SAN FRANCISCO — The Stockton, Calif., City Council voted Tuesday night to default on payments tied to $330 million of bonds and begin negotiations to try to avoid Chapter 9 bankruptcy.

Council members voted 6 to 1 to approve a rescue plan designed to avoid a bankruptcy filing amid a “best case” $20 million budget gap.

“It has been no secret to the world, and especially to the citizens of Stockton, that we have been dealing with a fiscal crisis for three years and instead of getting better, it has gotten worse,” said Mayor Ann Johnston. “We are still trying to avoid the ultimate bankruptcy.”

The plan includes delaying debt service payments on bonds backed by the city’s general fund through the end of June in an effort to save around $2 million.

In addition, the city would launch negotiations with stakeholders, such as bondholders and unions, under the terms of a new California law, AB 506, touted as a way for troubled cities to avoid bankruptcy.

Other emergency measures adopted by the city included suspending employee sick and vacation day payouts and continuing a fiscal emergency for a third straight year.

The council’s action will cause a technical default on $327 million of lease revenue and pension obligation bonds issued by the city, its redevelopment agency and its public financing authority.

Investors would still be initially paid either through other sources pledged to some bonds, bond reserves, payments already forwarded to bond trustees or bond insurance, according to a staff report by city manager Bob Deis.

When Stockton and its agencies issued much of its debt, it had to use its general fund as a backstop to ease investor concerns to secure better interest rates, Deis said.

All of the bonds except $35 million are insured by National Public Finance Guarantee Corp., Assured Guaranty Ltd. and Ambac Assurance Corp., according to bond disclosure documents.

The closed-door negotiations will be the first test of the new AB 506 process.

The law requires that before a bankruptcy, a majority of the municipality’s elected body must either vote during a public hearing to declare a fiscal emergency or take part in a minimum 60-day evaluation and mediation process by an independent third party.

If the Central Valley city is able to restructure debts during the mediation, it said it could produce $20 million in savings for the next fiscal year. If not, it may be forced into bankruptcy.

Stockton would join an exclusive California club if it ever filed for bankruptcy. Vallejo did so in 2008, Desert Hot Springs filed in 2001, and Orange County filed the state’s largest ever in 1994.

Stockton has hired Orrick, Herrington & Sutcliffe, who represented Vallejo during its bankruptcy, to advise it. City officials estimated the AB 506 process could cost it $3.5 million. Vallejo spent $12 million on its more than three-year bankruptcy case. 

The news of Stockton’s woes Friday led to “super-downgrades” of California’s 13th-largest city by Moody’s Investors Service and Standard & Poor’s to junk status.

Moody’s cut Stockton’s issuer rating to Ba2 from Baa1.

Standard & Poor’s dropped the city’s issuer rating to BB from A-minus on Friday and Wednesday afternoon cut it to CC after the City Council’s decision.

Both agencies kept the credit on watch for another downgrade.

Moody’s also downgraded the city’s water enterprise bond rating to A3 from Aa3 out of concern that if the City Council admitted it can’t pay its debt that could trigger a default event and the bank backing the bonds with a letter of credit would demand reimbursement.

There were more than $702 million of bonds issued by Stockton, including city and redevelopment agency debt as well as water, sewer and parking enterprises outstanding as of June 30, 2010, according to the CAFR.

The housing bust crushed the economy of the city of 290,000.

As of the end of the year, Stockton’s unemployment rate stood at 15.9%, one of the highest in the nation, according to the U.S. Department of Labor.

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