LOS ANGELES— If the California Public Employees’ Retirement System prevails in having courts define San Bernardino’s obligations to the pension fund as immutable in the city’s bankruptcy case, it could have widespread ramifications including sweeping bond downgrades, according to Matt Fabian, managing director of Municipal Market Advisors.

“With recent rating agency actions taking a dimmer view on California general fund obligations generally, we suspect success by CalPERS would trigger sweeping downgrades across the state,” according to an MMA market outlook report co-authored by Fabian. “We also assume a strong pullback by lenders, perhaps exceeding the rating impact, implying steep funding costs for issuers attempting to sell new lease debt.”

If CalPERS succeeds, lease-backed debt such as certificates of participation may be untenable, the report said.

“Were CalPERS to find success, COPs may no longer be a viable security for accessing the municipal bond market in California,” it said.

CalPERS filed a motion with the federal bankruptcy court Nov. 27 requesting relief from an automatic stay that prevents it from suing San Bernardino in state court over $6.9 million in missed payments. The move is considered to be part of a larger effort by CalPERS to have the courts rule that obligations to the pension fund cannot be impaired.

The issue first arose in Stockton, Calif.’s bankruptcy case when U.S. Bankruptcy Judge Christopher Klein ruled against a motion by retirees to lift the automatic stay in that case.

Protections afforded pension funds in the California state constitution have also hampered efforts by the state and cities to reform the benefits of current employees.

Investors are already skittish when it comes to California’s lease bonds, according to Fabian, so if the courts rule that obligations to the pension fund can’t be impaired, it could make it very difficult for California cities to access the capital markets, Fabian said.

MMA estimates California local governments have about $33 billion in outstanding COPs, plus more unsecured, general fund backstopped debt.

“If pension obligations cannot be adjusted—even in bankruptcy—this debt will be effectively subordinated to a permanently-extendable obligation to CalPERS,” MMA’s weekly outlook report says.

“It is hard to understate the importance of this decision that is looming,” Fabian said.

Many buyers have already pulled back from buying California lease bonds, he said, adding that it is one of the very few areas, other than Puerto Rico, that has become weaker over the past year.

Even if CalPERS succeeds in having the automatic stay lifted, the pension fund would still be several steps away from the kind of precedent-setting ruling that would make the city’s obligations to the pension fund impossible to impair, said Karol Denniston, a partner in the San Francisco office of law firm Schiff Harding.

“It could mean sweeping downgrades, but it depends on what CalPERS prevails in,” Denniston said.

Lifting the stay will not designate CalPERS as any sort of creditor, she said, and the state court might not necessarily determine what kind of creditor the pension fund is.

“I don’t know if the federal bankruptcy will trump state court,” Denniston said. “That issue might not be determined until Stockton or San Bernardino’s plan of adjustment is in front of the bankruptcy court.”

If CalPERS succeeds in having the automatic stay lifted, it still has to file a case in state court, Denniston said. And if a state judge rules in CalPERS’ favor, the pension fund would still have to return to bankruptcy court to receive the money it’s owed, because San Bernardino is in bankruptcy, she said.

Events in the state are creating momentum that could lead to the courts further defining the pension fund’s protections under the state’s constitution.

“CalPERS continues to push its stance that municipal obligations to the fund are immutable,” according MMA’s market outlook. “This argument arose first in Stockton and is now being reiterated in CalPERS motion seeking relief from the automatic stay in San Bernardino’s bankruptcy.”

If the courts decide that the pension contract cannot be impaired, debt owed to bondholders will be seen as subordinate to CalPERS debt, which is significant considering the amount municipalities owe the pension fund, Denniston said.

“If it is found that CalPERS is the kind of creditor that can be impaired, every municipality will look at it as a way to restructure, because they are all facing pension obligations,” Denniston said.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.