NEW YORK - Moody's Investors Service said it has affirmed the city of Stockton, Calif.'s Ba2 issuer rating. However, Moody's said it has downgraded by one notch the ratings on the city's 2007 pension obligation bonds and 2006 lease revenue bonds, to B1 and B2 respectively.

The city's water enterprise bond rating has also been downgraded, to Ba3 from A3. The city's sewer enterprise bond rating has been downgraded to Ba1 from A2, and each of the city's two, Moody's-rated community facilities districts' special tax bonds have been downgraded to Baa2 from A3. All of the city's long-term ratings remain on review for possible downgrade.

The affirmation of the city's Ba2 issuer rating primarily reflects the strong, unlimited property tax general obligation pledge that the issuer rating represents for a California municipality.

Such pledges have been demonstrated to receive favorable treatment in bankruptcy proceedings in California, largely owing to the "special revenue" nature of the California local government GO bond pledge.

The pension obligation bond and lease revenue bond rating downgrades primarily reflect the city's adoption of a resolution to suspend payments on general fund supported debts for the remainder of the current fiscal year and to enter into a mediation process with its creditors in an effort to avoid filing for bankruptcy protection.

The city has indicated that all of its near-term debt obligations would be paid from other revenue sources, cash funded debt service reserves, or bond insurers, thereby avoiding a debt service payment default. However, in the mediation period, the city's general fund creditors will most likely be faced with an offer to accept less than full amounts due in exchange for avoiding the expense and uncertainty of a bankruptcy proceeding.

Moody's would consider such an offer to be a "forced exchange" and the equivalent to a debt service payment default.

By adopting the resolution to proceed with the mediation, the city has also clearly indicated a significantly diminished willingness to make debt service payments beyond the end of the current fiscal year. In its recent material event notice leading up to adoption of the resolution, the city explicitly stated that "no assurance can be given" that these obligations will be paid in future fiscal years.

The water revenue bond rating downgrade primarily reflects the enterprise's likelihood of defaulting on a demand for immediate reimbursement (if made) by the letter of credit bank supporting $55 million of the enterprise's outstanding debt. The adoption of the resolution by itself likely represents the city's stated inability to pay its obligations when due, which is a defined event of default under the LOC reimbursement agreement.

The reimbursement agreement permits the bank, at its option, to make a full and immediate reimbursement demand.

Such a demand, if it were exercised, would put severe and likely unmanageable liquidity pressure on the enterprise and imperil payments on the enterprise's other, fixed rate parity obligations. The likelihood of acceleration will be a function of the bank's perception of its risks in the mediation process or a bankruptcy filing.

The downgrade of the sewer revenue and special tax bonds reflects the uncertainties that these obligations would face were the city to file for bankruptcy after the mediation process.

The downgrade of these obligations, as well as those discussed above, also reflects the city's indication that it is in the process of restating prior year audited financial results. While this process is in its preliminary stages and only estimates have been released, the potential for restatement reduces the credibility of the city's financial reporting to date for all of its obligations, not just those subject to the mediation process.

Future rating reviews will reflect the likely continued sufficiency and accuracy of the city's reported financial information.

All of the city's ratings remain on review for possible further downgrade.

Future rating action will be driven primarily by the results of the mediation process and whether or not the city ultimately files for bankruptcy protection.

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