This is part one in a two-part series.
Read part two: Pixie dust: How Stockton gambled its way from bad to worse.
STOCKTON, Calif. — The marina is beautiful, sparkling and new. So are the baseball park and the hockey arena, home to the Stockton Ports and the Stockton Thunder. Across the street is a stunning refurbished historic theater. The facilities glisten in the evening August sunshine, while teenagers do backflips off a pier and children fish for bass.
A stone's throw away is Stockton's City Hall. Above the entrance is an "All-American City" banner, reflecting faded glory from awards won in 1999 and 2004, but beneath the banner the lamp post foundations are badly cracked. It's one of many clues around the city that something has gone badly awry here.
Wells Fargo repossessed an eight-story office building meant to be a new city hall earlier this summer. The city had defaulted on its loans. The bank also seized underperforming parking garages, which the city built when boom times seemed here to stay.
At a city council meeting in that fading city hall on that warm August evening, the word "bankruptcy" is never mentioned but lies heavy in the air.
The council approves a renegotiated pensions deal with the fire unions. The private management company that oversees the shiny new venues reports on its progress filling seats. A 53-year-old retired police officer unloads his frustration about losing his promised free medical care.
The aftermath of Stockton's mismanagement will haunt the city's residents for years to come. Essential services are already being short-changed to pay debts and employee pensions.
Stockton's path to bankruptcy is an object lesson in how exuberance, naiveté and false hopes can supplant prudence. It's a lesson that cities, counties and states around the nation are rapidly learning.
Stockon is easily the largest U.S. city ever to file for bankruptcy. The next closest, San Bernardino in southern California, also filed this summer. But it may not hold the record for long. Former Los Angeles mayor Richard Riordan told FOX Business Network in August that he expects his city to be insolvent within two years.
It's an infection that is sweeping not just the nation but the world. As Mediterranean countries totter toward bankruptcy, U.S. states like California and Illinois, and a good handful of American cities from Stockton, Calif. to Scranton, Penn. are on the same path.
And unlike Europe, where profligate Greece can eventually be severed from frugal Germany, California is permanently tied to AAA-rated states like Utah, which will feel the economic tsunami when the financial earthquake hits.
"It was a perfect storm," said Stockton Mayor Ann Johnston in her office as she prepared for an afternoon city council meeting earlier this summer. The storm is a popular metaphor to describe Stockton's disastrous mix of ambitious public building, employee benefit overreach and the sudden collapse of its tax base, as property taxes evaporated after home values fell and foreclosures skyrocketed.
But Johnston does not view the city as a victim. She knows choices were made and that imprudence made the storm worse than it needed to be.
In the late 1990s and into the first years of the new century, Stockton boomed. As the pricey Bay Area pushed housing demand outward, home prices here jumped to a $400,000 median.
Building starts surged, property tax revenue skyrocketed, and the city got a gleam in its eye. At the peak, said Vice Mayor Kathy Miller earlier that afternoon, "they were pulling 3,000 housing permits a year. Money was just flowing all over the place."
"Prices became unhinged from the income," adds Jeffrey Michael, a finance professor at the University of the Pacific in Stockton.
In 2003, when home values should have leveled off after the economy cooled, prices continued to skyrocket, Michael said. "That was when the worst loose mortgages kicked in, when subprime lending and no doc loans became common."
The city responded to the resulting property tax bubble by overpromising.
Pensions and wages spiraled, especially for police and fire units. Fire fighters got a contract requiring that their salaries be at least 5th on a list of 16 California cities.
Lucrative overtime benefits also raised eyebrows. In 2010, a police sergeant made headlines for placing fourth on the city's salary list, earning $220,000 on a base salary of just under $100,000.
To overpromising, they added overbuilding, as ambitious mayors and city managers pushed through a series of dubious building projects.
On the edge of the San Francisco bay delta but still firmly within the fertile, hot central valley, Stockton is a working-class town that has long chafed in the shadow of its more glamorous Bay Area neighbors to the West.
Increasingly a commuter home for the Bay, Stockton is home to a large private university, and has long supported a symphony orchestra. A deep-water port plays a key role in California's agricultural exports, and lately has been exporting iron ore from Utah on its way to China. With a booming housing market beginning in the late 1990s, Stockton leaders thought it was time to upgrade the city.
Some of the early projects centered on the waterfront itself, including creating attractive piers and parks along the river, where drug dealers once roamed and a parking lot was sinking into the channel.
"We used redevelopment funds to clean up the brownfields, and laid the basis for private development. That was going along fine and we were able to afford all those things," Johnston said. "It went wrong when, in 2002 and 2003, the city decided things were going so well that they could issue bonds for other major projects."
Stockton pushed for an arena complex, including a 10,000-seat hockey arena, a 5,000-seat baseball diamond and an attached hotel complex. When cost overruns drove up the cost, the city got creative. Johnston recalls the scene in when she was on the city council.
"The mayor was talking about wanting a ballpark on the waterfront. The city manager said, 'There is no money. We can't do this.' And the mayor said, 'Can't we take money from municipal utilities, can't we take it from community development?' 'No, it's not legal to do that,' the manager said," Johnston recalled.
"And so he was stymied," she said, "but he kept trying to figure out how he could do some of these projects."
Eventually, a new city council was elected and a new city manager hired. "The city manager got an opinion from some attorney over in Oakdale, who said, "Oh yeah, you can borrow from municipal utilities," Johnston said.
So to help build the arena, the city raided dedicated sewer and water funds, which were legally segregated and not available for building projects.
But the Oakdale lawyer was wrong. Several years, $145 million and one lawsuit later, the city agreed to pay back to the stolen funds. With interest, it will cost the city $1 million a year over 30 years to pay back the $10.9 million it raided for the arena complex.
Altogether, the new complex cost more than $135 million in bonds. Unlike the parking garages and the office building, both now repossessed, the city has held onto the arena complex and the theater — subsidizing annual operating losses as it struggles with the construction debt.
As bad as the building binge was, the pension and employment compensation fiasco was worse.
"During the 1990s, we had a huge run up in benefits granted to our employees. People could retire earlier, and they could retire on a larger pension," said Vice Mayor Kathy Miller.
No small part of this, Miller said, was a bidding war that plagued police departments around the state, triggered partly by the California Highway Patrol.
In the 1990s, CHP unveiled unusually generous compensation and retirement packages, leading to an erosion of experienced officers from municipalities. To retain its officers, Stockton and other California cities tried to keep pace.
The biggest hit, Miller says, occurred when the city granted lifetime medical benefits to retirees. "Free. For them and a dependent. Forever. And at the same time, we were beefing up all of our pensions, which leads people to retire younger on larger pensions."
"It's easy to give away someone else's money," Miller said. "You get into this spiral. Every time you sit down with a bargaining unit, it starts all over again. 'Well, San Francisco and San Diego are offering their people 2.5 percent at 55 instead of 2 at 60.'"
But it was a house of cards. "We knew they weren't funding these commitments. They were robbing Peter to pay Paul," said David Macado, president of the Stockton firefighters union, which has a website laying out the bad decisions that bred the crisis.
When the money ran out, Macado said, the city "got personal," attacking the unions, laying off employees, and cutting benefits.
The bankruptcy has allowed the city to renegotiate employee contracts. The city has dropped the lifetime free medical coverage, and has asked employee unions to pay the employee share of pension contributions.
While the fire fighters have come to terms, the police union has still not reached a deal. The police have launched a public relations blitz, with billboards all over the city reminding citizens how much they do for them — and how dangerous their city is.
It's not a hard sell. Stockton had a record 58 homicides in 2011 and is on track to exceed that in 2012. There is something unnerving about turning a corner on a Stockton street and confronting a sign that says, "Welcome to the second most dangerous city in California" — sponsored by the police union.
But there is also something unnerving about Stockton losing its best officers to other cities. "They can write their ticket anywhere they want in California," Macado said. "We have guys with 15 to 20 years of experience leaving to finish their careers elsewhere."
Sworn police staffing dropped from 1.52 per 1,000 residents in 2005 to 1.16 today, the lowest ratio for any American city over 250,000 people, according to UOP's Jeffrey Michael.
Somehow, Stockton negotiated contracts that allowed police chiefs to hire and quickly retire with massive pensions. In the last nine years, four chiefs averaged just over two years each, retiring with an average of $192,000 a year pensions, according to Kathy Miller.
The most lucrative stint was Police Chief Tom Morris, who retired after eight months at $204,000 a year.
A black hole
While the debt from overbuilding hurts, most experts agree that employee benefits are the real killer.
Ninety-four retired Stockton employees earn more than $100,000 in pensions, according a Reuters report.
Nearly 96 percent of Stockton's general fund currently goes to four categories: public safety, debt service, pension funding and other post-employment benefits.
That compares to 72.6 percent for 118 cities of similar size, according to a study by Stephen Winterstein of Wilmington Trust Investment Advisors, and 76.7 percent in a smaller group of 27 California cities.
By 2006, with pension pressure torquing, Stockton was already off the map. Hard choices would have to be made. Or so it seemed. That was when Lehman Brothers came knocking with a painless solution.
In part two: Lehman Brothers offers a painless solution to the pension gap: a bond borrowed at 5.81 percent with hopes of earning 8 percent or more. The gamble fails badly, and Stockton heads for bankruptcy.
Read part two: Pixie dust: How Stockton gambled its way from bad to worse.
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