Moody’s Investors Service is considering both across-the-board and targeted downgrades in California in the aftermath of recent municipal bankruptcies there.

The targeted downgrades would affect particularly economically and fiscally distressed California localities. Moody’s also said there is potential for additional downgrades of bonds that are neither general obligation nor special tax bonds.

Moody’s expects to announce downgrades or outlook changes from its review in September.

Several factors have increased the likelihood that California cities will declare bankruptcy, senior vice president Eric Hoffmann and managing directors Robert Kurtter and Anne Van Praagh wrote in the special comment, “Why Some California Cities Are Choosing Bankruptcy.”

The peak-to-trough change in housing prices from 2005 to 2010 in inland California has been among the greatest in the country, they wrote. While the United States had a 24% decline, Stockton and Riverside, for example, experienced 60% declines.

In the five largest inland California cities, aggregate property tax revenues declined in fiscal 2009 and fiscal 2010.

Proposition 13 also reduces cities’ ability to deal with sudden declines in revenue. Passed in 1978, the proposition limits how much taxes can increase each year on a property and limits property taxes to no more than 1% of assessed value.

In general, the proposition keeps assessed values below market values, but that’s less true in cities like those in inland California with a great deal of new housing stock, the analysts wrote.

When the housing bubble burst, falling market prices more frequently brought down assessed values in these areas. This in turn meant that the inland cities’ ¬property tax revenues were more sharply curbed than those in coastal California cities.

California’s government has historically done little to support localities in fiscal distress, the analysts wrote. Instead, it has given them the right to declare an “emergency” and to file for bankruptcy after a 60-90 day mediation process. In this way, the state “paves the pathway” to bankruptcy, the analysts wrote.

Accounting irregularities, such as those alleged in the Stockton and San Bernardino bankruptcies, highlight a lack of state and local oversight, they wrote.

California cities’ granting of “generous” wage and benefit contracts in the boom years hurt the governments in the recent downturn, the analysts wrote. Declines in the values of the state and local pension funds also put stress on governments.

Features in California general obligation bonds make them substantially more reliable than other sorts of bonds, they wrote.

The state constitution requires local voters approve separate property tax levies for GO bonds. These are not bound by Proposition 13 limits. The analysts believe that in a municipal bankruptcy, GO bonds would be considered outside the bankruptcy estate.

GO bonds account for a small proportion of California cities’ debt. Moody’s expects a greater number of city defaults and bankruptcies in the next few years in California and elsewhere.

“We generally agree with Moody’s that California city revenues have been hit hard by the recession, with the deepest impacts felt in communities with the highest levels of mortgage foreclosure and irresponsible mortgage lending,” said League of California Cities executive director Chris McKenzie. “We part company with Moody’s, however, in its conclusion that cities in California are less vulnerable to state spending reductions than other local governments.”

Nonetheless, cities will carry on, McKenzie said.

“The vast majority of California cities will weather the worst recession since the Great Depression through making tough spending cuts, raising local taxes when possible, and partnering with employees and residents to avoid deeper service cuts,” he said.

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