Peter Pays Paul

California’s cities may be some of the biggest casualties of the real estate bubble:

RIO VISTA, Calif. — California may soon have more bankrupt towns on its hands.

The city of Vallejo, Calif., gained national attention earlier this year by filing for Chapter 9 bankruptcy protection. Now, two neighbors are fighting to avoid the same fate, as the state’s economic crisis spreads.

More California Towns Face Bankruptcy

City Income

Many of the cities and towns in California derived a major portion of their income through two sources.

First, fees paid by developers to expand the city and tap into existing services. As the housing market took off developers could afford higher fees. Cities realized this and decided to charge higher fees.

The second major source of income is property taxes. Since the passage of Proposition 13, California homeowners only experience a significant bump in tax revenue when a home sells or when additions are made to it.

During the wild and woolly days of the housing bubble, houses were selling fast and property values were skyrocketing. Cities saw their incomes increase as they collected more and more property taxes.

Political Wisdom

As a model to other Americans, the city politicians realized that a greater income should not go to waste. “We have more revenue therefore we should spend more money. And we should project to spend more money each year into the future,” these wise politicians said.

The wily politicians noted that to fuel demand for housing, their public services should be top notch. In order to attract the best and the brightest police force and firefighters the politicians decided to promise them the moon.

City Expenses

So the police and firefighters received great salaries and great benefits. Some of the cities could not afford their own pension plan, so in order to attract qualified public servants they joined up with the California Public Employees’ Retirement System (CalPERS). The city’s cost of joining CalPERS was less than the cost of offering a similar retirement guaranty independently.

Municipal police and firefighters often have contracts with guaranteed pay increases.

Now that the housing madness has cooled, city revenue has not grown. However, city expenses, related to salaries, are increasing. [Begin Sidenote: Sounds like the auto industry. End Sidenote] In many cases city revenue may actually fall. As housing prices fall, tax payers can ask for a reassessment of their taxes which may lower their tax burden.

This powerful combination of flat or falling revenue and increasing expenses is forcing some cities, like Vallejo, to file chapter 9 bankruptcy.

Insult to Injury

Let’s return to CalPERS:

Pacific Grove, a coastal town south of San Francisco, already faces a budget crisis. Now losses by California’s giant pension fund could make the pain worse.

“Calpers could bankrupt us faster than anything else,” says Mayor Dan Cort. City officials say other towns face financial stress unless the California Public Employees’ Retirement System is able to quickly recover from its investment losses.

Calpers Losses Add to a City’s Stress – WSJ.com.

Since July CalPERS has lost almost 25% of its value. This marked loss limits its ability to pay current and future employee retirement guarantees. In order to make up for the short fall, CalPERS may charge cities more in the future in order to recoup and adjust for the losses.

Coming Full Circle

CalPERS has been in the news lately for losing tremendously on investments in, wait for it. You guessed it residential real estate. Ouch!

The cities and CalPERS made bets that real estate would continue to go up. Now they are paying the price for foolish planning.

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