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Ponzi Scheme?

Cities are going bankrupt because they didn't adequately project their funding needs into the future—will community associations be next?

By Tyler P. Berding, Esq.
Published: July 2012

Vallejo, California declared bankruptcy in 2008. The city of Hercules defaulted on its bond debt repayments. Stockton, California filed for bankruptcy in June. Two days ago, on Tuesday, July 10, 2012, the city council of San Bernardino, California made the same decision. That makes two major California cities deciding to file Chapter 9 Bankruptcy proceedings in the last 30 days. Other U.S. cities and counties have either declared or are on the brink. Central Falls, R.I.; Harrisburg, Pa; Boise County, Idaho, and Jefferson County, Alabama all share that distinction.2 Stockton is, so far, the biggest city in the nation to declare bankruptcy.

Each of these public entities has a unique reason for its financial problems. Base closings. Industry shutdowns. A gradual financial decline. But Stockton's case is somewhat different and perhaps presages more accurately the fate of many other municipalities—they spent money they didn't have and failed to determine if they ever would have it.

The city's fiscal history "has eerie similarities to a Ponzi scheme," says Bob Deis, the city manager Stockton hired in 2010. Over the years, the city promised employees huge—and unfunded—salaries and benefits...3

Essentially, the Stockton City Council approved ever-higher salaries and pension benefits for public employees without the slightest idea of how these benefits would be funded.

Perched precariously atop this mountain of obligations are retiree health benefits. Stockton officials awarded these to city employees in a series of votes in the 1990s but made no effort to fund them, intending simply to pay costs out of their budget as workers retired…Stockton Mayor Ann Johnston voted for these expensive measures when she served on the city council. 'We didn't have projections into the future what the costs might be…I learned that you don't make decisions without looking into the future'… 'Nobody gave thought to how it was eventually going to be paid for,' says Mr. Deis, the city manager.4

Why would public officials be so shortsighted? Part of it was political pressure from public employee unions—pressure that is being applied even today to prevent further cuts in the Stockton budget. But part is that it is just too simple to satisfy present day demands by borrowing from the future—essentially kicking the funding can down the road.

The big question is whether Stockton is only the tip of an iceberg. The 50 states alone have promised their employees retirement health-care benefits amounting to a $627 billion future liability—and funded only 4% of that cost, according to a recent accounting by Bloomberg Data. Unfunded state and municipal pension liabilities range up to $4 trillion, depending on what future investment assumptions you make.5

The American Bar Association's definition of “Ponzi Scheme” is:

A Ponzi scheme is where the promoter makes some sort of false or misleading statement about an investment (often including a guaranteed high rate of return) and pays off older investors with newer investor's monies. Eventually, when the promoter can't find any new investors, the scheme collapses."

So how is this similar to the plight of community associations? Simple. The developer of a project creates a reserve program based on the false assumption that most components of a building have an infinite service life and will never need repair or replacement. The early owners (investors) pay into the venture (community association budget) at lower than necessary assessment rates. That not only attracts buyers to the initial sales offering but also, in turn attracts future buyers. Eventually the investors who are the owners when the underfunding is discovered are stuck with not only their share of the bill, but also the shares of all of the prior owners who underpaid their assessments for so many years and then sold off their interests. Not exactly a “Ponzi” scheme, but close.

An assumption of “infinite life” is permissible under most states' statutory reserve requirements. Only those components that are visible and accessible are required to be studied, the rest are assumed to have an infinite service life unless or until a problem is discovered. As a result, most reserve studies are only surficial, a visual observation of the condition of the exterior building components. The real problems in many association buildings are lurking beneath the surface, and these are almost never anticipated in any reserve program. Rot, corrosion, and soil issues are usually not detected until they have accumulated to such an extent that building components are in danger of failure, and by then it is too late to save for the future. No building, especially those built largely of wood, can be assumed to have an infinite service life.6

This sounds a lot like: “Nobody gave thought to how it was eventually going to be paid for.” Board members and managers might be excused given that hidden damage issues in community associations are, by definition, unknown until they become critical and because our statutes permit unrealistic funding plans. Also, the problem is relatively new—most community associations are not yet 40 years old. But recent experience has shown us that regardless of what a board might have known about the condition of the project twenty years ago, undetected deterioration in older association buildings, beyond anything required in reserve studies, is real, and there is little funding for it.

The failure to inspect sufficiently to detect the onset of gradual deterioration is like kicking the funding can down the road to the unfortunate later owners (“investors.”) The “Ponzi” aspect is promising present owners that the funding plan of the association will adequately protect their investments when in fact no one making those predictions knows whether they are true or false. The long-term funding strategy of all community associations that maintain buildings and other infrastructure must include forensic-like intrusive investigations periodically. Without doing this, perhaps half of all future funding obligations will be missed. You can't promise owners that future funding will be adequate at a given assessment level without really knowing that the promise can be kept.

Lack of awareness may constitute a defense for decisions made in years past, but it can no longer serve that purpose. Like cities heading for bankruptcy, there are enough examples of capital underfunding now available to put most boards of older associations on notice that what you see may very well not be what you get, and that eventually, the last owners standing will have to pay for it

  1. Community Associations can declare bankruptcy, but it will not have the same effect as an individual or business bankruptcy filing. Most of a community association's debts are underwritten by the owners and secured by their equity. To read more about this, see Berding, “Bankruptcy Won't Work
  2. Farnham, Alan. ABC News, September 8, 2011.
  3. Malanga, Steven, “How Stockton Went Broke in Plain Sight”, Wall Street Journal, March 31, 2012.
  4. Ibid.
  5. Ibid.
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