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Pixie dust: How Stockton gambled its way from bad to worse

Published: Sunday, Sept. 23 2012 6:48 p.m. MDT

A man walks his bicycle past a grocery store Wednesday, Feb. 29, 2012, in Stockton, Calif. A red, white and blue sign declaring Stockton an "All-America City" still adorns City Hall, but the building's crumbling facade tells the real story of the community's recent fortunes.

Ben Margot, Associated Press

Second in a two-part series: In the first article, Stockton, Calif., overbuilt and overpromised its way into a deep hole that required painful choices to climb out. In this article, Lehman Brothers comes knocking with a painless but risky solution. This does not end well.

Read part one: "In the red: From California to Pennsylvania, places like Stockton and Scranton run out of money.

STOCKTON, Calif. — A working class city with blue blood aspirations, Stockton's ambitious building plans and outsized employee benefits from the 1990s and early 2000s left it badly exposed when the housing bubble collapsed in 2008 and property tax revenue plummeted.

In 2012, the city filed for bankruptcy — the largest U.S. city ever to do so. It did so after determining that without restructuring its obligations, it was facing a $36 million deficit in 2012.

Warning signs had surfaced earlier. In 2003, a shallow recession had left the city's pension funds in a deep hole. The city's very generous pension programs had assumed steady strong growth in the markets. Just three bad years had exposed these faulty assumptions.

The city was now $150 million short. The California Public Employee Retirement System (CalPERS), where Stockton invests its retirement funds, said the city could make up the losses over time. But CalPERS would charge 7.75 percent annually on the liability for lost investment growth. The city would be hard pressed to catch up.

Prospects looked bleak. Without drastic action, the city would slip further behind each year. Stockton would have to revise its employee benefits, pour an ever-shrinking general fund into ever-growing pensions — or pray for a miracle.

Easy Answers

Into the breach came Lehman Brothers with a miracle product called "pension obligation bonds."

Issuing a POB is like using credit cards to invest in the stock market. Faced with unsustainable pension obligations, a city issues bonds, invests the resulting cash, and hopes returns beat the interest over time. Unlike traditional bonds for schools or parks, which create tangible assets for the community, POBs merely serve to paper over bad financial management, critics say.

The controversial approach is to this day widely used from Ft. Lauderdale to Los Angeles. The state of Oregon is up to its neck in them.

In June 2006, with the iceberg of the housing crash two years away, Lehman Brothers made its pitch.

Listening to the meeting is like watching tape of the Titanic's wheelhouse just before impact. The listener wants to scream, "Slow down and close the watertight doors!"

Council members asked fuzzy questions and respond to complex answers with uncertain pauses — and silence. The members of the city council were as confused as the Lehman Brothers pitchmen were smooth.

Their bonds, Lehman Brothers explains, would allow Stockton to make up its pension gap by borrowing $125 million at 5.81 percent, beating the 7.75 percent CalPERS was charging for the unfunded amount.

Desperation bred optimism. In 2007, the city council members issued $125 million in pension bonds and crossed their fingers, hoping the Lehman Brothers plan would work.

'Thieves and cowards'

By the time the market had leveled out after the 2008 crash, the city's $150 million gap — momentarily closed by a $125 million pension bond — exploded to $413 million. The city was that much further in the hole, and was now paying interest on the bond.

"Pension obligation bonds are an unmitigated disaster," said Dan Liljenquist, the former Utah state senator who re-engineered his state's pension system in 2011, helping Utah retain its stellar AAA bond rating. Liljenquist calls the politicians who use the bonds "cowards" and the brokers "thieves."

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