LOS ANGELES — The two California cities in bankruptcy now could return to insolvency if they fail to overhaul their pension obligations in Chapter 9.

That's the conclusion of a Moody's Investors Service report in which analysts compared bankrupt Stockton and San Bernardino to Vallejo, which exited bankruptcy nearly three years ago.

Vallejo is still struggling with mounting pension obligations, similar to those that Stockton and San Bernardino face.

"Like most California cities, Stockton's and San Bernardino's employees' pensions will require increasing city contributions," analysts wrote in the report released Thursday afternoon. "But unlike most of their peers, cities emerging from bankruptcy are likely to have budgets that are very thinly balanced, limited revenue growth prospects, and little in the way of financial reserves."

Moody's said that Vallejo, which has a persistent structural budgetary imbalance and is at risk of a second bankruptcy filing, could serve as a warning sign for Stockton and San Bernardino if they, too, fail to modify their pension liabilities.

The judge in the Detroit bankruptcy case recently found the city's pension liabilities to be contracts that can be modified in Chapter 9, something that could serve to help the argument for other cities to modify their liabilities. However, that ruling is nonbinding on federal bankruptcy judges elsewhere, Moody's noted.

The California Public Employees' Retiree System, one of the largest creditors in both bankruptcy cases, has argued that it falls outside the bankruptcy court's jurisdiction. It contends that it is an "arm of the state" and that a judge cannot interfere in the relationship between a state and its local governments.

CalPERS has also said that its relationship with municipalities is meaningfully different from Detroit's relationship with its pension systems, retirees and employees.

San Bernardino, which filed for Chapter 9 protection in July 2012, was ruled eligible for bankruptcy in August 2013. As it develops its plan of adjustment, CalPERS is challenging the city's eligibility for Chapter 9 in a federal appeals court.

The city has been in mediation with CalPERS and other parties since Nov. 24. The parties are due back before U.S. Bankruptcy Judge Meredith Jury, the primary judge in the case, on March 13 for a status hearing on the bankruptcy.

"San Bernardino could argue that the Detroit decision establishes a legal framework for reducing pension obligations, but the city faces an uncertain and potentially costly legal battle," Moody's said.

The city would first have to demonstrate that its relationship with CalPERS is based on a contract. Then it would still have to reduce its overall pension liability and annual payments, to which CalPERS would not likely agree.

Without an agreement, San Bernardino would have to reject its contract with CalPERS in order to reduce its liabilities, which would cost a termination liability of approximately $1.2 billion, Moody's said.

Stockton, on the other hand, is far less likely to change its two underfunded pension plans in Chapter 9, because it is much further along in the bankruptcy process.

The city, which declared bankruptcy in June 2012 and was granted eligibility in April 2013, has reached agreements with all of its major creditors, except Franklin Advisers Inc.

Under its proposed exit plan, the city's obligations to the CalPERS are unimpaired. However, the plan does impair retiree health benefits.

Stockton has been reluctant to challenge CalPERS, arguing that providing a pension with current benefit levels is integral to recruiting public safety workers.

"However, the city still faces the possibility that it will need to confront unfunded pension liabilities if it cannot reach a deal with Franklin Advisers before a May 2014 confirmation hearing," Moody's said.

Franklin is the sole investor in a series of lease revenue bonds issued by Stockton and has initiated legal action against the city and other Stockton creditors, including CalPERS.

If U.S. Bankruptcy Judge Christopher Klein does not approve the city's plan of adjustment during the confirmation hearing, the city would likely have to renegotiate with its creditors, which could include CalPERS.

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.