Insurance experiment a costly lesson for town
December 13, 2004
Gardena near bankruptcy after borrowing millions of dollars to start its own company.
James Sterngold, S.F. Chronicle Staff Writer
Sunday, December 12, 2004
Gardena, Los Angeles County -- It seemed like a good idea at the time.
A little over a decade ago, the small working-class city of Gardena was having trouble getting liability insurance, like a lot of other California towns, and it decided to take the kind of entrepreneurial leap municipalities were being encouraged to consider in those days. It borrowed $15 million and created its own insurance company.
Local officials congratulated themselves not only for fixing the liability problem but, with the profits they expected, for finding a way to make up for the millions of dollars in local property tax revenues the state had siphoned away to solve its own fiscal crisis.
But what looked like bold, market-oriented wizardry has now all but bankrupted this ethnically mixed city of almost 60,000 residents, leaving its future in doubt and making it economically dependent on two large card clubs that provide a less than desirable image. Some residents are wondering how things could go so wrong.
The misadventure has taught people here some bitter lessons on the promise and perils of the marketplace, and, more, it provides an object lesson for other local governments across California also looking for creative ways out of their current fiscal woes.
As it turned out, Gardena's sure bet lost money virtually from the day it opened for business in 1993, city officials say, burning through every penny of the borrowed capital.
"It was structured so poorly, it never worked, ever, at any time," said Gardena's mayor, Terry Terauchi.
Now defunct, it has left this city, already struggling under a weak economy, with a debt that has ballooned to more than $20 million after refinancings -- well, actually more than $26 million if you figure in a disastrous home mortgage scheme that went south, but that's another story.
Oh, and repayment is due Wednesday, an impossible burden for a city with barely $3 million in reserves and an annual budget of slightly more than $30 million.
Some city officials talked about filing for bankruptcy when Gardena got a last-minute, if temporary, reprieve. Two weeks ago, the banks gave the city another six months to work out a solution, still a far from promising situation, given that municipal credit agencies are threatening to lower the city's rating to junk status. Officials hope, all the same, they can get a write-off for some of the debt and a new long-term refinancing for the remainder.
"Let's just say what they want is different from what we want at this point," Terauchi said of the negotiations with the banks.
Gardena dug itself into a hole deeper than most other cities have ever experienced. But the story is emblematic of the kinds of pressures California cities have come under since the state, grappling with the fiscal crisis of the early 1990s, began taking away some local tax revenues to plug gaping holes in California's budget. All cities have felt the squeeze and a great many have at least considered nontraditional market schemes to rake in extra money.
In fact, Gardena's debt crisis comes almost exactly 10 years after the shocking bankruptcy of neighboring Orange County, which was sunk by $1.6 billion in losses from exceptionally complex bond market trades. The trading operation was initiated by officials who thought it was a clever way to raise revenue without raising taxes.
It actually worked for a while, until bets on interest rates turned sour and catapulted the county into a financial slide that required deep cuts in services and about $1 billion in new debt. Today, the prosperous county is in far better fiscal health, but the payments on the remaining debt, about $90 million a year, are a huge drag on the budget, and the county's ability to provide a full range of services.
Gardena is far less able to cope. Its households -- approximately 30 percent Latino, the rest split between whites, blacks and Asians -- have a median income of less than $40,000 a year, and it can ill afford the cuts in services already made, which have resulted in a badly undermanned police force, reductions in community services, such as parks and community development, and further deterioration of the city's already worn infrastructure. Trees are not getting trimmed and broken curbs are not getting repaired.
Officials here say even more belt-tightening is inevitable.
"All I can say is, we're trying to do more with less," said Terauchi. "We just never thought we would end up here. It's a mess."
Terauchi harshly criticized Sacramento for taking away such a large portion of the local tax revenues -- the city will lose an additional $3.7 million this year and next because of the state's actions, he said. But, he conceded, Gardena brought some of the troubles on itself with poor planning and a shocking gullibility.
"They believed everything they were told," Terauchi said.
Municipal finance experts agree that, though Gardena's experience is extreme, it is representative of the broader problems cities face.
"Because of the situation the state has placed the cities in, they're open to gimmicks to try and find ways to operate," said David Abel, a municipal finance consultant and chairman of the California Center for Regional Leadership, a nonprofit research group. "It's in the DNA of the arrangement with the state. It's a terrible situation for these cities."
The state's tax grab has taken a toll on many cities, but particularly in Southern California, experts say, because of increasing demands on public services by uninsured workers and other members of the working poor.
"If you look around, the cities are generally operating within their means here, but the quality of life is just going down," said Marc Pisano, executive director of the Southern California Association of Governments. "People thought I was Chicken Little when I warned them about what Sacramento was doing, but it has become pretty apparent now. The biggest threat the cities are facing is the state taking away more of their resources."
What many local politicians now acknowledge is that, facing limits on property tax revenues following the passage of Proposition 13 in 1978, one of the few ways to expand services was to raise money through unconventional schemes.
Orange County was the most spectacular victim of such schemes going bad. It declared bankruptcy, the largest ever for a municipality, after a little known investment fund operated by the county treasurer lost $1.6 billion trading in what are known as derivatives -- a market normally for the shrewdest players.
"It was true then and it's still true that you just find public officials making promises they can't keep," said Larry Agran, the mayor of the city of Irvine, which lost more than $20 million in the Orange County disaster. "They say they can improve services without increasing taxes, and it just can't be done. So they try and work some sort of magic. "
He added, "No one has the courage to say, 'We can't afford these services unless you raise taxes.' "
Agran admits, however, that the temptation remains. Irvine is considering forming a public power utility, and using any profits for government services.
"You have to be in the hunt for these kinds of things all the time, but you have to realize they are very risky," he said.
Gardena first started to think about creating an insurance company in the late 1980s when liability premiums started soaring and some private insurance companies stopped offering coverage, leaving cities exposed.
After speaking with consultants, city officials thought they had found the perfect solution. With a $15 million investment, Gardena would form a mutual insurance company to insure itself and, it hoped, other small California cities. It would thus obtain coverage and, at the same time, boost its revenues with the expected profits.
"All the insurance consultants told us it could be done and that this was a once in a lifetime opportunity," said James Cragin, a member of the City Council who approved the plan. "This was going to be the big one. We thought we could make it fly and that it would solve our problems."
However, by the time the city had borrowed the $15 million and created the company, in 1993, the big private insurers were writing liability policies once again, offering formidable competition.
"Before it was even running, the market had changed," said Terauchi. "It never had a chance."
The company continued to write policies for Gardena as well as a number of small municipalities in the Southern California desert and some pools of small cities spread around the state, but far fewer than had been anticipated. Because of the competition from the large insurance companies, Gardena was forced to offer premiums that were too low to cover the costs of the policies, city officials said.
Gardena kept trying to make the operation work and refinanced the original investment to roughly $20 million of borrowed money -- with no profits to pay it off.
"It was like maxing out a new credit card to pay off the old one," said Mitchell Lansdell, the city manager.
Making matters worse, Gardena discovered that a city manager had been embezzling money in the mid-1990s. After he was indicted, officials discovered the budget was in far worse shape than believed, and the city's finances went into a tailspin. Credit experts said Gardena has actually done a good job of restoring its finances since then.
"Actually, their financial performance has been pretty good for the last five years or so," said Gabriel Petrek, an analyst with Standard & Poor's, the credit rating agency. "Aside from their debt obligations, they are on the mend. "
But the recovery has come at a price.
In addition to the cuts in services, the city has become economically dependent on two large card clubs, which provide nearly a fifth of the city's yearly tax revenue, said Terauchi, but don't present an attractive image. One of them, the huge Hustler Casino, is owned by pornography tycoon Larry Flynt.
Terauchi also worries that growing competition from nearby Indian casinos could steal away some of the card club business, and tax revenues, leaving Gardena in the lurch once again.
"This may not be a good political answer for you, but, yes, they're too risky," he said of the heavy reliance on the card clubs.
E-mail James Sterngold at firstname.lastname@example.org.