SAN FRANCISCO — Stockton may not exactly be the next Vallejo, but similarities between the two California cities have started people talking.

Stockton, located 80 miles east of San Francisco, is more than twice the size of the Bay Area’s Vallejo and also has much more debt outstanding, making it one of the largest and more significant municipalities in the country teetering on the edge of bankruptcy.

As in Vallejo, Stockton officials say its finances are severely strained from a steep drop in revenues due mainly to the housing bust, while labor costs locked into contracts continue to rise.

Jeff Michael, director of the business forecasting center at the University of the Pacific’s business school in Stockton, said development and construction in the housing sector had been a major driver of the city’s economy, and was essentially wiped out.

“Basically, it comes down to the housing collapse,” Michael said. “You have a city that overextended itself and had unrealistic expectations.”

Stockton recently hired former Vallejo assistant finance director Susan Mayer as its chief financial officer and tapped Vallejo’s  bankruptcy attorney, John Knox of Orrick, Herrington & Sutcliffe, to help it deal with its fiscal woes.

When asked whether he was hired to consult Stockton on a potential bankruptcy, Knox said his contract with the city is broad and he could not comment further because of attorney-client privilege. In the past, he has helped the city as bond counsel.

All the talk has even forced Stockton’s mayor to mention the dreaded Chapter 9.

“We will do everything, absolutely everything, in our power to avoid bankruptcy. Underline it,” Stockton Mayor Ann Johnston said during a state of the city address on May 19 in front of business leaders. “Because that is a list we do not want to be on.”

Vallejo filed for Chapter 9 bankruptcy in 2008 and has yet to emerge from bankruptcy proceedings.

Johnston’s speech came just a few days after the City Council declared its second fiscal emergency in as many years, giving the city the power to continue to renegotiate with its unions in an effort to cut its deficit.

Stockton is facing a $37 million deficit in a budget with $160 million of revenues, a 60% increase from last year’s $23 million gap. The budget hole is expected to grow to $48 million by 2014 without major changes, according to city staff.

Stockton’s recently hired city manager, Bob Deis, said in a recent staff report that the main reason for the growing deficit is rising employee wage and benefit costs that are locked into contracts, especially with public safety, which represents 80% of general fund spending.

The city is grinding through negotiations with its unions that will likely determine its financial future.

But the chasm between Stockton and labor unions stands at around $20 million and some unions have declined to even negotiate, city staff told the council during a special meeting last month.

If the city does not get concessions from its unions, Deis has said it may have to make further cuts to an already decimated workforce. He said the City Council would be forced to choose between dramatic public safety cuts or temporary emergency measures.

But there has been a bit of a silver lining added since last year’s emergency.

City voters in November passed a measure that replaced binding arbitration for labor contracts with voluntary, non-binding arbitration, giving the city greater flexibility when negotiating with its unions. The new tool should help the city as contracts expire.

The multimillion dollar deficit comes after the government has already cut 25% of its workforce in the last two years. During a recent presentation to the City Council outlining the fiscal emergency, Mayer described the crisis as “severe and chronic.”

Because of its dire finances, the city has had its ratings dropped over the last year by Standard & Poor’s and Moody’s Investors Service.

In its most recent report last June, Standard & Poor’s lowered its rating on Stockton to A from A-plus with a stable outlook, citing the dire local economics and the city’s challenges in reaching deals with its public safety unions.

“The challenge of an economy that is having a clear effect on revenues is how the city deals with that — can they achieve structural balance and adequate reserves,” said Chris Morgan, an analyst with Standard & Poor’s. “We’re focused on structural balance and in our latest report that is what we are looking for. How they achieve that we are less concerned with.”

In January, Moody’s downgraded the city to A1 from Aa3 with a negative outlook. In its report, the agency said Stockton’s ability to renegotiate public safety contracts and achieve a sustainable budget will be critical to maintaining its rating.

Moody’s said debt levels are manageable but that the city’s variable-rate debt has added some risk.

Stockton has $224 million of outstanding debt — $87 million of lease revenue bonds, $13 million of certificates of participation, and $124 million of pension obligation bonds, according to its most recent comprehensive annual financial report, for the period ending June 30, 2010. Of the lease revenue bonds, $40 million are in variable-rate mode.

The outstanding bond payments represent 6.4% of general fund revenues, according to Moody’s. The city’s redevelopment agency also has $160 million of outstanding revenue bonds.

Located in the Central Valley, Stockton was crushed by the bust of the housing bubble during the recession, even leading the nation in foreclosures for a time.

The city’s assessed property values dropped 19% in fiscal 2010 and then 5% in fiscal 2011.

In October, Stockton’s unemployment rate hit 19.6% and in April it stood at 17.3%, one of the highest in the nation, according to the U.S. Department of Labor.

However, the University of Pacific’s Michael said signs of economic growth have begun to reappear, especially in the large agricultural sector as well as in manufacturing. 

But whether Stockton files for Chapter 9 bankruptcy will likely depend more on what happens in the near future.

The city’s budget is due June 21 and the much anticipated outcome of negotiations with the firefighters union is expected soon.

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