SAN FRANCISCO – Moody’s Investors Service has further downgraded Stockton, Calif.’s bonds on the likelihood of more defaults and haircuts for bondholders.

The agency Tuesday said it downgraded the city’s 2007 pension obligation bonds to B3 from B1 and its 2006 lease revenue bonds to Caa1 from B2.

Moody’s kept the city’s issuer rating at Ba2. All of the city’s ratings remain on review for downgrade.

“Moody’s rating action on the city’s general fund obligations (its pension obligation and lease revenue bonds) reflects the growing likelihood of default and the potential for less than 100% recovery for bondholders,” analyst Dari Barzel said in the report.

Stockton, a city of 300,000 residents an hour and a half drive east of San Francisco, is trying to avoid becoming the largest city in the country to file for bankruptcy. Its City Council voted on Feb. 28 to begin mediation with creditors under terms of a new California law, Assembly Bill 506, which is designed to give financially stressed local governments a chance at staying out of bankruptcy.

The council also voted Feb. 28 to suspend payments toward $110 million of general fund-supported bonds through June 30, the end of the fiscal year.

According to Moody’s, Stockton’s general fund creditors will most likely be faced with an offer to accept less than the full amounts of what they are owed in exchange for avoiding the expense and uncertainty of bankruptcy proceedings, Moody’s said. Moody’s said it would consider it a debt service payment default if creditors accepted such an offer.

In the event of a default, Moody’s said it expects the pension obligation bonds to recover 95% to 97% and the lease revenue bonds about 90%.

The rating agency said the Baa2 ratings on the city’s special tax bonds, B1 rating on its sewer revenue bonds, and Ba3 rating on the water revenue bonds reflect the expectation that the debt would be protected during a bankruptcy.

“Like the issuer rating, however, these ratings reflect the uncertainties that these obligations would face were the city to file for bankruptcy after the mediation process,” Barzel said.

Moody’s held the issuer rating at Ba2, reflecting that it is the equivalent of the rating for voter-approved, unlimited tax general obligation bonds, an “extremely strong” security pledge in California. Stockton has no GO bonds. Its move to the edge of bankruptcy last month spurred Moody’s to cut Stockton’s rating to Ba2 from Baa1.

Standard & Poor’s has dropped the city to “selective default” after successive downgrades from A-minus.

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

Moody’s also reiterated that Stockton’s $55 million of water revenue bonds could possibly be bought out by Union Bank and reimbursement forced if the bank finds the city in violation of its letter of credit agreement because of its decision to mediate with creditors, which could be interpreted as a state inability to pay its debts. Union Bank is among the creditors that have agreed to participate in the mediation process.

Moody’s noted city officials said explicitly in its material event notice leading up to its decision to mediate with creditors that “no assurance can be given” that the city would pay near-term debt obligations in future years.

Stockton’s rating also reflects, according to Moody’s, the city’s indication that it is in the process of restating previous audited financial statements, which reduces the credibility of Stockton’s finances to date.

The city said Thursday it has started working with creditors to start selecting a mediator, a process that should take up to 12 days, according to the law.

The selection of a mediator would start a 60-day clock on negotiations that can be extended by up to 90 days by a majority vote of creditors.

If the mediation fails, the city can still file for Chapter 9 bankruptcy, or at any time it could declare a fiscal emergency during a public hearing and start the bankruptcy.

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