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The story behind Moody's review of California cities

The ratings agency announced that it's reviewing more than 30 California cities for bond-rating downgrades. However, Los Angeles could get an upgrade.
The ratings agency announced that it's reviewing more than 30 California cities for bond-rating downgrades. However, Los Angeles could get an upgrade.

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Moody's, the big ratings agency, announced last night that it's reviewing the bond ratings of 32 California cities including Santa Monica, Glendale, Huntington Beach, and Long Beach. The reviews are for downgrades, mostly, but two of California's biggest cities - Los Angeles and San Francisco - are under review for bond-rating upgrades. This is particularly good news in L.A.'s case, given the city's looming $200 million budget deficit.

This action didn't come out of nowhere. Back in August, Moody's emphasized that although municipal debt defaults are exceptionally rare, bankruptcies in Stockton, San Bernardino, and Mammoth Lakes — along with the general fiscal stress that California cities are under — compel the agency to review the 95 Golden State municipalities whose debts it rates.

Tuesday's announcement is the culmination of that exercise. All the cities Moody's is reviewing may not be downgraded, but the agency's examining one-third (the review process will take about 90 days). The pension-obligation bonds of eight cities were downgrades. That indicates how serious a problem funding legacy pensions has become for some cities in the state.

This is from Moody's release:

"California cities operate under more rigid revenue raising constraints than cities in many other parts of the country," says Senior Vice President Eric Hoffmann, who heads Moody's California local government ratings team. "Combined with steeply rising costs, these constraints mean that these cities will likely recover more slowly than their peers nationally, even if the state's economic recovery tracks the nation's."

A few recent high-profile bankruptcy filings by cities in the state demonstrate that the willingness of some cities to continue to cut costs and associated municipal services to pay debt obligations may be eroding. For the most part, this affects the debt obligations that are paid out of a city's general fund, such as pension obligation bonds and leased-backed obligations, and that must compete with other priorities for payment. 

In response to Stockton's bankruptcy, Moody's has zeroed in on a distinction between a city's ability and its willingness to service its debts. The creeping concern is that financially troubled cities will use the bankruptcy process in California to shed debt obligations; that would free up money to cover other costs. Stockton, for example, may have the ability to pay its debt, but not the willingness. This obviously affects the credit risk profile of other cities, large and small, that could face fiscal problems in the future. Compton and Atwater — a city of 28,000 not far from Stockton — are both staring down the barrel of bankruptcy.

Moody's isn't prepared to call this a trend just yet. In the $3.7 trillion municipal bond market, almost all cities pay their debts. But in California, the extraordinary stress brought on by the Great Recession is upsetting that situation.

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