(Updates with Moody's downgrade of city debt)
By Jim Christie
STOCKTON, Calif. Feb 24 (Reuters) - Moody's Investors Service said late on Friday it downgraded Stockton, California's general fund-supported debt ratings to below investment grade after the city's manager said he would urge suspending some debt payments as part of a financial restructuring meant to stave off a bankruptcy filing by the city.
Moody's said in a statement that it lowered its issuer rating for Stockton to Ba2 from Baa1 and its rating on the city's 2007 pension obligation bonds and 2006 lease revenue bonds to Ba3 and B1 respectively.
Moody's also lowered Stockton's water enterprise bond rating to A3 from Aa3 and said all of the city's long-term ratings remain on review for further downgrades.
The rating agency said its actions affect $341 million in debt.
Stockton City Manager Bob Deis said earlier on Friday that he recommended to the city council that bond payments of about $2 million be suspended as part of a broad restructuring of the city's finances, which were hammered by the housing crisis, to avoid Stockton becoming the biggest U.S. city to declare bankruptcy. The city has a debt payment due March 1.
Moody's criticized that plan, saying that suspending payments would show a "significantly reduced willingness, if not ability, to make full and timely debt service payments."
Stockton faces a budget deficit of about $20 million in its next fiscal year, Deis said. Spending has already been slashed dramatically, and Diaz said further cutbacks alone cannot bridge the gap and that mediation with creditors was essential.
The city of 292,000 people, located about 85 miles east of San Francisco, has suffered from two decades of poor financial management, overly generous retirement packages for city workers, unsustainable labor contracts and too much debt, Deis said.
Long a commercial hub for the rich agriculture industry of the Central Valley, Stockton also became a low-cost bedroom community for the San Francisco Bay Area during the housing boom. But when boom turned to bust, the city's high crime rate, run-down central business district, weak schools and other urban ills quickly brought growth to a halt.
Stockton's once-torrid housing market is now in a free-fall, with building activity at a standstill and a foreclosure rate that's among the highest in the nation.
Property values in Stockton will decline for the foreseeable future, Deis said. "We haven't hit bottom."
State Treasurer Bill Lockyer said his office is keeping a close watch on Stockton, saying the bankruptcy's "reputational stain can bleed onto other local issuers and the State, and that can hurt taxpayers in the bond market. So we hope a Chapter 9 filing is not the final outcome."
If Stockton, located about 85 miles east of San Francisco, were to file for Chapter 9 bankruptcy, it would the second city in California in recent years to do so after Vallejo, which declared bankruptcy in 2008.
Stockton has responded to tumbling revenue from its dramatic economic downturn by slashing services and payroll. But Deis said the city can no longer rely on cuts, especially in public safety spending. With few options to increase revenue, he is urging the city council to approve talks with creditors to restructure the city's debt.
Stockton's city council will take up Deis' recommendation at its meeting on Tuesday, along with a plan to begin a process required by a new California law under which the city will seek a settlement with its creditors to avert bankruptcy.
However, a so-called material event notice filed on Friday with the U.S. municipal bond market regulator said "no assurances can be given" that bankruptcy would ultimately be avoided.
Vallejo's bankruptcy in 2008 made national headlines and put a spotlight on other financially troubled cities in the most populous U.S. state. Stockton will revive those worries.
"You don't need a large number of defaults to scare (retail) municipal investors out of the marketplace," said Kenneth Naehu, a managing director, at Bel Air Investment Advisors.
Still, investors are likely to see Stockton as an isolated example of a municipal bond issuer overwhelmed by unique financial troubles, said analyst Bill Schmohl at municipal bond broker-dealer Alamo Capital in Walnut Creek, California.
"We're seeing a lot of very responsible municipal issuers being able to pare back expenses" in response to weak revenue, Schmohl said.
According to James Spiotto, a muni bankruptcy expert at the law firm of Chapman and Cutler, 49 of 264 municipal bankruptcies filed since 1980 involved cities, counties and villages, and 31 percent of the filings were dismissed.
Currently, there are about 16 municipal bankruptcies pending in federal courts, including the largest ever - Jefferson County, Alabama, which defaulted on more than $3 billion in sewer revenue debt.
A financial review of Stockton by Management Partners that was included in the "material event" notice concluded Stockton "is facing a very serious financial crisis," and is insolvent from a budget perspective.
While the recent recession depleted city revenue, debt issuance between 2004-09 increased Stockton's debt-service payments linked to the general fund budget by 600 percent, "creating major cash-flow demands after revenues and reserves plummeted," it said.
The review also pointed to unpredictable payments on variable-rate debt, investment losses on pension bond proceeds, rising retiree healthcare costs and continued revenue declines. (Reporting by Jim Christie; Additional reporting by Karen Pierog in Chicago and Joan Gralla in New York; Editing by James Dalgleish and Paul Simao)