Bankruptcy jitters in Stockton. Will other cities fail?

When the city of Stockton, California announced last month it would skip some bond payments and enter talks with its creditors, the municipal debt world shuddered.

If Stockton were to go bankrupt, it would be the largest U.S. city ever to do so. Other troubled Californian municipalities might be tempted to follow suit. Predictions of mass defaults on municipal bonds might start to look a little more realistic.

But a close look at the municipal finance situation across California suggests mass bankruptcies are unlikely.

Most troubled local governments in the state have taken drastic steps to cut spending, with city managers asserting they have their arms around the problems. A new, state-mandated mediation process may also help municipalities avoid the worst - though it could force bondholders to accept losses outside the bankruptcy process.

The new law, passed after the San Francisco Bay area city of Vallejo filed for bankruptcy in 2008, requires Stockton to try to corral its major bondholders, bond insurers, city employees and retirees into mediation for up to 90 days.

"City negotiators will surely hold the bankruptcy gun to stakeholders' heads, including employees and their unions and bondholders represented by the insurers," wrote Alan Schankel, an analyst with Janney Capital Markets, in a recent note.

The city's credit ratings have been slashed. Moody's Investors Service lowered Stockton's general fund-supported debt ratings to below investment grade, a move affecting about $341 million in debt, while Standard & Poor's has taken Stockton's issuer credit rating down to one notch above 'D', the bottom speculative-grade level.

As in other troubled cities around the state, the depth of Stockton's problems is a mirror image of the heights the city of 292,000 appeared to reach during the housing boom. An inland port and agricultural hub for Central Valley farms, Stockton was abruptly - and briefly - transformed into a distant bedroom community for the Bay area in those prosperous times.

According to online foreclosure marketplace RealtyTrac Inc, Stockton last year had the second-highest foreclosure rate of all large U.S. metro areas, with 5.43 percent of its housing units receiving foreclosure filings. Las Vegas had the highest rate: 7.38 percent, compared with a nationwide 1.45 percent.

Stockton's financial problems were worsened by two decades of profligate spending on items including rich public employee contracts, a downtown sports arena and other urban revitalization projects, according to its city manager, Bob Deis.

The city faces a deficit of as much as $38 million on its general fund budget of $165 million.

In Stockton, as in Vallejo and other cities, the root of the problem is a dramatic fall in revenues. Developer fees have largely vanished with the near-halt of home building, and property taxes have followed housing values south. In Stockton, general fund revenue fell to an estimated $161.8 million for its current fiscal year, from $217.5 million in 2007-2008.

With unemployment at 10.9 percent across California - and above 16 percent in hard-hit places such as Stockton and Fresno - raising revenue with new taxes and fees is difficult. State law also puts firm limits on property tax increases and makes any type of tax rise difficult.

Still, many local officials say bankruptcy and default concerns are exaggerated.

Hercules, a town about 10 miles (16 km) south of Vallejo, recently defaulted on a debt payment amid a lawsuit with its bond insurer, prompting Standard & Poor's last month to drop its ratings on some city debt by five notches to a speculative grade 'BB'.

Since then, though, Hercules and Ambac Assurance Corp, a subsidiary of Ambac Financial Group Inc, have reached a settlement; together with union concessions, that will keep the city from having to consider pre-bankruptcy mediation.

"For the most part, the unions have been willing to come to the table," said Steve Duran, city manager of Hercules.

The only other California municipality currently seeking pre-bankruptcy talks is Mammoth Lakes. But the issue in the 7,400-person ski resort town is not the economy but rather a $42 million legal judgment against it over a property development dispute. Assistant City Manager Marianna Marysheva-Martinez said the town would not default on its roughly $2 million in debt.

A more typical case might be the town of Lincoln, a bedroom community outside Sacramento that has also suffered severely from the housing bust.

Over the course of a decade, Lincoln was transformed from a sleepy rural community of 8,000 into a bustling suburb of 42,000 and city services were expanded accordingly, including a full-time fire department put in place in 2001.

When the housing market went bust, Lincoln's revenue shrank. City leaders responded by tapping reserves and slashing spending on public safety, which accounts for most of the budget. The city reduced the number of its police officers to 20 from 40 and closed two of three fire houses. Increased contributions by city employees to their retirement accounts also helped.

Bankruptcy isn't an option, said Mayor Spencer Short, adding that more cuts are coming: "I'm looking at the possibility of introducing a budget that's beyond bare bones."

Antioch, a city of 100,000 on the eastern fringe of the San Francisco Bay area, is another municipality clobbered by the housing slump. Unlike in Vallejo and Stockton, though, relations between Antioch's city leaders and labor units were not contentious, allowing quick action to cut costs when the scale of its financial troubles became clear, City Manager Jim Jakel said.

Jakel ticked off Antioch's moves to keep its books balanced: a hiring freeze; furloughs; employees waiving pay increases; and a city workforce reduced to 245 from 401 through attrition and layoffs.

Costa Mesa, a city of 110,000 south of Los Angeles, has slashed its payroll from 611 to 450. It is selling its police helicopters and has hired a neighboring city for air patrols. It's also pursuing a controversial effort to convert to a charter city from a general law city, which would give City Hall more power to outsource more work, said councilman Jim Righeimer.

In a similar vein, nearby Santa Ana, population 325,000, recently folded its fire department and turned fire protection over to the county, saving $10 million a year. Consolidating fire districts has become a popular cost-saving move across the state.

In San Diego, Mayor Jerry Sanders wants to hire private firms for some services - unless city employees undercut them. Last month, city workers won a bid for street sweeping that will cut the city's expenses by $560,000 a year. Similar city-worker bidding last year resulted in $5.5 million in savings.

Sanders, who said cost-cutting and a revenue uptick would help San Diego post a $16.6 million surplus this year, has a more dramatic plan to pare expenses over the long term: a ballot measure that would put nearly all new city employees into 401(k)-style retirement accounts instead of traditional pensions.

Voters in San Jose, California's third-largest city, will vote in June on a pension measure to reduce retirement expenses that Mayor Chuck Reed blames for consuming an increasing share of funds for city services. Reed has said San Jose faces "service-level insolvency" if it fails to control pension costs.

While political battles over pensions in those two big cities have been contentious, public employees across California have been quietly agreeing to pension concessions in recent years and local officials are seen pressing for more, according to the League of California Cities.

They'll keep clamping down on other costs too as property tax revenue remains tight. "Those of us who look at government economics just don't see a near-term turnaround," said Stewart Gary of Citygate Associates, a government consulting firm in Folsom, California.

The new California law mandating mediation came after the Vallejo situation exposed the weaknesses of bankruptcy as a means to address municipal finance problems. City services there have been eviscerated, many employees lost much of their healthcare and other benefits, and legal bills have topped $10 million.

Yet many of Vallejo's largest long-term costs, namely pension liabilities, remain in place, and the hit to the city's reputation has further depressed its housing market and discouraged businesses from opening.

Mediation could enable cities to get some debt relief without the stigma and costs of bankruptcy.

But some in the municipal bond world worry that the process will create moral hazard.

"I'm just wondering if Stockton's actions are going to prompt some people to say 'Hey, we've got a quick fix here'," said Dick Larkin, director of credit analysis at HJ Sims.