotiating all the city’s labor contracts, including those with unions representing police, firefighters, and the Department of Water and Power’s workers.

On April 13^th, the City Council’s Budget and Finance Committee, by a 3-1 vote, put a freeze on the hiring of new police officers.  This is but a baby step.  It is a freeze, not an in force reduction or the opening of negotiations on wage and benefit levels.  And, already there is huge resistance.  Whether Los Angeles can avoid default remains in question.

Los Angeles is not the only city in the U.S. with budget issues.  One needs only to turn on the local news to hear about municipal budget woes, furloughs, and firings.  Municipalities get their revenues from income taxes, property taxes, and sales taxes all of which are down significantly in the current economic environment.  Detroit has had to “trim” its workforce by 300 people, move satellite offices back to City Hall, and cut budget spending significantly in all departments.  Detroit’s Mayor Bing said, “It is indeed now or never” if the city is to avoid bankruptcy.  It appears that such actions will become the norm as city and state budgets become more strained.  As Ms. Greuel put it, “the sooner you take action, the less draconian the cuts need to be and you don’t find yourself at the edge of a cliff, peeking over”.

So, it may well be that the budget battle in Los Angeles is a tipping point.  While not every municipality is in such dire straights, many are.  After one or two major municipal entities use the Chapter 9 bankruptcy, it won’t be such an “unthinkable” event, and, seeing that the world won’t end, many others will follow suit.  Municipal bond investors should take heed and review and adjust their portfolios before that first major seminal bankruptcy event occurs.

Joshua Barone, Managing Partner

April 16, 2010