The Stockton Bankruptcy Effect

Today, a judge declared that Stockton can file for bankruptcy protection, in spite of creditors' vehement protests.

This case brings to the forefront the fact that bankers are fiduciary and equally responsible for the borrowers' ability to pay back the borrowed money. When I owe money to a financial institution it needs to factually endorse my ability to pay the loan -they granted- back.

In Stockton's case -and over many years- bond holders have agreed to provide loans -by buying the bonds the City issued- to the City of Stockton either 1) because they were lied to about Stockton's financial state or 2) because they were expecting to get a good return, regardless of Stockton's ability to pay the money back (they thought that Stockton could just increase local taxes at will).

Certainly, creditors cannot claim reason #1 above as they would look totally incompetent. As far as for reason #2 the City has the right 'to penalize' its creditors by, perhaps, not paying them back fully.

Cities should not be able to easily have access to credit unless they develop certain/new revenue streams able to pay for the loans at the time of loan engagement. 

Creditors should not buy any municipal bonds until cities show clear ability to pay the loans back.

The Stockton bankruptcy effect dictates that the municipal interest rates will go up rather quickly, unless the Fed or Congress intervene. When municipal bond rates go up cities will first need to slow down their increasing costs (a majority of increases are retirement costs associated with their current and former employees) and the sooner that happens the less pressure we will see on new taxes.

Hopefully, the Stockton effect will encourage both creditors and cities to be more realistic in terms of expectations during the engagement and execution of financial transactions.

There is absolutely nothing wrong with some large municipal bankruptcies and we need to see a few more of these before the municipal bond rates reflect the true difficult financial realities many cities, counties, and municipalities are facing.

Markets do reign supreme, after all, and creditors cannot be kept far away from their own mistakes.

Denver (MI), Jefferson County (AL), and San Bernardino (CA) are all coming up next.