While concerns about municipal credit quality have occasionally surfaced, municipal bond defaults have remained exceedingly rare within the investment-grade segment of the market. And that reality has not changed, despite three California municipalities recently moving toward, or filing for, Chapter 9 bankruptcy protection.

The fiscal distress in Mammoth Lakes, Stockton, and San Bernardino shares some familiar themes with the few bankruptcies that emerged in prior years, such as those in Harrisburg, Pennsylvania, and Vallejo, California. Whether these themes relate to a specific issue, such as an unfavorable legal judgment, or idiosyncratic structural issues, such as unusually high unemployment rates, they should remind investors of the consistent need for portfolio diversification, rigorous security selection, and continuous monitoring in order to avoid pockets of distress within the market.

Although the current economic environment might have contributed to Mammoth Lakes' plight, the town's decision to file for Chapter 9 was precipitated by a single event: a $43 million legal judgment that it lost to a real estate developer.¹ The amount of the judgment is more than twice the size of the town's whole budget for the year. The impact of the ruling is reminiscent of Harrisburg's Chapter 9 filing where a single issue—the malfunctioning trash incinerator—was enough to push an already strained city into bankruptcy. Yet, a major difference between the municipalities is that Harrisburg chose to borrow a large amount of money to pay for the incinerator, while Mammoth Lakes has a minimal amount of outstanding debt and has never raised money for an ill-conceived project.

As a ski-resort center, Mammoth Lakes would find it difficult to generate enough money to settle the legal judgment in a timely manner due to its inconsistent revenues and high unemployment rate. Yet the credit profiles in San Bernardino and Stockton indicate even worse fiscal conditions.

San Bernardino's move toward a bankruptcy filing was swift, yet the city's demographic profile has been on a prolonged slide, to the point where its poverty, unemployment, and crime rates are about double, or higher, than those for the rest of the country and well above those for the rest of California. With an unemployment rate of 17.5%, the metrics for Stockton are also in worse shape than those for the state and the country.

Meanwhile, personnel costs consume about 90% of San Bernardino's and Stockton's budgets. These burdensome personnel contracts are remnants of the cities' dramatic population growth over the previous 10 years, which far exceeded the growth rates at the state and national levels. At the time of this explosive growth, the population surge was expected to continue and may have eventually justified these contracts. But after the collapse of the housing bubble and deterioration of economic conditions, the cities can no longer afford their personnel costs.²

The market's negligible reaction to the recent California bankruptcy filings comes in part because these are only three municipalities out of 482 in California, and they have very little outstanding bond debt. Indeed, the cumulative debt of Mammoth Lakes, San Bernardino, and Stockton amounts to 3 basis points (bps) of the total $3.7 trillion municipal bond market and 15 bps of the $615.2 billion California tax-exempt market. Stockton has the most debt outstanding, at $703 million, of the three cities, and about $233 million of insured bonds are expected to be impaired, which would account for 1 bp of the total market.³

Yet there may be additional effects from these recent filings. Some observers believe that other municipalities, with potentially more outstanding debt, might regard Chapter 9 as an effective way to restructure. And if the stigma of municipal bankruptcies is fading, then it should not be surprising to hear that other, highly distressed entities might also be considering Chapter 9 filings in the current economic environment. For example, the California city of Compton, with its $43 million budget deficit, is said to be considering a bankruptcy filing by September 2012.⁴

Cities contemplating Chapter 9 are also likely to consider the experience of municipalities that have previously filed for bankruptcy. Personnel costs also consume much of Vallejo's budget, and even after three years and $12 million in legal fees, the city continues to face some major fiscal issues that were unaddressed by bankruptcy, such as an increase of about 8% in pension payments in its 2013 fiscal year.⁵

If pressure continues to build at the local level, California could respond in several ways. For instance, municipalities previously had access to excess proceeds at state-run redevelopment agencies, which were recently dissolved by the state. It is currently unclear where these proceeds may end up, so the state could redirect them to cities as a form of financial support. California also has a 2% cap on property tax increases, and while raising taxes could further harm the most strained municipalities, an adjustment to the cap could further assist many cities and towns. In addition, there is a statewide vote in November 2012 on whether to raise sales and income taxes, which, if passed, could also lessen the fiscal pressure within the state.

For investors, the recent bankruptcy filings should emphasize the need for liquidity and the need to thoroughly research each investment, including analysis of local revenue sources, flexibility to raise revenue, population growth trends, and budgetary commitments. Also, investors should be aware that if a city declares bankruptcy, this does not mean that other entities related to the municipality are in similar situations. In San Bernardino, for example, the school district and the transportation authority are not in the same fiscal conditions as the city.

While an objective look at the current state of the municipal bond market should acknowledge that there are pockets of distress, an objective overview should also recognize the strengthening credit profile of the broader tax-exempt market. This improvement includes 10 consecutive quarters of rising state tax collections, reduced expenditures on projects and payrolls, and adjustments to pension plans by 35 states.⁶ Overall, the municipal bond market has successfully handled the tough economic environment, but as with everything, there are exceptions, and investors need to constantly monitor their investments for changes in credit quality.