LOS ANGELES - With falling bond ratings, a weak economy, dwindling reserves, and high labor costs, Fresno seems like a probable candidate to become California's next Stockton or San Bernardino.

At the beginning of 2013, Fresno's lease-supported obligations were downgraded to junk, and recently its issuer rating was dropped to the lowest investment grade rung by Standard & Poor's.

In recent years the Central Valley city has implemented many cuts in expenditures and attempts at finding new revenues, but it continues to "weather severe financial distress," as put by auditors in the city's most recent comprehensive annual financial report.

The CAFR covers fiscal year 2012, ending in June 2012, and was released in March 2013.

"They're trying very hard to do the right thing, but I'm not quite sure they're going to do enough to really get them out of the problems they're in," said Roberto Roffo, senior vice president and portfolio manager at Advisors Asset Management in New York. "And they're really not getting any help from the local economy."

Unemployment is still high at 15.6% in 2011, per capita income levels are below average, and the housing market has still not recovered, keeping property tax revenues low.

As of June 30, 2012, the city had depleted nearly all of its emergency reserve, to the extent that it is "dangerously low and plainly imprudent," according to auditors. Fresno's emergency reserve was at $1.48 million with no prospect of near term increases.

General fund reserves for fiscal 2012 were less than 1% of expenditures, or about $2.4 million, which includes its emergency reserve.

While the general fund results were unfavorable, the city's deficit of $3.5 million was an improvement over 2011 as a slight increase in general fund revenues and continued control on expenditures led to a smaller operating deficit.

"The majority of their expenditures are related to paying government workers," Roffo said. "They're locked in with a lot of different union contracts, where they haven't been able to make as many cuts as they want, and that leaves them in a pretty difficult bind."

The city's largest existing contracts — its closed police contracts — don't expire until June 30, 2015, and offer raises and job protection with no formal re-openers.

As Fresno continues to grapple with its financial challenges, one big question looms: could California's fifth largest city, one with half a million residents and almost a billion dollars of bond debt, be the next to file for Chapter 9 bankruptcy?

A Definite Risk

"I hate to say that it's imminent, because I don't think you can necessarily predict that, but I think they're in a very distressed situation, and it's something that investors have to realize is a distinct possibility," said Dan Genter, president and chief executive officer of RNC Genter Capital Management in Los Angeles.

Based on the most recent data available — the 2012 CAFR — Genter said he hasn't seen anything that's significantly improving.

"The trend we've seen with the data that's available is that since the top in 2007, the deterioration is still accelerating, so unless they've had a significant change in the very near term, they're in a lot of trouble," Genter said. "There is definitely a significant default risk here."

He added that Fresno is a credit his firm has actively avoided and that they haven't purchased any of their bonds for years.

Roffo, who views the city's situation as "provisional," said his firm has also avoided the credit.

"I'm not quite sure if it's going to make it into bankruptcy, but I'm not quite sure it's going to be able to make the cuts needed to avert all those problems," Roffo said. "Personally, for my clients, I don't see this as an appropriate investment. There are just too many questions right now."

Michael Ginestro, head of municipal research at Bel Air Investment Advisors in Los Angeles, also said it's unclear whether Fresno is the next Stockton and that there are a lot of things need to play out before a bankruptcy situation would occur.

"They've got to reduce their expenditures," he said. "The mayor's trying to do that, but you can only reduce them by so much each year. They have no liquidity; they're really strapped."

Ginestro said Fresno has more of a cash-flow and budgetary problem than a debt problem. Total government fund debt service is about 13% of total government fund expenditures, which he views as low-to-moderate.

The city has no outstanding general obligation debt, but has $934 million of outstanding lease revenue obligation bonds, pension obligation bonds, judgment obligation bonds, and other lease obligations, as of June 30, 2012.

Fresno's controller said in the financial report that the city has no intention of following the path of other cities in California in walking away from its debt commitments.

Other news reports, as recent as Dec. 9, have cited city officials, including city manager Bruce Rudd, stating they have no plans to file for bankruptcy.

City officials did not respond to requests for comments for this article.

Slow Recovery

Like most California cities, Fresno is limited in its ability to enhance existing revenue resources and create new ones. Its top three revenue generators — property tax, sales tax, and charges for services — were pummeled by the housing downturn and recession, and have been slow to recover.

A variety of additional factors have also caused the city's financial distress, including unsuccessful local investment decisions, an increase in indebtedness burdening the general fund, as well as other unaffordable future commitments, according to the city's auditors.

"Some cities in California are seeing some improvement in sales and some improvement in property tax revenues, but because Fresno isn't seeing it on the revenue side, and the expenditure side continues to go up, they're still in this situation," Ginestro said.

Starting in 2009, the city began budget reductions, city-wide layoffs and furloughs, and cuts to city services. The city has continued to trim costs in the years following, but with little improvement.

In an attempt to create a new source of revenue, the city council approved an ordinance to outsource its trash and recycling collection services.

However, the city solid waste department employees led a petition drive to force a special election on ordinance to the voters for approval. Measure G was rejected by voters in June 2013, leaving trash collection in public hands.

"If that passed, they would have gotten to raise about $14 million in garbage contracts or fees over the next several years and I think that would have helped mitigate the pain," Ginestro said.

In March 2012 Mayor Ashley Swearengin, and other city officials came up with a ten-year "Fiscal Sustainability Policy" to restore Fresno's financial health and credit ratings. The plan includes achieving spending and minimum financial reserve targets, adopting employee compensation policy changes to be negotiated as employee contracts are opened for negotiations, and immediate actions to match expenditures to revenues.

Narrowly Stabilizing

Michael Pietronico, CEO and senior portfolio manager at Miller Tabak Asset Management in New York, said he's concerned about the city's weak finances and limited flexibility to respond to shocks in the near-term, but that revenue gains and substantial expenditure cuts have helped move the budget closer to structural balance.

His firm gives Fresno an internal issuer rating of Baa3.

"The city's large and liquid balance sheet remains the main protection against economic uncertainty," Pietronico said. "The city no longer expects to draw its fund balance to below zero, which would have necessitated some inter-year borrowing from enterprise funds."

He added that the city's willingness to pay appears to be sound.

Standard & Poor's recently dropped Fresno's issuer credit rating to BBB-minus from BBB and its long-term rating on lease revenue bonds, POBs, and JOBs to BB-plus from BBB-minus. The outlook is stable.

The agency downgraded the ratings on Dec. 7, citing the auditor's comments in the 2012 CAFR that the city's fiscal conditions "raise substantial doubts about its ability to continue as a going concern."

Moody's Investors Service had already downgraded the ratings on the city's outstanding debt to junk at the beginning of this year. Most of the city's lease supported obligations were dropped to Ba1 from Baa2, and its POBs, JOBs, and convention center bonds were downgraded to Ba2 from Baa2. The agency assigned all of the ratings a negative outlook.

Moody's gives the city an issuer rating of A3.

Kevork Khrimian, lead analyst at Moody's, said Fresno's finances are stabilizing at a very narrow reserve level, but not much has changed since the agency's last credit report on Jan. 23.

"Finances are stable in that the general fund budget in 2013 was balanced and it looks like — based on monthly data and some brief conversations — 2013 revenues were more or less the same as expenditures," he said. "So materially, that's unchanged and that's more or less what we expected."

He said the next audit is expected sometime soon, which would present a good opportunity to review the ratings. The city has until the end of March to release the audit for fiscal year 2013.

As for bankruptcy, Khrimian said that's very hard to predict and that Moody's has not publicly anticipated such an action for the city.

Last month, Fitch Ratings affirmed Fresno's issuer rating at BBB-plus, and its various lease revenue bonds at BBB and BBB-minus. The outlook is negative.

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