Muni Threat: Cities Weigh Chapter 9

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Just days after becoming controller of financially strapped Harrisburg, Pa., in January, Daniel Miller began uttering an obscure term that baffled most people who had never heard it and chilled those who had: Chapter 9.

The seldom-used part of U.S. bankruptcy law gives municipalities protection from creditors while developing a plan to pay off debts. Created in the wake of the Great Depression, Chapter 9 is widely considered a last resort and filings under it are more taboo than other parts of bankruptcy code because of the resulting uncertainty for everyone from municipal employees to bondholders.

The economic slump, however, is forcing debt-laden cities, towns and smaller taxing districts throughout the U.S. to consider using Chapter 9. As their revenue declines faster than expenses, some public entities are scrambling to keep making payments on municipal bonds. And that is causing experts to worry about the safety of securities traditionally considered low risk.

"People believe that municipal debt is safe based on assumptions that are no longer true," says Kenneth Buckfire, managing director and chief executive of Miller Buckfire & Co., an investment bank that has worked with corporations on restructurings and now is advising municipalities. For example, it isn't safe to assume that governments can raise taxes to cover shortfalls, he says.

Even threatening bankruptcy signals that municipalities are willing to compromise the security of bondholders, says Richard Raphael, an analyst at Fitch Ratings. That makes it harder for cities and towns to raise money from investors and will slow the U.S. economic recovery.

In Harrisburg, which is Pennsylvania's capital and has a population of about 47,000, a March 1 deadline is looming on a payment of $2 million out of the $68 million due this year for the financing of an incinerator plant. The facility has about $288 million in overall debt.

"Bankruptcy is inevitable," Mr. Miller says. "We are in a terrible bind." A budget passed Saturday by Harrisburg's city council didn't include any funds to cover the debt payments, according to the city clerk's office.

Harrisburg Mayor Linda Thompson, a Democrat elected in November, opposes a bankruptcy filing and has presented an emergency plan that includes selling some of the city's assets. She couldn't be reached for comment. A spokeswoman for the mayor says Ms. Thompson is working on the plan.

Michele Torres, executive director of the Harrisburg Authority, which oversees the incinerator plant, says there are sufficient reserve funds to make the March 1 payment to bondholders. But that doesn't fix the problem. "No matter how perfect the facility runs, it just can't generate enough … to meet the $288 million debt," she says.

Since Chapter 9 was enacted in 1934, just 600 cases have been filed under the code, partly because they require state approval. Some municipalities have found escape hatches, such as raising taxes. The largest Chapter 9 case was filed in 1994, when Orange County, Calif., lost $1.6 billion on wrong-way bets on interest rates.

But many experts fear that a surge in municipal bankruptcy filings is unavoidable. "The day of reckoning is coming," says Michael Pagano, dean of the University of Illinois at Chicago's College of Urban Planning and Public Affairs.

To keep cities and towns from toppling into Chapter 9, more states are likely to make use of state laws to assume oversight of financially distressed municipalities, he predicts. Pittsburgh, for one, has been operating under such a law since 2004.

Vallejo, Calif., a city of about 116,000 people near San Francisco, has been trying to rejigger worker contracts in bankruptcy court since it filed for Chapter 9 in 2008, after buckling under declining real-estate values. Some union contracts expire later this year, and Vallejo is attempting to scrap them and start over.

In San Diego, political leaders have faced outside pressure to file for Chapter 9 bankruptcy protection as a way to get around benefits packages for public workers. San Diego Mayor Jerry Sanders has publicly dismissed the idea.

Last month, Las Vegas Monorail Co., a nonprofit with over $600 million in municipal bonds, filed for Chapter 11. The company runs a 3.9-mile monorail system along the Las Vegas Strip that has been hammered by the downturn. Ridership shrank 21% last year from 2008. According to Fitch, while the monorail is covering its operating costs, default "is virtually certain" on a payment due in July.

Ambac Assurance Corp., the bond-insurance unit of Ambac Financial Group Inc., is seeking to have the case converted to a Chapter 9 proceeding. The insurer contends that the company is akin to a municipality. A judge is set to decide on the petition later this month.

Sandy Hoskins, interim chief executive of Sierra Kings Health District in Reedley, Calif., worked for nearly 30 years as an auditor and financial consultant. He says he never heard of Chapter 9 until October, when Mr. Hoskins filed a bankruptcy petition for the hospital system. "There was no other way around it," he says. With low cash balances, "there were vendors not even willing to do business with us. It was a critical situation."

Mr. Miller, Harrisburg's controller, also sees no way out of the financial squeeze. The city's per-capita debt of $9,500 is the highest in Pennsylvania and triple the debt load of Philadelphia, he says. And selling parking facilities or other properties in a fire sale would cost Harrisburg future revenue. A spokesman for Pennsylvania Gov. Edward Rendell says Harrisburg hasn't sought help from state officials.

"We can't raise taxes; they're already very high," Mr. Miller says. "If we did, people would just leave. It's cheaper to move out to the suburbs."