I participated in a recent discussion sponsored by the American Bar Associations' State and Local Government Law Section. The focus was on municipal bankruptcy an increasingly prevalent danger across the United States.  The moderator was Charles Blowsher, former Comptroller General of the United States.  He was in the middle of earlier efforts to bailout out New York City. Other participants included: Judge Christopher Klein, senior bankruptcy judge in California, a state with an increasing number of municipalities on the fiscal brink, explained federal and state laws regarding municipal insolvency; Harriet Welch, a law partner at Squire Sanders and bond counsel to San Diego and Los Angeles, talked about the sale of municipal assets as a way of fending off insolvency; Josh Rauh, a Professor at Kellogg School of Management and an expert on public pensions explained why the problem is going to just get worse until states adopt more realistic accounting methods. My job was talking about ways of getting the public involved in working things out before the bankruptcy courts take over and citizens lose control all together.

Municipalities must litigate their way into bankruptcy court.  One city in California paid more than $5 million it didn't have to get into bankruptcy court. The public employee unions in that city spent an equal amount trying to keep the case out of court (for fear that the court would impose reductions in long-standing pension obligations). State laws dictate how municipal insolvency will be handled (and just because a state takes over doesn't mean that it will provide funds to bail out a city). What we are going to do when states go bankrupt, I have no idea.  Under the law, state's are not permitted to declare bankruptcy. Once the federal courts, however, invoke national bankruptcy laws, these trump anything states might want to require.

Why are cities going broke?  They have long-standing liabilities (especially bonds and pension obligations) that haven't been adequately funded for a long time.  Some municipalities in Illinois, for example, are using as much as 15% of their annual tax revenue to cover long-standing pension liabilities. That means they are going to have make horrendous cuts in service levels.  Why haven't they put aside enough money each year so that they could have avoided this situation?  The accounting methods they use (which continue to pretend that they will earn almost 8% annual interest on their investments) are utterly unrealistic.  The gap continues to grow each year.  Some states have just turned a blind eye and kicked the can down the road by permitting municipalities (and state governments) to push this indebtedness off into the future.

Some municipalities are looking for creative ways to raise  new money like selling or leasing municipal assets (e.g. parking lots, zoos and other facilities).  While this may offer temporary relief, it won't fill the gap in the long term.  Why don't these communities raise the taxes they need to pay their bills?  Because no politician wants to vote for higher taxes in a down economy (or any time, really).  And, if given a chance to vote, citizens will rarely choose to raise their taxes, especially when unemployment is high and job security is low.

So, what's the answer?   I suggest it's NOT declaring bankruptcy.  Once the court takes over, the judge will just liquidate assets and cut back everything and anything.  The court is not empowered to raise taxes. It might liquidate outstanding bonds at a few cents on the dollar, but I wouldn't want to be that community going forward when it no credibility left in the bond market. And, while the court may not be able to reduce past pension obligations (because they are protected by state law), it can certainly refuse to offer future pension benefits to new public employees.  Of course, whether police, firemen, teachers or others would ever want to work in such a place in the future is not clear. And, slashing expenditures in this way can create a death spiral.  Massive cutbacks in services reduce property values almost immediately.  A loss in property value reduces property tax revenue going forward. And, the downward spiral continues.  So, cities that think they can handle insolvency by declaring bankruptcy better think again.

What's the alternative?  In some states, like Massachusetts, the governor can step in and appoint a receiver to take over the management of the city.  While this doesn't solve the underlying problems, it does put someone in charge who isn't worried about getting re-elected or satisfying various constituencies. Of course, from a resident's perspective, who wants some non-accountable bureaucrat making decisions about what services and expenditures will be cut and which will be saved?  It would be better if local leaders organized an ad hoc municipal management task force and asked this group to make a last ditch effort (once the red flags about forthcoming insolvency have been raised) to come up with a cut-back plan that citizens can get behind.  The four key ingredients are:  a professional mediator to help identify the relevant stakeholders and manage the problem-solving conversation in a non-partisan way way; a joint fact-finding process that gives a large stakeholder panel access to a range of technical advisors; a transparent and accountable process that invites citizens, employers and public agencies to follow what's happening on-line every step of the way; and a binding referendum on a negotiated package that will give political legitimacy to whatever informed agreement is reached.   Mediation of this sort should be paid for by the municipality. It will cost a lot less than the legal fees involved in litigating a case into bankruptcy court.  If such a group fails to reach agreement within a reasonable time, all the usual legal maneuvering will then begin.

The "ugly truth" I learned from my participation in this panel, is that bankruptcy is the worst possible solution to municipal insolvency. Cities and towns in trouble need to take action before they are at the edge of the precipice. Very few elected officials will address forthcoming insolvency problems in a useful way unless they are pushed by the electorate to do that.  And, most residents and business owners are inclined to lobby only for what they think will help them, rather than for what will be in the community's long-term best interests.  So, it will take concerted leadership by non-elected interests to initiate the mediation of impending municipal bankruptcy.  Get with it citizens, you know what you need to do do.

This blog entry was originally published on Lawrence Susskind's blog The Consensus Building Approach.