Noteware: Why the City of Houston Should Want No Part of BANKRUPTCY

Image credit: Pixabay

The City of Houston has not been paying all its bills.  It has funded its deficits by borrowing — from its employees’ pension funds, from bondholders and others.  Meanwhile, the City’s Long Term Financial Management Task Force observed three years ago that the City was dangerously close to running out of cash (rescued in the interim by record property and sales tax collections), and all observers have noted that the City’s current cash position is below standards recommended by the Government Accounting Standards Board (GASB).  The technical definition of bankruptcy is when an entity is “insolvent” — that is, not able to pay all its bills as they come due.  The City of Houston is therefore, by this definition, insolvent and essentially bankrupt.  And, looking forward, nearly everyone agrees that the City’s pension obligations will continue to rise at an accelerating rate, “crowding out” expenditures on essential services, like repair and maintenance of basic physical infrastructure, including roads and water both sanitary and storm sewer pipes, and the hiring and training of sufficient police officers.

The experience of Detroit, Michigan and Stockton, California, which entered and have now exited Chapter 9 Municipal Bankruptcy should be instructive for Houston — in many ways.  The first way is the that bankruptcy judge Christopher Klein in Stockton coined a term called “service insolvency” — basically recognizing the reality of crowding out of other services and the trade-off that governments make in funding some types of payments (say, to employee compensation) while deferring or denying others (say, repair of streets).  Thus, the insufficient provision of services, rather than the cash position or payments themselves, constitutes the insolvency.  By this wider definition “service insolvency”, Houston is even more clearly, bankrupt.

The purpose of a bankruptcy, including municipalities in Chapter 9, is to restructure debts, operations and other financial affairs so that the city can be sustainably solvent – that is, it can conduct is operations, and pay its bills and debts on a sustainable basis.  As I have written previously, the City of Houston, despite record revenues in recent years, has expenses well in excess of these revenues; the City’s operations are therefore not sustainable in their present condition.

The next experience that Detroit and Stockton’s bankruptcies tells us is that there are three constituencies that can be looked to address and restructure a city’s finances — creditors (a relief in outstanding debt); labor (a reduction in current compensation and/or pension/health care obligations); and taxpayers (the potential for increasing taxes and/or fees).  In a Chapter 9 case, the City would propose a plan and the judge would decide whether the plan is confirmable or dismiss the case.  The bankruptcy can become a “dance” during which all three groups, as part of the plan, attempt to shift responsibility from one to another.

The clear experience and reality is that in bankruptcy, outstanding debt, including general obligation bonds, can be reduced — but access to the capital markets will likely be restricted or possibly denied, even for sound future borrowings.  (And, other neighboring municipalities, such as Harris County and suburban Montgomery and Fort Bend Counties, would also find their credit downgraded and therefore impaired.)  Similarly, taxes can be raised, which in Houston would accelerate the City’s population flight to the suburbs.  However, given the presence of Prop 1 and Prop 2, which are now City Charter amendments that limit tax revenues, any attempt to raise taxes, even within the Chapter 9 bankruptcy context, would likely start a major legal battle.

In the Detroit and Stockton cases, “OPEB” (Other Post Employment Benefits, the unfunded, “pay as you go” premiums for retiree health benefits, which in Houston’s case total over $1.2 billion) were reduced.  And, as the New York Times reported recently in an important article entitled, “Cracks Starting To Appear in Pensions’ Armor”, “Detroit froze its existing pension plan and shifted its workers into a new plan that is supposed to have limited ability to tap taxpayers for any investment losses.”  Following that ruling, while Stockton declined to challenge CALPERS and left its pension program intact, Judge Klein wrote that even though Stockton did not even seek permission to freeze its pension plans…it was entitled to do so; further, he went on to cite “steps that struggling cities in general should take to trim their pension costs legally”.   Now, several other cities, including San Bernardino, are now challenging their pension plans in court.

The most important experience of Chapter 9 municipal bankruptcy is that key decisions regarding the future of the City are largely taken away from the citizens of the City and its elected representatives and placed in the hands of the courts.  In other words, for the most part, the City loses control of its own destiny.  The clear message is that the City of Houston must address and resolve its serious financial problems before it even contemplates entering into bankruptcy.  Since the City is already technically bankrupt in both the accounting and legal sense — as well as in the practical “service” sense — the City of Houston is already living on borrowed time.  Our leaders must act to place the City’s financial affairs on a permanently sustainable path — NOW!

A version of this article appeared in the Houston Business Journal on March 24, 2015.

About Jim Noteware 18 Articles
Jim Noteware is a Houston-based real estate developer, focusing on suburban master-planned and urban infill communities. He also specializes in the turnaround of distressed properties, portfolios and organizations. He has served two big-city mayors, in Houston and Washington, D.C., working to improve the performance of large troubled public agencies.