Three Decades After Cleveland Defaulted on Its Debts, Cities Face Recession Budget Woes

Today, facing a deepening downturn, many cities are struggling to avoid default—or even bankruptcy.

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Struggling to emerge from the results of a recession and massive auto industry layoffs, Cleveland became the first major American city to default on its debts since the Great Depression, 30 years ago today.

The city owed $15.5 million, mostly to six banks, which stayed open until midnight on Dec. 15, 1978, to see if an agreement could be reached. None could. The resulting fiasco torpedoed the city's credit rating, which Moody's Investor Service had labeled with a healthy "A" just six months earlier.

The default ended 22 months later, and only when the mayor persuaded the banks to extend the loans. And then there was the remaining $111 million budget deficit.

Historically, cities rarely default on loans. Rarer still are city bankruptcies, despite Vallejo, Calif.'s much-publicized May filing under Chapter 9, the section of the bankruptcy code that applies to municipalities. And such moves usually stem not only from a financial downturn but from each city's particular situation—from whether the budget has balanced in the past to how willing leaders are to make the politically unpalatable move of raising taxes.

As today's economic crisis deepens, however, so will its impact on cities. In fact, experts say municipalities will feel the recession's full effect slightly after businesses and industries. Even if they do not declare bankruptcy outright, more cities might default on their loans in the coming months.

But before any of that, experts say, expect budget cuts. Lots of them.

"Hopefully, you maintain essential municipal services," says James Spiotto, a leading government bankruptcy attorney. "But we may have to define what we mean by essential municipal services."

Some cities already are. In San Francisco, city officials announced last weekthat the current year's budget will have to be slashed by $71 million. Proposed cuts include laying off 400 of the city's 28,000 workers, halving appropriations to the San Francisco Opera, Ballet, and Symphony, shutting a seniors' day-care center, and eliminating $5.3 million in mental health services.

The next day, a new announcement came: On top of that, the city would have to cut next year's budget by another $144.7 million, or 12.5 percent.

The real signifier of municipal woes, however, is the public safety budget, says Chris Hoene, director of policy and research at the National League of Cities. "Whenever you see public safety get cut, you know that the situation has turned dire for those places," he says.

If so, that's already the case for some cities and towns. Phoenix, for example, currently has a budget deficit of up to $250 million. As it's a growing city, its public safety budget should be increasing, too. But the city's mayor, Phil Gordon, says that he's overseeing the first cuts to the public safety budget made during his tenure.

Equally worrying, says Ben Harris of the Brookings Institute, are cuts to services for people most affected by the economic downturn, such as those in low-income brackets.

When budget cuts can't seem to go much deeper, or when a municipality simply doesn't want to make them or raise taxes, says Spiotto, filing for bankruptcy can be tempting. "It's attractive: 'I don't have to pay people; they can't file lawsuits against me,' " he says. "But like any other narcotic, this sort of euphoria that comes at the beginning—as it wears off, in reality, there's real pain."

The move can ruin a city's credit rating, which it needs to take out loans—loaning money is the usual way for a municipality to cover costs and projects. Chapter 9 filings don't erase debt, but only adjust it. Then, there's the image problem.

"It affects not just creditworthiness but the perception of life in the city and the economic vitality of the city for years and years to come," says Mark Baldassare, president and CEO of the Public Policy Institute of California and author of When Government Fails: The Orange County Bankruptcy.

Those factors all account for the rarity of Chapter 9 filings. Even Cleveland narrowly avoided filing for bankruptcy in 1978. Since 1980, there have been approximately 40 bankruptcy filings by cities, villages, or counties, and only another 150 or so by other municipal entities, like utility or hospital districts.

Updated on 12/15/2008