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First, I must correct an erroneous slur: it is widely assumed that the bankruptcy of Mammoth Lakes, California, is in some ways comparable to the previous bankruptcies of Vallejo, Stockton and San Bernandino, California. This isn't fair. Mammoth Lakes filed Chapter 9 because it wound up on the wrong side of a lawsuit, a $32 million judgment against it, which was enhanced by legal interest and costs to $43 million. That could happen to any municipality defended by typically incompetent county counsel. The bankruptcy of Mammoth Lakes is not really indicative of a general trend toward insolvency of cities in California.
The way that bankruptcies in Vallejo, Stockton and San Bernadino are indicative of a general trend toward insolvency of cities in California. They will soon be followed by a couple of other Southern California cities, probably Compton, then Montebello. These cities are facing Chapter 9 because they've run out of money. It's not really a lot more complicated than that.
Chapter 9 was enacted during the Great Depression to give cities and other local government entities (such as transportation districts) a way to "reorganize" in bankruptcy, along the lines of corporate reorganization under Chapter 11. It imposes an "automatic stay" against further legal action versus the city except through the auspices of the bankruptcy court, which oversees such litigation and the city's plan for reorganization. While a corporation has the option of converting a Chapter 11 to a straight belly-up Chapter 7 if there is no hope, a city can't really go out of business since technically it's not in business in the first place, and it can't really simply cease to exist. Otherwise, people living in the city would not be living anywhere, and that violates one or more physical laws, I'm sure.
Cities use Chapter 9, in general, to deal with onerous and unpayable recurring costs (Mammoth Lakes being an exception, as we've seen) such as pensions and muni bond payments. This is what's going on in Compton, for example, and Stockton rolled over for the same reason (that sleepy little Valley town is the largest muni b/k in history, by the way). The bankruptcy court can release a city from its collective bargaining agreements with government employees, thus paving the way for relief from pension payments it can't afford or bond payments it cannot make. Some form of "cram down" can be visited on the unhappy heads of the city's many creditors.
I was thinking that California would be particularly susceptible to muni b/k for a couple of reasons. (You might think of this as a Feynman-style First Approximation, since I've been reading a lot about that remarkable man and his unworldly-smart mind of late.) California has Proposition 13, which sets strict ad valorem limits on real property taxes, a principal source of revenue for the state and local governments. A curious feature of Prop. 13 is that it was originally designed to shield homeowners from runaway assessments on the values of their homes back in the go-go days of the mid-1970's in California, when everyone wanted to live here and houses were appreciating at an astonishing rate.
Essentially, taxes are set at 1% of the house's fair market value. Assessments can only add 2% per year to the tax bill, a constraint on government. It's all written into the state constitution, of course; Howard Jarvis saw to that. I believe a War Between the Worlds is necessary to relieve the state of Prop 13's rules - nothing less. Yet another curious feature of Prop 13 is that it has a yo-yo effect. It can cause assessments to go down as well as up, and there is no "2% per year" limitation on declining real property values. Thus, when the housing bubble popped around 2007, and the first waves of foreclosures hit with all of their distress sales and bank repo action, the bottom fell out of state and local governments. Real property values plummeted and with them that inexorable 1% calculation.
Meanwhile, California's cities and state government had blissfully planned their future based on Jarvis's great fear, that housing prices would always go up, and furthermore that the anomalous period of high capital gains paid during the DotCom boom would represent some kind of permanent bonus for the state treasury.
Alas, no. As with everything else in matters fiscal in the United States, everything depended on sustained growth, growth which is not happening, Quite the contrary. If we strip out deficit spending at the federal level (which has been as high as 10% of GDP), the economy has been contracting as a matter of reality. What kept California afloat during these five years since the bursting of the bubble was ARRA, aid from the federal government to states in particular. All of that money, of course, was borrowed or printed or in some form hallucinated into existence, but now Congress doesn't want to do that anymore, and California faces the icy cold winds of penury without that cover.
A disturbing situation. California tends to lead the way in national trends, after all. The Golden State is saddled with a 2012 budget based, perhaps, on revenues from 1996 valuations, or at least we're gravitating toward that reality. Every time a house changes hands at a price below the value carried on the tax rolls, the state budget takes another hit. Each time a real estate developer applies to downgrade his mid-city skyscraper's tax valuation (permitted under Prop 13, and this is a booming business for lawyers), California goes a little deeper into the red.
The question is how far this will go. Will there be a tipping point? Some dreary prognosticators (such as Mike Shedlock) forecast that it is only a matter of time before a big enchilada like Los Angeles or Oakland files for Chapter 9, since all of the same problems seen in miniature in places like Compton and Montebello are present in Large Format in L.A. and Oakland.
To finish my Thought Experiment: it seems that at the root of this malaise is the natural human tendency to conceptualize the future in terms of what's happening in the here and now. This was unrealistic. Not only did the housing bubble pop, but with its bursting came the knock-on effects caused by the loss of all that notional "equity," the re-fis and equity loans that powered so many of the "discretionary" businesses in the Golden State. It was hard to see all that coming, especially if you're a government bureaucrat running a business that isn't really a business, and it doesn't seem to matter, at the time while you've got the job, whether you're right or wrong.
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