NEW YORK - Moody's Investors Service said it has downgraded to B3 from B1 the rating on the city of Stockton, Calif.'s 2007 pension obligation bonds, and downgraded to Caa1 from B2 the rating on the city's 2006 lease revenue refunding bonds.

Concurrently, Moody's affirmed the city's Ba2 issuer rating, the rating on the city's sewer enterprise revenue bonds of Ba1, on its water enterprise revenue bonds of Ba3, and on the two Moody's rated community facilities districts' special tax bonds of Baa2. All the city's long-term ratings remain under 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 as the city continues down the path of mediation and potential bankruptcy.

The city has taken the steps needed to begin the mediation process, although a mediator has not yet been selected and therefore the 60 to 90 day mediation process has not yet officially begun. During the 60 to 90 day mediation process, 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, if accepted, to be a "forced exchange" and the equivalent to a debt service payment default. The B3 rating on the pension obligation bonds reflects a likely recovery, in the event of a default, of 95% to 97%, while the Caa1 rating on the lease supported obligations reflects a lower potential recovery, though still above 90%.

The affirmation of the city's Ba2 issuer rating primarily reflects the fact that this rating represents the equivalent of the city's voter-approved, unlimited tax general obligation bonds, were it to have such debt outstanding. The security for a California municipality's unlimited tax general obligation debt is extremely strong. This strength is based on the constitutional requirement that property taxes levied for GO bond repayment may not be used for any other purpose than the related debt repayment. GO bond investors also benefit from a lock-box structure which requires that the county levy and collect the taxes.

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 issuer rating also reflects the risk that the favorable treatment received to date is not based on well established legal precedent, suggesting that this treatment may not be consistently applied. The city's issuer rating therefore also reflects the risk associated with the city's potential bankruptcy filing once the mediation process is completed.

The Baa2 ratings on the special tax bonds, B1 ratings on the sewer revenue bonds, and Ba3 ratings on the water revenue bonds primarily reflect the expectation that these obligations would be protected in the event of city's bankruptcy, owing their being obligations secured by sound special revenue streams. 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.

The Ba3 rating on the water revenue bond additionally 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. As  previously noted, by itself the city's adoption of the resolution to enter into mediation 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.

By adopting the resolution to proceed with the mediation, the city clearly indicated a significantly diminished willingness to make debt service payments beyond the end of the current fiscal year. The city 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 its 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 ratings on the general fund obligations, as well as those discussed above, also reflect 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 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.

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.