How Cities Go Broke: The Mechanics of Municipal Insolvency

National City's recent financial warning has cast a spotlight on the precarious nature of municipal budgets. In early August 2026, City Manager Doug Schulze cautioned that the Southern California city faces a $13 million deficit and potential insolvency by 2030, driven largely by a 50 percent surge in personnel costs over just three years.[1]

The situation highlights a broader vulnerability in local governance. When ongoing operational expenses consistently outpace recurring tax revenues, cities rely on their reserve funds to bridge the gap. Once those savings are depleted, the mathematical reality of a structural deficit forces a severe reckoning.[1][4]

Unlike a private corporation, a city cannot simply close its doors, liquidate its assets, and distribute the proceeds to creditors. Municipalities are legally and ethically bound to provide essential services to their residents, including police protection, fire response, and basic sanitation.[2][3]

Because of this non-negotiable obligation, the legal frameworks governing municipal distress are designed to preserve the civic entity rather than dismantle it. The first line of defense is almost always severe austerity, where city councils must slash discretionary spending to keep the government afloat.[1][3]

In practice, these discretionary cuts directly impact the daily lives of residents. Facilities that do not strictly involve public safety—such as community pools, public libraries, and senior feeding programs—are typically the first to face reduced hours or permanent closure.[1]

If local elected officials cannot balance the budget through spending cuts or new taxes, the state government may intervene. This intervention frequently takes the form of receivership, where a state-appointed trustee assumes direct control of the distressed city's finances.[1][4]

Under receivership, the standard democratic process is temporarily suspended. The appointed receiver is granted the unilateral authority to make financial decisions, overriding the mayor and city council to implement the harsh cuts necessary to restore solvency.[1]

When state intervention is insufficient, or if the debt burden is too complex to manage through austerity alone, a municipality may seek federal protection under Chapter 9 of the U.S. Bankruptcy Code.[2][3]

Chapter 9 is a highly specialized and relatively rare legal remedy. Since its inception during the Great Depression, the law has been carefully structured to respect the Tenth Amendment, ensuring that federal bankruptcy courts do not improperly interfere with state sovereignty.[2]

The eligibility hurdles for Chapter 9 are intentionally steep. A city cannot simply declare bankruptcy to avoid unfavorable contracts; it must prove to the court that it is officially insolvent, meaning it is genuinely unable to pay its debts as they become due.[2][3]

Furthermore, the municipality must be explicitly authorized by its home state to file for Chapter 9, and it must demonstrate that it has attempted to negotiate in good faith with its creditors before seeking federal court protection.[2][3]

Once a city successfully files for Chapter 9, it is granted an "automatic stay." This powerful legal provision immediately halts all debt collection efforts and lawsuits, giving the city a crucial breathing spell to organize its finances without the threat of asset seizure.[2][3]

During this protected period, the city drafts a comprehensive plan of adjustment. This plan outlines exactly how the municipality intends to restructure its obligations, which may involve extending debt maturities, reducing principal amounts, or renegotiating labor contracts and pension obligations.[2][4]

The treatment of municipal bonds during this restructuring process depends heavily on how they were initially structured. General obligation bonds, which are backed by the city's broad taxing power, are often treated as unsecured debt and may be subject to significant reductions.[2]

Conversely, special revenue bonds—which are tied to specific, revenue-generating projects like water treatment plants or toll roads—typically continue to be serviced from their dedicated income streams, shielding them from the broader bankruptcy proceedings.[2]

Ultimately, the goal of Chapter 9 is to foster the continuation of the municipality. By providing a structured environment to renegotiate unsustainable debt, the process allows distressed cities to eventually regain their financial footing and return control to local residents.[3][4]