SAN FRANCISCO — Stockton, Calif.’s bond defaults have already started a legal tug-of-war with insurers.

Wells Fargo Bank NA, trustee for all of the city’s general fund-linked debt, has filed a lawsuit in San Joaquin County Superior Court seeking repossession of three city parking structures that guarantee $35 million of lease revenue bonds now in default.

The bank filed the complaint at the behest of National Public Finance Guarantee, the insurer of the bonds, after the city failed to make a $779,000 debt service payment on the bonds March 1.

“We cannot ignore the fact that the city has defaulted on its obligation to make a lease payment in support of our insured exposure and we intend to exercise our rights accordingly,” NPFG spokesman Kevin Brown said in an emailed statement.

National will still make sure bondholders are paid on time, Brown said.

The defaults are a result of the City Council’s vote last month to declare a financial emergency and respond, in part, by suspending payments toward general-fund supported bonds through June 30, the end of the fiscal year.

Of the seven bond issues that rely in some way on general-fund support, the action directly resulted in missed debt-service payments on three series of $110 million in initial par value.

The council, which represents a city of nearly 300,000 in California’s Central Valley, also voted on Feb. 28 to begin a confidential mediation process with creditors under terms of a new state law designed to give financially stressed local governments a chance at staying out of bankruptcy.

The Stockton Public Financing Authority sold $32.8 million in lease revenue bonds in 2004 to fund construction of parking garages and other capital improvements.

According to the bond indenture, lease payments by Stockton support the debt and the property is security.

Wells Fargo served the city with a notice on March 1 requiring it to pay delinquent rents in three days or vacate and deliver possession of the property to the trustee.

“As the trustee, we are obligated pursuant to the terms of the trust to act at the direction of the bond insurer and for the benefit of the bondholders,” the bank said in a statement.

“Wells Fargo has no funds at risk in this case, nor are we attempting to recover funds for our own accounts.”

According to the official statement, the city owed $1.9 million in interest and principal payments for fiscal 2012 ending in June and roughly the same amount next fiscal year.

Stockton said it so far has stopped payments until the end of June on the 2004 parking bonds, and on $35 million of 2009 lease revenue bonds issued by the Public Financing Authority.

The city also defaulted on $40 million of two series of 2007 variable-rate lease revenue bonds issued by the SPFA for property at 400 East Main Street, which had been set for the future city hall. The troubled European bank, Dexia, also provided liquidity on the bonds.

“The city had a $15 million shortfall that had to addressed. Unfortunately, we had to suspend payment on three bond issues in this fiscal year (March-June) to help address the deficit,” said city spokeswoman Connie Cochran in an emailed statement.

Overall, Stockton has $327 million of general-fund-supported lease revenue and pension obligation bonds issued by the city, its Redevelopment Agency and its Public Financing Authority until after June 30, the end of the fiscal year. It its disclosure to holders of all general-fund backed bonds, the city said “no assurance can be given” that the city can make payments due for debt service in fiscal 2013 or later.

Stockton had more than $702 million of bonds outstanding as of June 30, 2010, including city and RDA bonds and debt issued for restricted enterprise funds such as water, sewer, and parking enterprise debt, according to city financial statements.

The 2007 bonds were insured by Assured Guaranty Corp. and the 2009 bonds were not insured, according to the official statements.

Assured was not able to comment on the issue as of press time.

National Public Finance Guarantee has said it has $224 million of insured exposure to Stockton’s debt, $89 million of which is backed by its general fund.

Assured said it is exposed to the tune of more than $150 million net par. Ambac insures $13 million of Stockton bonds, according to city documents.

Stockton’s restructuring attempt has resulted in “super-downgrades” of its rating by Moody’s Investors Service to Ba2 and Standard & Poor’s to “selective default.”

The process created in the new California law, Assembly Bill 506, is supposed to provide a venue for the city to restructure its debts with creditors such as bondholders and employee unions enough to avoid filing for bankruptcy.

AB 506 requires a city to either publicly declare a fiscal emergency or to hold “neutral” talks with stakeholders for at least 60 days before filing for Chapter 9.

Stockton has declared fiscal emergencies for the last three years, but it is also moving ahead with the mediation process.

The confidential mediation process is voluntary for creditors and is not binding. The 60-day window begins after the participants have agreed upon the mediator. It may also be extended to 90 days. The city can file for bankruptcy at the end of the process if it doesn’t get enough concessions.

AB 506 was adopted during the 2011 legislative session, so participants in the mediation will enter a process that has never been tested.

The small ski town of Mammoth Lakes is the only other municipality in the state so far to choose the AB 506 procedures to address its financial problems, but it’s no further along than Stockton.

If it files for Chapter 9 bankruptcy, Stockton would be the largest city in modern times to do so.

In California, the only other municipalities to go bankrupt are Vallejo in 2008, Desert Hot Springs in 2001 and Orange County in 1994.

Some experts have questioned whether entering into the mediation may have triggered a default on all of the city’s debt. But so far, the trustee has not declared an event of default on any other debt while the city has remained up to date on its payments.

Stockton officials said in a statement last week that the city is in compliance with its covenants and has the money to cover its debt service for the bonds tied to utility revenues, such as water and sewer bonds.

“Special funds legally cannot and will not be used to resolve the city’s general fund fiscal needs,” the city said in a press release.

However, Moody’s recently downgraded Stockton’s sewer revenue bonds, water revenue bonds and special tax bonds, as analysts cited “the uncertainties that surround the potential bankruptcy.”

The rating agency singled out $55 million of water revenue bonds, cutting them to Ba3 from A3, because it believes the city may have violated a letter-of-credit agreement with Union Bank when it voted to suspend some bond payments because it would be an admission the city can’t pay its debts.

Union Bank could conceivably tender the bonds under that scenario and demand immediate reimbursement from Stockton, putting “severe and likely unmanageable liquidity pressure on the enterprise and imperil payments on its other, fixed-rate parity obligations,” according to Moody’s analysts.

Real-estate values in Stockton bubbled during the housing boom, but the housing bust crushed the city, which had given generous benefits to its workers and financed showcase projects, including a sports arena, a baseball stadium and a movie multiplex. 

Stockton officials have struggled for years to try to claw back some employee benefits from public unions given out during better times. The difficult negotiations led to strained management-labor relations. The city still has one of the highest foreclosure rates in the country and for a time had the highest.

As of the end of the year, Stockton’s unemployment rate stood at 15.9%, one of the highest in the nation, according to the U.S. Department of Labor.

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.