Vallejo: Portrait of a Broke Town

Municipalities across the U.S. may be headed for the same grim recessionary spiral dragging down this once prosperous California exurb

By Nanette Byrnes

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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.