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San Bernardino watches Stockton bankruptcy hearing 'with interest'

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San Bernardino City Hall. The municipality has declared bankruptcy and is next in line behind Stockton to go through a legal process of determining eligibility to enter Chapter 9.

Stockton, the largest U.S. city to declare bankruptcy, last week became mired in a legal hearing to determine its eligibility to move forward with Chapter 9, the city government version of Chapter 11.

On Monday, U.S. Bankruptcy Court Judge Christopher Klein ruled that Stockton, with a population of nearly 300,000, could proceed and that the city's bondholders, issuers and insurers hadn't negotiated in "good faith" prior to the Chapter 9 declaration. 

The issues were sufficiently complicated that Klein had to take the weekend to review thousands of pages of documents. But he determined that the city was genuinely insolvent when it declared Chapter 9 after a mediation period with creditors established by a relatively new California law.

Assured Guaranty — a Bermuda-based firm that issued and insured some of Stockton's debt and that had opposed the city's eligibility for bankruptcy — said in a statement that it "respectfully disagrees" with Klein's ruling and highlighted the judge's comment that this was "very much a preliminary hearing."

The $3.7 trillion municipal bond market has been following the Stockton case closely because municipal bankruptcies are exceptionally rare and, even when cities declare Chapter 9, they typically continue to make good on their debt payments. Two other California cities also declared bankruptcy last year: Mammoth Lakes and San Bernardino.

The debate in Stockton involves where creditors stand in line to get paid. The California Public Employees' Retirement System (CalPERS), the country's largest pension fund, wants to be at the front and get paid no matter what, arguing that pension obligations can't be discharged in bankruptcy. It retained that position in the last major California municipal bankruptcy, Vallejo, which entered Chapter 9 in 2008 and exited in 2011.

Stockton has so far remained current on its obligations to CalPERS — but San Bernardino hasn't. And late last year, a judge ruled that CalPERS couldn't use the state courts to make an end-run around federal bankruptcy court to collect the $1.2 million per month that the city owes in payments.

"We're watching what's happening in Stockton with interest," said Jim Morris, chief of staff to San Bernardino Mayor Pat Morris. "Municipal bankruptcy is a new area of law, so any ruling will establish some clarity. But our position now is to remain vigilant."

Morris said that the city continues to work with all its creditors, including CalPERS, as it prepares for its own eligibility hearing. Unlike Stockton, San Bernardino didn't enter mediation but instead declared a fiscal emergency and moved directly to bankruptcy. It is awaiting its own eligibility hearing.

"We continue to reduce costs and the City Council continues to make difficult decisions," Morris said.

He added that although the city was able to reduce employee costs through negotiations with some of its union, solutions "had to be imposed" on the police and firefighters unions.

"The city remains largely the same as beforehand," he said. "The focus has been on delivering core city services, but evidence of our financial strain is showing up in terms of long-term maintenance that hasn't been done in a long time, since city starting cutting the budget in 2008."

There's evidence of economic recovery San Bernardino. Its housing market, the collapse of which precipitated its fiscal crisis — although there have also been questions about the city's financial management — has been showing sustained signs of life. Its unemployment rate remains above 11 percent, but has fallen steadily if not rapidly over the past few years.

That is yielding some increases in property tax and sales tax revenue, but not enough to close a $46 million deficit.

"It's never an upward skyrocket," Morris said. "The economy is in slow recovery, and revenues are always fickle. That's the reality of local government."

Ratings agency Moody's doesn't rate San Bernardino's debt, but it has been keeping a close watch over the finances of numerous California cities, with a special focus on Stockton. 

"This just another example of what a city must overcome to get into bankruptcy," said Greg Lipitz, a Moody's analyst in New York.

But he added that clearing Stockton to enter Chapter 9 has created an avenue to file. From a credit-rating standpoint, that's a negative — even if municipal bankruptcies remain rare.

"We don't expect a lot of cities to go into bankruptcy," Lipitz said.  "But there will be a small number of cities that do."

His California-based colleague, Eric Hoffmann, pointed to a review of the state's cities and their finances that Moody's completed last year, in the wake of the Stockton and San Bernardino bankruptcies. 

"We have an expectation that California local governments will be financially challenged, with the impact of the economic recovery modest when compared with cost growth."

Interestingly, San Bernardino has done exactly what Stockton's bondholders sought: it stiffed CalPERS. But compared with Stockton, San Bernardino had less overall debt. It considered its pension fund obligations to be a bigger threat to keeping the lights on — and likely understands that, as an older city with long-deferred maintenance to address, post-bankruptcy access to bond markets will be critical.

But that doesn't mean the city assumes it will move smoothly into bankruptcy.

"Vallejo had the misfortune of being the first to try to find its way through an ill-defined forest," said Morris, before he mixed his metaphors a bit. "We want to come up with a solid long-term plan that puts the ship on the right course, through difficult if navigable waters."

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