Moody’s Investors Service has downgraded Montebello to Baa2 from A3 because of weak cash flow, depleted reserves, and ongoing budget problems.

“The negative outlook reflects the remaining challenge the city faces in structurally balancing its budget, restoring its liquidity, and repaying a significant loan from its redevelopment agency,” Moody’s said last week.

Montebello, which has $126 million of outstanding bonds, has seen its financial problems intensify this year, including a rare audit by the California controller. A city official has said the government could go bankrupt without a bridge loan in the next six months.

The rating agency also downgraded $14.5 million of certificates of participation to junk-grade Ba1 from Baa2.

Montebello is facing a $1.2 million shortfall in its $43 million fiscal 2011 budget.

Moody’s said the City Council recently failed to pass spending reductions that would have helped close the gap.

The city, located in the heart of Los Angeles County, still has a relatively stable tax base and below-average debt burden, Moody’s noted.

State Controller John Chiang sent a letter to city officials in April notifying them his office will audit Montebello’s finances because it has reason to believe that its annual reports are “false, incomplete, or incorrect.”

Last year, the controller audited the scandal-plagued city of Bell after press reports broke that it was paying former city manager Robert Rizzo a salary of $800,000.

Chiang’s letter cited concerns about two “off-the-books” bank accounts that have been open for more than 10 years, the use of $15 million of redevelopment funds used to pay restricted fund loans, and Montebello’s use of U.S. Housing and Urban Development funding.

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