In our coverage of Recent Case Decisions, first tuesday was the first to report the case of Mammoth Lakes in anticipation of its disastrous implications for California’s economic health and the vigor of our real estate market. This companion piece discusses the facts of the case in the context of California’s ongoing spate of Chapter 9 municipal bankruptcies.   

Facts: A real estate developer entered into a development agreement with the town of Mammoth Lakes (the town) to develop a parcel of land including a municipal airport and surrounding areas. The development agreement contained a clause requiring the developer to adhere to basic rules and regulations of the Federal Aviation Administration (FAA), the agency that agreed to fund the development, but did not require the developer to comply with any conditions of the funding agreement reached between the town and the FAA. After development began, the FAA objected to an aspect of the development and pulled funding for the project until the developer satisfied the FAA’s demands. The town made a demand on the developer to modify the development plans in order to satisfy the FAA’s request and the developer refused. The developer made a demand on the town to perform based upon the terms of the development agreement. The town refused, causing the developer to suffer money losses.

Claim: The developer sought to recover his losses, claiming the town breached the development agreement by refusing to perform since the town’s performance of the development agreement was not contingent on the FAA’s performance under their separate funding agreement.

Counter claim: The town claimed it was not liable for the developer’s money losses since the conditions of the funding agreement between the town and the FAA were part of the FAA’s rules and regulations that the developer agreed to in the development agreement.

Holding: A California court of appeals held the town of Mammoth Lakes was liable for the developer’s money losses for breaching the development agreement since conformance to the FAA’s rules and regulations called for in the development agreement did not expressly include funding conditions covered under a separate agreement between the town and the FAA. [Mammoth Lakes Land Acquisition, LLC v. Town of Mammoth Lakes (2010) 191 CA4th 435]

A closer look at Mammoth Lakes

Although drawn out for many years and resulting in millions of dollars in losses for the town of Mammoth Lakes— tipping the first domino in California’s municipal bankruptcy crisis— the case is really quite simple. The development agreement entered into between the town and developer held the project was to take place in two phases:

  • the development of an international airport; and
  • the development of a hotel and condominium complex.

The agreement stipulated that in exchange for the developer’s work on constructing the airport facilities, the developer would receive the right to lease the surrounding land and develop it as a hotel and condominium complex, all with the option to purchase the land at an agreed upon future date (an option the developer made very clear that he planned on exercising). Once the airport was completed, the town decided it was no longer interested in leasing the surrounding land to the developer. To accomplish this, the town colluded with its cronies at the FAA to boondoggle the developer out of the contract.

Simply put, the town of Mammoth Lakes, drunk on power and stupid with corruption, decided to buy a horse without building a stable. It was under the impression that, with the FAA on their side, it could easily slip out of the development agreement with impunity. It was wrong, horribly wrong.

But what lesson does this leave for the rest of California?

California’s bankruptcy crisis: in the grips of a money illusion

The town of Mammoth Lakes is the third California city to file Chapter 9 bankruptcy this year, preceded first by Stockton and next by San Bernardino. The common thread running between all three bankruptcies is real estate.

Related article:

San Bernardino finds bankruptcy and foreclosure ugly cousins

Mammoth Lakes is a somewhat exceptional example, given that the town’s bankruptcy clearly stemmed from a singular botched real estate transaction, albeit of mammoth proportions (pardon the pun).

Stockton and San Bernardino, on the other hand, have each arrived at the final solution of bankruptcy due to a collective money illusion among the municipalities and their citizens.

To listen to the pundits speak on Stockton’s ills, one would think its bankruptcy was solely precipitated by a corrupt local government and a city pension system that careened off the rails. Yes, this is all true — the corruption in Stockton’s local government and a series of poor decisions to allow early retirement and endless health benefits for city workers was the most visible cause of the city’s bankruptcy.

However, this was not the root cause: it was the collective money illusion of both the city’s leaders and its citizens that allowed for these disastrous decisions to be made (decisions which were made with a clear conscience at the time).

The average Stockton home price at the height of the Millennium Boom in 2005 was nearly $400,000, according to Zillow. From the vantage point of Stockton’s leadership (and tax collectors) in 2005, home prices, and thus property taxes, were on a perpetual and phenomenal upswing with no chance of descending below these dizzying heights.

One must keep the historical perspective of the Millennium Boom in mind when critiquing its aftermath — everyone, most especially Californians, perceived the strength of the housing market to be an everlasting and universal truth – a new real estate paradigm of perpetually rising prices.

The allure of the myth

California real estate always appreciates in value, so the old myth goes. Thus, the municipalities acted in accordance with this deeply entrenched and erroneous belief. Since housing wealth was through the roof and the property tax coffers were overflowing with glittering gold everlasting, city workers in Sacramento were given early retirement. These city workers basked in the confidence that if all else fails, they could sell their home for an obscene profit and move on to greener pastures — a veritable safety net woven from the silly string of irrational exuberance.

By 2009, in the deep and dark trough of the housing bubble implosion, Stockton’s leaders and citizens all breathed a collective “uh oh” when home prices fell back to the region’s mean price anchor, well below $200,000. Reality set in and the choices made in the fog of the Millennium Boom came back to haunt them.

Related article:

The equilibrium trendline: the mean price anchor

The grim horizon

The same scenario occurred in San Bernardino. The seat of California’s largest county was on a long and sustained growth period, and now it is looking down the barrel of massive default and the painful reality of bankruptcy.

Unfortunately, the same seems to be true in many California cities. Moody’s, the credit rating agency giant, has recently launched a statewide review of all California cities in expectation of what it calls a growing threat of massive municipal defaults.

Related article:

More California cities at risk of bankruptcy, Moody’s says

Although long, drawn-out and painful, this is what we affectionately refer to as the magic of a recession.

Of course, this is no longer a mere recession but rather a persistent Lesser Depression. The Fed often induces recessions in order to cool off markets before they have a chance to balloon out of control. Since the Fed aborted its preemptive measures to mitigate the obvious risks of market collapse after 9/11 in the years leading up to the Great Recession, the cobwebs of un-sustainability were allowed to grow into black widow’s nests.

Now, rather than allowing the winds of a minor recession to whisk them away, California is being sprayed down liberally by the Orkin man’s poison of job loss, widespread default and large-scale municipal bankruptcy.

Lamentably, the municipal defaults occurring in California are part of a vicious market cycle, one that will only enervate any budding growth these towns may have experienced from the bumpy plateau recovery. The turmoil these cities are now experiencing has absolutely demolished the money illusions they once held so dear and for so long. Though waking from the dream will be unpleasant, it is necessary to lay the groundwork for real, sustainable growth going forward; growth built on the solid foundations of fundamentals, not eager fantasies.

We like to think this spate of municipal bankruptcies will ensure that bad history does not repeat itself and the cyclonic cyclical nature of California real estate may find a healthy and sustainable equilibrium as a result. But in order to completely lose these illusions and insure against repeating them, the reality must be seen for what it is.

These are not simply stories of a few foolish treasurers and bad actors in City Hall. Rather, this is a tale of an entire state (and country) buzzed on the high of perpetually rising real estate prices — period.