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Watch Video about Vallejo's Bankruptcy

[HOT: We include this article to highlight the economic consequences for entire neighborhoods and towns due to substandard construction and resulting mortgage foreclosures.]

Vallejo is broke. The picturesque city of 121,425, situated between San Francisco and Sacramento along the California coast, was forced to seek bankruptcy protection last year, another casualty of the deepening global recession. Now boarded-up storefronts with "For Rent" signs dominate Georgia Street and other tree-lined thoroughfares. Newly built developments on the outskirts of town largely sit empty. And no one has an answer for how to fill them.

The dramatic downfall of this once-bustling community offers a glimpse into the growing fiscal burdens faced by cities and towns across the U.S.-and shows how rapidly dwindling public tills might be weakening the broader economy even more. Vallejo's desperate financial maneuvers, including a bid to wiggle out of union contracts in bankruptcy court, could point the way for other municipalities as the recession grinds on. "We're watching a train wreck unfold [in American cities]," says Donald J. Boyd, a senior fellow at the Nelson A. Rockefeller Institute, a public policy think tank in Albany, N.Y.

LITTLE RELIEF

For the first time in recent memory, states and cities are suffering simultaneous declines in income, property, and sales tax receipts. In Vallejo, property and sales tax revenues are expected to drop by 7% this year. "There's not enough money to go around," says Mayor Obsy Davis, a 63-year-old lawyer who has lived in the community most of his life.

Vallejo isn't alone: Plunging receipts have made it difficult for some 92% of U.S. cities to pay for basic services such as utilities, infrastructure, and public safety, according to a survey by the National League of Cities (NLC).

State and local governments, in many cases bound by law to balance their budgets, are responding the only way they can: by cutting services, laying off government employees, and raising taxes. To help make up a $42 billion budget shortfall, for instance, California lawmakers recently approved $12.5 billion in tax hikes, including raising sales and income taxes and nearly doubling the tariff on cars.

Local troubles could exacerbate the national downturn. State and municipal governments make up 13% of gross domestic product. "If [they] go south, it has the same impact on the economy as any other big industry," says Christopher Hoene, the NLC's director of policy and research.

Sure, states and cities will get some relief from the $787 billion stimulus package signed by President Barack Obama on Feb. 16. But that lifeline will go away in two years. "In the longer term, state and local governments will continue to feel pressure," says Nick Samuels, a senior analyst at Moody's Investors Service (MCO).

One historically cheap source of capital, the $2.7 trillion municipal bond market, isn't providing much help. Fears of fiscal calamity are prompting muni bond investors to demand higher interest payments, making it more expensive for states and cities to issue new bonds-if they're lucky enough to find buyers. "It's hard to get away from picking up the paper and reading about a budget issue somewhere," says Hugh McGuirk, who heads the muni bond department at mutual fund firm T. Rowe Price (TROW). Interest rates on munis are now higher than those on U.S. Treasury bonds, a highly unusual situation, since investment income from munis is tax-free.

BOOM BATTERED

For much of its 150-year history, Vallejo was a blue-collar town dominated by the U.S. Navy's ship-and-submarine yard on the eastern edge of San Pablo Bay. In 1996 the Navy closed the base, eliminating thousands of well-paying jobs. As the city struggled to replace those positions, the seeds of the real estate boom began to sprout-masking Vallejo's underlying problems.

Like many U.S. commuter towns, Vallejo prospered over the past decade by attracting middle-class professionals looking for a slower pace of life and a lower cost of living. Bay Area transplants flocked to Vallejo, 35 miles north of San Francisco, to remodel charming old Victorian homes or buy big new houses in upscale developments. National retail chains and local entrepreneurs set up shop to cater to them. PGA legend Arnold Palmer even built an 18-hole golf course there.

But another group of opportunists descended on Vallejo, too: subprime lenders who targeted the city's blue-collar population. Risky loans accounted for 37.5% of all new mortgages at the peak in 2006, according to the advocacy group National Community Reinvestment Coalition. Easy lending helped inflate the bubble: From 2003 to 2006, the median price of a single-family home in Vallejo jumped from $270,000 to $450,000, says research firm MDA DataQuick.

Over the past two years, Vallejo home prices have dropped 57%. In January lenders moved to foreclose on 569 properties-roughly 1 in 90 homes, among the highest rates in the country, according to data firm RealtyTrac. Jean Stacy Buffin, who works at a local nonprofit, has had to move four times in the last 31/2 years as her landlords have lost one property after the next. Her last landlord sold the three-bedroom Spanish-inspired home she was renting for less than he owed on the mortgage. "It's a beautiful home," says Buffin. "Now it's someone else's."

PRICEY POLICE FORCE

The real estate bust is only part of Vallejo's fiscal woes. During headier times, city officials agreed to lavish pay packages for unionized workers. Even after pay cuts in January, the average police officer still makes $106,000 in salary, plus $63,000 in other benefits. The municipality is also on the hook for $135 million in retiree medical benefits, but it has saved nothing.

The city is trying to renegotiate key union contracts in bankruptcy court. If it's successful, other municipalities, including nearby Rio Vista, could follow Vallejo's lead and file for bankruptcy, in part to escape union contracts. "I doubt cities have experienced this kind of revenue reduction in one year, ever," says Michael A. Pagano, dean of the College of Urban Planning & Public Affairs at the University of Illinois at Chicago. "Part of what they're confronting is union contracts they can't afford. Are they watching Vallejo? Absolutely."

Meanwhile, the local economy continues to weaken. At the Gateway Plaza shopping center just off I-80, the main highway through town, two of the anchor stores have liquidated: Linens 'N Things and Shoe Pavilion, two retail chains that filed for bankruptcy last year. A Mervyn's department store has also closed its doors. Foster Lumber Yard, in business since the 1940s, is struggling to survive. Sales have fallen off a cliff, says Dave Jones, who inherited the lumber yard from his father. "I feel like I've got all of my eggs in one basket, and there's no way to get the eggs out of the basket," he says.

The city's cost cuts make the task of reviving growth more difficult. Vallejo eliminated two positions for business permit coordinators. It can't afford a full-time employee to assess construction plans, either. That means new projects and even remodeling jobs have to be reviewed by out-of-town consultants, which can add four to six weeks to the process, says Fred Sessler, a local commercial real estate broker. "They're shooting themselves in the foot," says Gary Morris, a local developer. "You don't fire the guy at the cash register."

With business slowing, Morris says he has laid off 10 employees. He did some work on his latest project, a family-friendly steakhouse with seating for 400. But he has put the project on hold until the economy picks up.

The owner of the local Chevrolet dealership, Kenny Ross, doesn't know whether the national or the local economy is hurting him more. Ross has had problems borrowing money to finance his business, and terms are getting tougher. He is trying to use the bankruptcy to his advantage-if only modestly. Ross wants the county to reduce the property taxes on his 20 acres of land, which have dropped in value. Says Ross: "It's still ugly out there."

To see a video report on how Vallejo's bankruptcy has affected the city's businesses and residents, go to www.businessweek.com/go/09/vallejo.

Nanette Byrnes, Business Week, 02/26/2009
Source: http://www.businessweek.com/magazine/content/09_10/b4122052964412.htm

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