The same officials that controlled the municipality prior to the filing continue to run it, and the bankruptcy court has no authority to intervene or to deviate from their authority. Note that since the bankruptcy process changes nothing in the locality's political structure. Therefore, the incentives that promoted local spending and caused the bankruptcy to begin with, remain in force.
This explains why municipalities that file for Chapter 9 tend to return to insolvency after only a few years. The city of Mack's Creek, for example, filed for bankruptcy in 1998, then for a second time in 2000, and then it contemplated a third bankruptcy in 2004. The city of Westminster, Texas filed on 2000, and only 4 years later filed again. The city of Prichard, Alabama filed for bankruptcy at the end of 1999, came out of the bankruptcy only in 2007, and now, talks of a new bankruptcy filing has resumed. Without addressing the cities' core problems, the bankruptcy filing offered no help, and the cities' situation quickly deteriorated again.
The weakness of the municipal bankruptcy process was the reason for Connecticut's objection to Bridgeport's bankruptcy filing in the 1990s. Back then Bridgeport suffered from a severe economic crisis. The city projected a $16M budget deficit for the years 1991-1992, and its residents were burdened with the highest effective tax rate in the state. Bridgeport was unable to finance an adequate level of public services, and even basic services, such as police protection and street cleaning, were not properly provided. Hoping to escape financial disaster, in 1991 the city filed for bankruptcy. The state of Connecticut, however, objected. The state officials did not believe a bankruptcy court to be the proper venue to solve Bridgeport's problems, and they understood bankruptcy could do more harm than good.
Not only is Chapter 9 an unsuitable mechanism for helping distressed localities, but it may very well aggravate their situation. First, bankruptcy filing harms the city's reputation as a place for residence. A bankrupt municipality is associated with poverty and misery, and this image deters businesses and individuals from locating in the city. Bankruptcy, with its uncertainties and stigma, decreases real estate prices and stifles economic activity and investments in the city. Instead of creating growth, bankruptcy may shrink the local tax base and hold the city's development back even further. Second, bankruptcy damages the city's reputation as a debtor. The creditors, harmed by the city's debt load, are reluctant to extend the city any more credit, and the city's credit rating may suffer for long period of time. Bankruptcy, therefore, vastly escalates the city's costs of borrowing, and it can block the city's access to the credit markets altogether. Indeed, bankruptcy filing jeopardizes the very resources the city needs in order to recover -- additional taxes and credit. The city may come out of the filing with less debt, but also with fewer prospects for the future.
Moreover, a municipal bankruptcy filing can produce negative implications for the state. States have a tremendous impact on the financial condition of their municipalities, and they largely influence both the local revenues and expenditures.
Due to this strong link between the state and the local economies, a default or bankruptcy filing of one municipality raises concerns about other adjacent municipalities in the same state. A local crisis may be the result of general state policies toward local governments, and it shows that the state does not take the necessary measures to maintain the fiscal health of its municipalities. The crisis, therefore, although seemingly an isolated local event, may be a sign for more widespread crises in the future, and may cause the creditors to re-evaluate the risk associated with public debt in the entire state. These concerns increase the price of credit for all public issuers in the state, even for those issuers that have no direct connection with the city's default. This claim received empirical support in various studies on the effects of the Orange County, CA bankruptcy.
Studies show that the county's bankruptcy had significant conspiring effects on the entire municipal bond market, and especially on public issuers within California.
Following the bankruptcy, there was a considerable decrease in the value of many municipal bonds, even in bonds that were issued by local governments and other public bodies that had no direct exposure to Orange County's crisis. The claim also echoes the positions of states with regard to municipal bankruptcy filings. Many states object to Chapter 9 filings, and one of the main reasons state officials provide to support the objection is the effect bankruptcy might have on other public issuers in the state.
Municipal bankruptcy filings, states fear, will have adverse effects on the credit markets all over the state, and they do not want to incur these costs.
This analysis on the effects of municipal bankruptcy sheds light on the data on municipal bankruptcy filing that was described earlier in the paper. First, it explains why there are so few bankruptcy filings to begin with. If Chapter 9 offers little in the way of rehabilitation, but it aggravates the city's economic situation, then it is not surprising that many distressed cities prefer not to file. Second, the analysis explains why most states object to municipal bankruptcies even when a distressed city is inclined to file such as Camden, NJ or Bridgeport, CT. As opposed to a city, a state internalizes all costs and benefits associated with the filing. It takes into account not only the bankruptcy's effects on the city, but also the bankruptcy's effects on the municipal bond market in the state as a whole. Since, as we have seen, the benefits of the bankruptcy, especially in the long-term are small, whereas the costs to public issuers can be substantial, states often object to municipal bankruptcies. Third, the analysis clarifies why cities that do undergo bankruptcy have the special characteristics, such as, they are extremely small, and entered the crisis due to a one-time unexpected financial calamity. Under these extraordinary circumstances, Chapter 9 can help the city recover, because the municipality essentially suffers from liquidity problems for a long time. The bankruptcy relieves the city's debt burden created by the single exogenous event, and since the city does not suffer from structural systemic problems, it can thereafter continue to function properly. In addition, in such cases, because of the city's small size, and the extraordinary circumstances of the filing, the effects of the bankruptcy on the bond market are narrower.
Placing the rare cases of small localities aside, it is now clear why Chapter 9 cannot provide a solution for local economic crises. As opposed to Chapter 11, Chapter 9 does not benefit the creditors, and, as opposed to common wisdom, it also does not benefit the municipality or the state. Indeed, Congress's underlying assumption in the 1976 legislation that municipal bankruptcy protect should track along with corporations is mistaken. A municipal corporation is different from a commercial corporation, and the corporate bankruptcy's logic collapses when applied to municipalities. A bankruptcy process that focuses on the readjustment of debt may be sufficient to help a financially distressed commercial corporation with the exception of liquidation problems which prevent the municipality from properly function in the market place for long periods of time. It is still not sufficient to help localities that suffer from systemic problems that are associated with grand social economic processes and political structures. These localities are in need of a more pervasive and in-depth recovery process - a process that the Bankruptcy Code, at least in its current form, does not contain.
Orange County, CA Bankruptcy
Going into more detail on the Orange County, CA filing is particularly interesting because at first glance the county's financial troubles seem isolated and unrelated to the financial situation of other adjacent municipalities in the state. The bankruptcy occurred due to bad investments made by the County's treasurer. By the way these investments were made without the state's approval and without proper financial disclosure. However, a closer look at the circumstances surrounding the crisis does reveal a connection between the crisis and the state's general local policies. The origin of the Orange County bankruptcy can be traced back to the approval of California's proposition 13. Proposition 13 imposed limits on property tax increases, and had a significant effect on the local governments' revenue by way of taxes. Orange County lost a significant portion of their revenues, and as a result they were in a frantic search for new non-tax revenues to replace the lost revenue. This caused the treasurer, as well as other local government officials, to invest in risky investments, so as to make up for the lost revenues. The assumption of these risky investments as well as the dwindling revenue stream led to the municipality's bankruptcy.
So if the rehabilitation of distressed municipalities can be better achieved through state intervention actions, and if Chapter 9 filing has adverse effects on…