SAN FRANCISCO — Stockton, Calif., is set to become the third largest issuer of debt in the country ever to file for Chapter 9 bankruptcy protection.

Stockton Timeline

City spokeswoman Connie Cochran said the city will file for Chapter 9 in U.S. Bankruptcy Court in Sacramento before end of business Friday.

The big question in the municipal bond market right now is how much of a hit will be borne by investors in and insurers of the more than $300 million of bonds supported by Stockton’s general fund.

As Stockton has no voter-approved general obligation debt secured by the unlimited-tax pledge of the city, experts say bondholders face more risk.

“Stockton has the typical of debt structure of a California city, annual appropriation debt rather than voter-approved GOs,” said Richard Ciccarone, a managing director at McDonnell Investment Management. “These issues are more likely to be subject to a discount or delay during a period of bankruptcy.”

The Stockton City Council voted 6-1 Tuesday night to file for bankruptcy after city officials said negotiations with its creditors failed.

City manager Bob Deis said negotiations with the city’s 18 creditors under a mediation process set up in state law failed by Monday’s deadline to provide enough cuts to close Stockton’s estimated $26 million gap for the next fiscal year.

James Spiotto, a lawyer and an expert on Chapter 9 bankruptcies with Chapman and Cutler LLP in Chicago, said everyone will watch very closely what happens in Stockton, which would be the third largest bankruptcy by size of debt after the largest, Jefferson County, Ala., and the second largest, Orange County, Calif.

“From a market perspective, people certainly are going to be watching it,” Spiotto said. “Is this again another aberration or is it something else?”

He said the municipalities that have been most successful in dealing with bondholders typically end up refinancing their debt in a way that includes some benefits and concessions.

“Trees that don’t bend in the wind are uprooted, or what I have also heard some people say, ‘If you don’t take a haircut, you get beheaded,’ ” Spiotto said The average municipal bankruptcy takes more than a year to resolve, he said.

Vallejo, Calif., spent more than three years and around $12 million on attorneys before exiting bankruptcy.

As part of its plan, the city slashed bondholder debt by almost 50% and unsecured claims, such as retiree medical benefits, by 80% or more.

Stockton has hired the same bankruptcy attorney who represented Vallejo, Marc Levinson of Orrick, Herrington & Sutcliffe.

The mediation process that Stockton participated in with its 18 creditors under the recent AB 506 law that directs local government to negotiate before entering bankruptcy — which did not exist when Vallejo filed — may speed up the process.

“They are moving into bankruptcy with a much better set table than Vallejo ever could have because of the exchange of financial information and 90 days worth of conversations with creditors,” said Karol Denniston, a lawyer who helped craft AB 506 law and a partner at Schiff Hardin LLP.

Deis said the city hopes to reach agreements with some of the creditors during informal talks that would be honored during the bankruptcy process.

The result could be a speedier process and lower bankruptcy costs for the city of Stockton, which it has budgeted at $3.5 million.

Denniston said if the AB 506 mediation makes bankruptcy fast and effective for Stockton, it could lead to other California municipalities entering the process more quickly.

That concerns Ciccarone.

“I think this first one is not a good way to start it off,” he said. “We have been more cautious in California cities for a while now because of AB 506.”

Under the fiscal 2013 budget plan adopted by council this week, the city will slash debt payments from the general fund to zero.

The fiscal year starts July 1. It also will adopt major employee cuts, including to retiree medical benefits.

Stockton has been struggling for years during the recession under the high cost of rich retirement benefits and debt it incurred during the housing boom.

According to city documents and industry data, Stockton will have $327 million outstanding as of June 30 from seven different bond issues tied in some way to its general fund and issued by either the city, its former redevelopment agency or its public financing authority.

The city’s outstanding bonds are either lease revenue bonds, revenue bonds, pension obligation bonds or certificates of participation.

Stockton will stop payment on $302 million of bonds that will be affected by its plan to remain solvent next year, according to Cochran. Most of that debt is insured and some is enhanced by letters of credit.

National Public Finance Guarantee Corp. has said it is exposed to $89 million of debt linked to Stockton’s general fund. Assured Guaranty has said it is exposed to $150 million of bonds net par. Ambac Assurance Corp. insures $13 million of Stockton’s bonds.

After declaring fiscal emergencies in previous years, Stockton’s City Council moved towards bankruptcy when it voted on Feb. 28 to enter into AB 506 mediation.

After 60 days of confidential talks were extended another 30 days, Deis announced last week that council members would consider the plan to slash more than $10 million of debt payments to help close its $26 million budget gap if the mediation process failed.

The city has closed $90 million of budget shortfalls over the last three years.

Stockton will withhold a $2.58 million payment on its 2007 variable-rate lease revenue bonds and a $5.7 million payment on its 2007 pension obligation bonds during the next fiscal year. It would also continue to miss payments on its 2004 lease revenue bonds.

Stockton has already let three sets of bonds default — the 2007 and the 2004 lease revenue bonds, as well as another set issued in 2009 — after the city decided in February to stop paying its part on $110 million of par value of debt through the end of the fiscal year.

Seven bond issues rely in some way on support from the city’s general fund, though some have backstops from other sources.

As a result of the defaults, the city has lost possession of three parking garages tied to the 2004 bonds along with an office building that had been slated to become the next city hall; its lease revenues support the 2007 bonds.

Stockton lost possession of the two properties after Wells Fargo, the trustee for the debt, sued for control of the related revenues.

Another $55 million of variable-rate revenue bonds issued in 2010 by Stockton’s financing authority could be declared in default by Union Bank, the letter-of-credit provider on the debt, resulting in a mandatory tender, according to city officials.

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 the city’s most recent audited financial statements.

Stockton officials have said the debt tied to restricted funds would be protected from the bankruptcy process.

Standard & Poor’s rates the city at a “selective default” and Moody’s Investors Service Wednesday downgraded the city's general fund-supported bonds to Caa3.

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