Hercules, California’s Herculean debts

What lead the city of Hercules, California to default on its debts? Guest poster Marc Joffe, Principal Consultant at Public Sector Credit, finds a case of mission-creep in the “dynamic city on the Bay’s”  decision to issue debt to finance power plants and affordable housing.

(For more of Marc Joffe’s research on modeling credit risk, read his 2013 Mercatus Working paper comparing Illinois and Indiana)

Hercules, California Public Power Failure Leads to Default

by Marc Joffe

Cities can default on obligations to their creditors without filing for Chapter IX bankruptcy protection.  This is the lesson of Hercules, California – a 25,000-resident San Francisco suburb whose finances are not quite as mighty as its name implies. Hercules experience is also illustrative of the risks that cities take when they expand beyond their core functions of public safety and public works.

The city is threatening to default on $12.8 million of municipal bonds as early as this August.  In a tender offer issued earlier this month, Hercules offered holders of these bonds 90% of their securities’ face value. According to the bondholder notice, “If an insufficient number of bonds are not tendered, the City anticipates it will soon default on the bonds.” Offering bondholders 90 cents on the dollar in order to avoid facing the risk of non-payment is, for all intents and purposes, a default.

In fact, it is the city’s third default in recent years. In 2011, Hercules failed to repay a $3.75 million loan from the California Housing Financing Agency (CHFA). The state loan was intended to support a mixed use development Hercules planned to build. The development, which included a large affordable housing component, was stymied by neighborhood opposition to low income housing and the City’s inability to acquire a portion of the intended construction site from a nearby homeowner’s association. Earlier this year, Hercules sold the site to a developer who plans to build market rate housing. It has also agreed to repay the CHFA loan in installments through 2026 at a reduced interest rate.

Hercules’ second default occurred on February 1, 2012, when it failed to make a $2.4 million interest payments on Redevelopment Agency (RDA) bonds. The default was absorbed by Ambac, the agency’s municipal bond insurer. Ambac filed suit against the city claiming it had failed to remit RDA related property tax collections to the bond trustee as required. In March 2012, Ambac and the City settled the litigation with the City pledging two parcels of land to the insurer. The City further agreed to place these two properties on the market, apparently to offset the $4.05 million property tax remittance the city had failed to make earlier.

The most recent default (or, more euphemistically, the current tender offer) involves bonds issued to finance a failed public power scheme. In 2001, the City established a public power company – the Hercules Municipal Utility (HMU) – on the assumption that it could replace the area’s for-profit utility, Pacific Gas & Electric (PG&E). The expectation was that HMU would generate a similar rate of profit to PG&E, but under public ownership, those profits could fund other city spending priorities. Unfortunately for Hercules creditors and taxpayers, things did not work out as planned.

In a 2011 expose, the Huffington Post reported that HMU was serving only 840 customers, charging rates 17% higher than PG&E and had lost money in every year since its 2003 inception. In 2010, the City issued $13.5 million in new bonds to finance HMU, but the proceeds were never invested. Now the City has agreed to sell its power plant to the local utility – Pacific Gas & Electric. Unfortunately, PG&E’s bid was insufficient to retire the $12.8 million in 2010 bonds still outstanding and (for reasons discussed below) the city lacks reserves that could be used to fully redeem these remaining bonds. Thus the need for a 90% tender offer.

Municipal bond analysts often assess a city’s fiscal well-being by reviewing its audited financial statements. Unfortunately, Hercules routinely files its audited financials on a delayed basis. Currently, the latest available statements for Hercules are for the fiscal year ended June 30, 2011. Many California cities have already filed their 2013 audits. The failure to file audited financials on a timely basis is part of a larger financial management issue in Hercules. In May and November 2012, the State Controller’s Office issued three audits highly critical of the city’s fiscal controls. One report “found the City of Hercules’ administrative and internal accounting control deficiencies to be serious and pervasive.” These insufficient controls may explain why RDA tax revenues could be directed away from debt service, thereby subjecting the city to costly litigation.

As shown in the accompanying table, Hercules has persistently run large General Fund deficits since 2008.  The city’s inability to balance its books has resulted in the depletion of its financial reserves. According to Hercules most recent budget, the city had a negative unassigned General Fund balance at the end of FY 2012 and FY 2013, meaning it had no reserves that had not already been earmarked for one purpose or another. Despite having borrowed over $150 million, the city thus lacked liquid assets to cover contingencies.

Hercules fiscal straitjacket appears to be the result of government overreach. Instead of focusing on efficient delivery of basic services and providing effective financial oversight, City leaders ventured into enterprises attractive to many of their Progressive constituents: publicly owned power and publicly-financed affordable housing. Lacking the skills to properly manage these undertakings, city leadership squandered large sums of borrowed money and ran down their financial reserves. The result for Hercules will be years of higher taxes, subpar real estate performance and reduced access to the municipal bond market.