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Flood of California Chap. 9s Seen as Unlikely, But Investors on Edge

SAN FRANCISCO — Concerns about bankruptcies in California and their impact on the municipal market are still front and center for investors in the Golden State.

Muni market professionals during this week's Bond Buyer California Public Finance Conference here said a flood of government bankruptcies in the state is unlikely, but Stockton's Chapter 9 case has led to other worries.

"The prospect of municipal bankruptcies becoming very commonplace is exceptionally low," said Tom McLoughlin, a managing director at UBS Corp., during a California Debt and Investment Advisory Commission panel Wednesday.

"I don't think it has to become that commonplace to change the outlook of investors," he said. "That is the real risk of Stockton."

Three cities filed for Chapter 9 bankruptcy during the summer:  Stockton, San Bernardino and Mammoth Lakes.

The small town of Mammoth Lakes is something of an outlier compared to the other two and the 2008 bankruptcy of Vallejo, because a $42 million judgment spun the mountain resort into bankruptcy.

California's other, larger local bankruptcies are more worrisome for the municipal bond market because fundamental structural insolvencies landed them in the bankruptcy docket.

Stockton is arguably the most worrisome for the market because it has indicated that it will treat its pension liabilities as senior to its bond debt, proposing a major haircut that could set a troublesome precedent for bondholders.

If a judgment by U.S. Bankruptcy Judge Christopher Klein ultimately swings against bondholders, investors fear it could entice other municipalities to take the same path.

In July, Stockton — a city of 300,000 residents an hour-and-a-half drive's east of San Francisco — became the largest city in the country by population and the third largest by debt to file for bankruptcy, following three months in a mediation process set up by state law.

The proposed haircuts would impose sizable losses on the two main insurers of Stockton's debt, National Public Finance Guarantee Corp. and Assured Guaranty Ltd.

They have objected to the city's bankruptcy petition partly because bondholders are being asked to take more of a hit without touching employee pensions through the California Public Employees' Retirement System, which the city has listed as its largest creditor.

James Spiotto, a bankruptcy expert with the law firm Chapman and Cutler LLP in Chicago, said on the sidelines of the conference that the litigation could drag on for a long time and have broader implications.

"The bondholders and insurers' concern is, look, if we provide money to help these people are we just second-class citizens?" he said. "It is not just one municipality, there are others that will suffer this as it becomes a larger liability on their balance sheet."

McLoughlin said the case could go on for two to three years, causing a lot of agitation in the market.

Spiotto noted that local governments need to consider the long-term implications of getting a short-term gain from bondholders during Chapter 9 bankruptcy while suffering in the long term when they need to access the markets going forward.

Even though some municipalities could be enticed by Stockton's case in the near term, it's possible that the bankruptcies may end up more as horrible warnings than good examples.

Case in point: Vallejo, which spent $12 million on its three-year Chapter 9 bankruptcy case.

"I think over time what municipalities will start seeing are more municipalities like Vallejo, where Vallejo spent ungodly amounts of money and took many, many years," Eric Friedland, head of muni research at Schroders Asset Management, said during a panel Wednesday.

"I think you are going to start seeing these bankruptcies play out so that municipalities realize that the cost of filing is much greater than any benefits they garner from it," he added.

Stockton's final plan of adjustment, which would formally indicate how it plans to slash its debt obligations, will not be presented to Judge Klein until he approves the city's petition to file for bankruptcy.

Stockton's proposal during the pre-bankruptcy mediation to slash debt payments by more than $350 million gained no ground with bond creditors. Experts have said this would be an unprecedented haircut for bondholders in a Chapter 9 case.

The city's proposal included a five-year holiday on all payments from the general fund toward debt service, and permanent elimination of all general fund payments toward the city's pension obligation bonds, wiping out about $100 million of that debt, which is wrapped by Assured.

The insurer said Stockton continues to benefit from the proceeds of the pension bond deal because CalPERS continues to hold and invest those proceeds, which are also going towards determining what the city owes the retirement systems.

Assured said in a court filing that bondholders have been asked to account for 42% of the city's proposed savings despite taking up only 8% of Stockton's general fund budget.

CalPERS has been listed by the city in its bankruptcy court documents as its largest unsecured creditor.

The city's obligations to the retirement system — which are projected at $17 million in fiscal 2013 and expected to increase to more than $30 million annually by 2020, — were left untouched by the city's proposal.

National has said it is exposed to $89 million of debt linked to Stockton's general fund, mostly through lease revenue bonds, many of which the city has already defaulted on.

Despite the recent bankruptcy filings, the consensus of market participants here at the conference appears to be that the majority of California local governments are weathering the fiscal storm brought on by the recession.

"I genuinely believe these cities are outliers," Bill Statler, a consultant and former director of finance and information technology for San Luis Obispo, said during a panel Wednesday.

Statler said he believes most cities are going to want to work out their difficulties in a way that makes sense for their communities, rather than just "leave it up to a bankruptcy judge."

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