(Updated with additional reporting)

With the stroke of a pen, California Gov. Jerry Brown could avoid one of the largest municipal bond defaults of 2011. If not, the San Jose Redevelopment Agency could default on nearly $100 million of variable-rate debt this November.

But the bill sitting on Brown’s desk, which emerged from the Legislature to clean up controversial motions passed as part of the budget in June, contains other provisions the governor is expected to want to veto.

The situation is complex, fraught with politics, and the consequences could be dire. Brown has until the end of Monday to act. (October 9 is the last day for the Governor to sign or veto bills passed by the Legislature on or before Sept. 9; Senate Bill X1 8, an urgency bill, was passed in a special session and presented to the governor on Sept. 21, starting a ticking 12-day clock).

The potential default stems from the unintended consequences of recent legislation, beginning with bills passed in June as part of the budget, calling for the elimination of all California redevelopment agencies unless they hand over large payments totally $1.7 billion this year to the state. The two bills helped the state close a more than $9 billion budget gap.

But various RDAs, with support from the California Redevelopment Association and the League of California Cities, sued to block the move in late July, calling it unconstitutional. The state Supreme Court bypassed lower court hearings and agreed to hear the case. It is expected to rule in mid-January 2011.

Meantime, RDA officials are not allowed to issue new bonds or tinker with outstanding debt.

The problem: the San Jose RDA has $100 million of variable rate debt backed by a liquidity facility expiring Nov. 25.

According to Standard & Poor’s, the variable-rate notes are subordinate debt supported by letters of credit with JPMorgan.

The senior debt, backed by non-housing tax allocation revenue, was downgraded to BBB-plus with a negative outlook from A-minus in late March.

JPMorgan has acted as the liquidity provider on the debt since inception in 1996 and 2003. It’s willing to extend the letters of credit without changing any terms.

The RDA is willing to extend the agreement. Yet it has no legal authority to do so.

“We’re under official stay,” said Richard Keit, managing director of the San Jose RDA.

“We can only do enforceable obligations whether it be a project, or paying bonds or debt, honoring leases and contracts — anything that’s legally obligated. Technically, we can’t amend a letter of credit.”

If the LOCs expire, the consequences will reach far beyond the RDA, says an open letter from JPMorgan to Brown, dated Sept. 15.

It said failing to sign the bill will mean “the likely default” on more than $95 million of debt, which could have “resounding financial implications” for the RDA and the city of San Jose.

Tom Jacobs, senior credit officer at Moody’s Investors Service, said when a letter of credit is unable to be renewed, holders of the bonds tender their bonds to the trustee, who draws on the expiring facility to fund the puts.

Investors aren’t at risk, therefore, and JPMorgan would effectively own the bonds at that point.

Typically, Jacobs said, principal would amortize over three to five years starting a few months after the draw, with interest accruing at an above-market interest rate.

But in this agreement, the San Jose RDA would immediately be obligated to repay the full amount drawn by the trustee — the full $95 million, and the JPMorgan letter says the San Jose RDA will not have the capacity to repay that amount.

Keit confirmed this and added: “We know we could go into default. That’s why we’re working with all parties to prevent that.” He said other parties seek to avoid default as well.

The governor’s press office said Brown does not comment on whether he intends to sign any bills on his desk. But others say the chances of Brown signing the bill that would avoid default are slim.

“He probably will veto it,” said Tom Hart, deputy director of the California Redevelopment Association.

“The Department of Finance has mentioned that any new bill that is set forth, that is being litigated — even though a clarification — should be vetoed,” Hart said. “We think the governor will take the advice.”

A pending lawsuit that would block the original redevelopment law is what makes Brown’s decision such a dilemma, and the governor is unlikely to sign the new legislation until that suit is resolved.

H.D. Palmer, a spokesman for the California Department of Finance, confirmed that his office has advised against signing any legislation that would change the new redevelopment agency law.

“Our opposition is based on the fact that the state Supreme Court will shortly hear arguments in this case,” he said. “We think it is premature to make any changes to the underlying statute until there is a final disposition by the court.”

The defendants in the suit include state finance director Ana Matosantos, Controller John Chiang, and Patrick O’Connell, auditor-controller of Alameda County and a representative of county auditor-controllers

In the 126-page suit, the plaintiffs pointed to Proposition 22, a ballot measure passed in 2010 they said prohibits state politicians from taking or interfering with revenue dedicated to local governments.

In early August, the California Supreme Court also granted a stay against the state implementing new laws that would force redevelopment agencies to pay or face elimination. However, the court did not issue a stay on the portion of the new laws that prevent redevelopment agencies from taking on new debt.

It’s not just San Jose that is in trouble. Rocklin, a city of 57,000 located near Sacramento, is close to defaulting on $3.4 million letter of credit balance with Bank of America.

The city’s RDA was in the process of issuing emergency refunding bonds to refinance the letter of credit by July 5, but the deal fell through when the budget legislation passed.

The principal balance on the credit line is due Friday, Sept. 30.

Rocklin officials urged Brown to sign the legislation, saying a default will have “dire” consequence for the redevelopment agency and “negatively impact” the city.

“If the issue would have been dealt with in separate legislation we would have supported it,” said Tom Dresslar, a spokesman for Treasurer Bill Lockyer. “We don’t support the bill as a whole, we do support making an accommodation for Rocklin and San Jose.”

Dresslar said the Treasurer’s office is working with both sides to develop a plan if the legislation is vetoed.

San Jose’s Keit wouldn’t comment on what options exist beyond Monday if Brown doesn’t sign the legislation, but he’s hopeful that with more than five weeks before the LOCs are drawn by the trustee, some other solution could be found.

“We’re not going to speculate on whether he vetoes it or not,” Keit said. “We’ve been working with the governor’s office to inform him of the severity of this problem … The only good thing is we will have some time, one way or the other, to discuss the situation.”

“Nobody wants us to default,” added Tom Manheim, director of communications for San Jose. “We’re all working together.”

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