SAN FRANCISCO — Stockton’s attempt to make bondholders take a $350 million hit will likely blackball it from the bond market for years and cost the California city a pretty penny when it does return, municipal market watchers say.
Stockton, one the largest cities ever to file for Chapter 9 protection, is locked in a battle with most of its bond market creditors over whether it should be allowed to reorganize its debts in bankruptcy court. The four-day trial over Stockton’s eligibility for bankruptcy is set for March 25.
U.S. Bankruptcy Court Judge Christopher Klein’s ultimate ruling on that question will likely have little bearing on the city’s standing in the market because it has already defaulted on debt and has tried to make bondholders take the largest haircuts. Investors have long memories.
“When Stockton goes out to the market, what are they going to say, we didn’t mean it?” said James Spiotto, an expert on municipal bankruptcy and partner at Chapman & Cutler LLP in Chicago. “People who invest money in municipal debt are not fools and they will just not repeat the mistake. The first time I didn’t know the stove was hot, don’t expect people to touch the stove again.”
Spiotto said reorganization of debts during bankruptcy is meant to be sustainable and affordable, and that includes reasonable access to the bond markets, noting that virtually all state and local government infrastructure improvements are funded by municipal bonds.
Stockton, a city in California’s Central Valley with a population of more than 300,000, filed for bankruptcy at the end of June. It is one of the largest municipalities, measured by outstanding debt, to file for Chapter 9 protection.
The market creditors, a group made up of bond insurers Assured Guaranty Corp. and National Public Finance Guarantee, investor Franklin Advisors, and trustee Wells Fargo NA, are fighting the possibility of an unprecedented $350 million of total reductions to the city’s bond debt through the bankruptcy. That includes ceasing payments from the general fund toward $124 million in outstanding Assured Guaranty-insured pension obligation bonds.
The city proposed the cuts to bondholders and bond insurers during 90 days of mediation prior to its filing. The proposal called for a five-year holiday on all payments from the general fund toward debt service.
Bondholder claims represent only 8% of the city’s general fund, while they were expected to account for 42% of savings in the plan proposed by Stockton, according to Assured, which has lashed out at the city publicly in addition to fighting it in court. Legal experts have said the potential debt-service cuts are without precedent in other municipal bankruptcies.
“The market has a long memory,” said Bud Byrnes, chief executive officer of Los Angeles-based RH Investment Corp. “If Stockton is effectively able to do a cram-down, it will hurt their ability to come back to market for several years.”
Stockton’s adopted fiscal 2013 budget said debt service for all city funds would be $27 million, or 5% of its total $521 million spending plan. Its general fund budget was $155 million. The city’s adopted budget calls for Stockton to 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. It would also continue to miss payments on its 2004 lease revenue bonds.
Stockton’s defaults have already cost it control of three parking garages tied to the 2004 bonds, along with an office building that had been slated to become the next city hall, which was linked to its 2007 variable-rate lease revenue bonds.
The city has planned to walk away from the parking garages, but to try and keep the office building.
“The markets are watching us and it is an important case. The city certainly didn’t want to be the in the position of being the groundbreaker in this; it was in the position to be unable to pay its debts, it had no choice,” the city’s bankruptcy attorney, Marc Levinson of Orrick, Herrington & Sutcliffe, said after a hearing Tuesday in Sacramento. “And it simply can’t pay all this debt over time and it just doesn’t have the resources to do it.”
Stockton on Friday did reach a deal on debt insured by Ambac Assurance Corp., which has a smaller exposure to Stockton debt than Assured and NPFG. According to the city, the agreement places a cap on the amount of money that could be paid each year out of the city’s general fund, provides for use of the reserve fund to pay some of the debt obligation, and if necessary extends the term of repayment.
Levinson said it is an example of what happens when two parties sit down and try to work things out.
Stockton’s plan to cut bondholder debt and its possible repercussions harkens to Orange County’s historic Chapter 9 filing in 1994. After making losing bets on derivatives, the wealthy California county was in a liquidity crisis and made a quick decision to file for bankruptcy protection. The county did not make payments due on short-term debts of $2 billion during the pending bankruptcy. But it ultimately made good on its debt.
The debtholder agreed to have the maturities extended one year at higher interest rates. Orange County was able to get market access to pay off the balance through issuing tax-exempt certificates of participation and taxable refunding pension obligation bonds. The county paid a penalty of 10 to 23 basis points, which with the inclusion of underwriting and bond issuance fees, cost the county $60 million because of its status as a bankrupt issuer, according to a report by Chapman & Cutler.
Vallejo, Calif., a much smaller city with much less debt, also made bond investors take haircuts as part of its plan to exit bankruptcy in 2011, though at a smaller scale than Stockton is proposing. It hasn’t yet returned to the market.
Stockton 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 debt, according to the city’s most recent audited financial statements.
Stockton officials have said debt tied to restricted funds would be protected from the bankruptcy process.