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Ben Margot, Associated Press
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.
In our view, this bankruptcy is about fiscal mismanagement and unwillingness to pay shown by elected officials. —Barclays Municipal Research report

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."

Jeffrey Michael, a finance professor at the Stockton-based University of the Pacific, agrees. "The bond salesmen charm financial staff," Michael said, "and then the financial staff pitches these things as a miracle drug to the city council."

"Go back and look at the sales pitch from Lehman Brothers," Michael said. "The pitch amounts to this: You can issue these bonds or you can cut your pension benefits — and you don't want to do that. Borrow it at a low rate and gamble it in the market. If it pays off, you don't have to make the tough choice."

While Michael thinks agrees that the core problem is Stockton's failure to wrestle with its employee costs, he does wonder if a default by Stockton might actually help correct the bond market. "If Stockton did not pay back their bonds and it caused the whole market for pension bonds to dry up, in my opinion, that would be a good thing," he said. In short, the risky bonds should be uninsurable, unaffordable, and thus unused.

Are they serious?

Some see the city is less a victim than a perpetrator.

A scathing June 2012 report by Barclays Municipal Research argued that Stockton could dig out if it were willing to make hard choices with employees, but it has chosen to abandon its bond holders instead.

"In our view, this bankruptcy is about fiscal mismanagement and unwillingness to pay shown by elected officials," the Barclays report stated, arguing that the largest and fastest growing part of the mess are employee costs, and that these have been barely addressed in the "Pendency Plan," which lays out Stockton's plan to emerge from bankruptcy.

Payroll is 74 percent of Stockton's expenses, Barclays notes, with debt service just 14 percent But the city's plan calls for half the savings to be taken from debtors, which the report characterizes not just as unfair but mathematically undoable.

While Stockton's defenders point to declining employee headcount — especially in public safety — Barclays argues that by cutting only lower-paid staff, Stockton reduced headcount but raised payroll.

With each reduction, the report states, "the average salary climbs dramatically, as low-cost employees are eliminated in favor of more senior, high-cost employees."

Stockton's median household income is now under $50,000. The median city employee, who earned $70,620 in 2006, suddenly earned $102,260 in 2010. From 2006 to 2010, Barclays notes, the city total payroll increased by 5 percent while the number of employees plummeted by 28 percent.

Contrast Vallejo. Like Stockton, a working class city on the San Franciso Bay-area periphery, Vallejo also saw explosive growth in the past two decades, and then ran into trouble. Vallejo went bankrupt in 2008.

There the similarities end. Vallejo used the bankruptcy to aggressively re-engineer its personnel costs, according to a widely cited California Common Sense report. Vallejo cut its police and fire forces, negotiated lower wages and benefits, and emerged with its bond obligations largely intact.

Stockton's plan shows the city "does not plan to address the fundamental cause of the crisis: employment expenses," Barclays argued.

Barclays doubts the courts will approve Stockton's bankruptcy plan, predicting that "eventually the city will be forced either by logic or judicial ruling to change its treatment of labor costs."

Blame games

Most agree that the city is mainly to blame. Some also point to pixie dust brokers at Lehman Brothers. Michael does not absolve those who insured the bonds. "They encouraged the city's risky fiscal behavior," he said, "and profited from it."

Some critics point to CalPERS itself, which helped drive the city to the bonds by charging a heady 7.75 percent on the pension shortfall — thereby encouraging the city to take bigger risks to catch up.

CalPERS, critics say, burned Stockton twice with these aggressive assumptions.

First, outsized investment assumptions prior to 2000 seduced the city into thinking moderate investments would cover huge pension deals. More realistic return projections would have given earlier warning signals.

Then CalPERS jeopardized Stockton's contributions with high-risk portfolio strategies needed to justify such rosy predictions, putting Stockton's bond gamble in greater jeopardy. Thus, CCC calls out the "high-return, high-risk instruments that CalPERS favored in recent decades."

Innocent victims

"The only innocent victims are the law-abiding citizens of Stockton," Michael said, calling the affair both "a financial and a social crisis."

The threat is real. Stockton's public safety has fallen over the past two years. Its homicide rate set a record in 2011 and is on track for for another new high in 2012. Stockton ranks 10th in the U.S. for violent crimes per capita.

Meanwhile, Michael said, "The 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.

Somehow Stockton has managed to cut its police force while increasing city payroll costs.

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"Since debt service on all the city's bonds represents a small fraction of the city's general fund expenditures, even totally eliminating it will not solve the city's structural deficit," said said Robert Tucker, managing director of investor relations and communications for Assured Guaranty, which insured Stockton's bond.

Unless Stockton can escape the blind alley of excess employee benefits, Tucker argued, residents will continue to suffer reduced services even as they are bled today to pay for yesterday's profligate employee packages.

Email: eschulzke@desnews.com