By Michael Aneiro

With three California cities opting to file for bankruptcy protection within the past month, many are worrying this could open the floodgates to more municipal bankruptcies. But Citi strategists say the bankruptcy option still brings enough stigma and costs to deter other troubled cities.

Citi notes that the cases of Stockton, San Bernardino and Mammoth Lakes are more or less outliers, with typical municipal issuers tending to be much more financially disciplined. But other California issuers share similar problems, such as weak revenues from property, sales, and personal income tax, as well as high employee salary and pension fixed costs. Citi says California’s Proposition 13, which caps property taxes, has also hamstrung the state.

As this week’s Barron’s wrote, some market observers worry that there’s suddenly less stigma associated with filing for Chapter 9 bankruptcy, the muni equivalent of Chapter 11, which could encourage its use by other cities facing revenue shortfalls and heavy debt loads, or as a tool to renegotiate collective bargaining agreements. Not so fast, argue Citi strategists George Friedlander, Mikhail Foux and Vikram Rai:

We strongly disagree with this view and caution against this option as the cost of a chapter 9 filing remains harsh, with a near-certain lockout from access to capital markets, high litigation costs, and an uncertain outlook for governments and governmental employees once the Bankruptcy judge takes over. Access to capital markets to fund cash flow shortfalls (via BANs/RANs/TRANs) remains critical for maintaining key government functions and continuation of essential services. 

Citi says the spotlight has now shifted to Fresno, Calif., which it says also suffers from a high fixed costs and limited financial flexibility, as well as “excessive exposure” to a fragile economy. While the city has a well-funded pension plan, Citi says its revenue options are limited, forcing an over-reliance on spending cuts at a time when most services are already reduced. Moreover, Citi says long-term labor contracts with the police union have locked in compensation costs “at a level that no longer appears sustainable” amid weak revenue performance.

Despite all this, Citi notes that yields on California state general obligation bonds have yet to show any impact. Citi adds that fears of contagion remain limited and any market impact should remain isolated to weaker credits with specific budget shortfalls. More from Citi:

We believe that contagion on overlapping credits such as counties, school districts revenue bonds backed by “special revenues” resulting from the association with the problem credits could create some attractive values. Both market psychology and rating agency actions on these associated credits could cause trading levels to weaken in a number of cases, despite the likelihood that these credits will generally maintain their capacity to pay debt service.