May 14, 2013 / 5:51 PM / 4 years ago

UPDATE 2-California cities to remain 'fiscally challenged' -Moody's

WASHINGTON, May 14 (Reuters) - Many California cities will remain fiscally challenged over the next few years due to limits on raising revenues and demands for pensions and other spending, Moody’s Investors Service said on Tuesday.

The agency said it downgraded the ratings on 27 cities’ obligations and upgraded the general obligation ratings of two cities - San Francisco and Los Angeles - after reviewing all of the 95 California cities it assesses.

The review was inspired by the bankruptcy filings of Stockton and San Bernardino, California, to understand the risk of future bankruptcy filings and the cities’ current budget conditions, Moody’s said.

California stunned the $3.7 trillion municipal bond market last year with three bankruptcy filings. Mammoth Lakes also filed for creditor protections under Chapter 9 municipal bankruptcy law.

In general, lease-backed and unsecured bonds are at greatest risk, Moody’s said, noting that all three bankrupt cities defaulted on some of the obligations. It downgraded all lease-backed obligations that already had ratings below an issuer’s general obligation rating, it said.

“These bankruptcies reinforced our belief that large tax bases and stabilizing economies are not sufficient by themselves to assure repayment,” Moody’s said. “The risk to these general revenue-backed obligations is markedly greater than to those supported by a city’s general obligation pledge.”

Stockton neighbor Fresno suffered a raft of downgrades. Its taxable pension obligation bonds were knocked down three notches to Ba2 with a negative outlook, as 10 of its lease revenue refunding bonds were cut two notches to Ba1 with a negative outlook. Some revenue bonds issued by nearby Sacramento were also downgraded.

The median rating for California cities’ general obligation bonds “remains relatively high” at Aa2, Moody’s said, a reflection of “their fair success, so far, in adapting to the new fiscal reality: moderate revenue growth compared to pre-recession levels and continuing cost pressures.”

“After some initial optimism for a quick economic recovery, most cities adopted more realistic economic expectations and implemented significant budget cuts, reestablishing, for the most part, structural budget balance and stable credit quality,” it added.

The revenues of inland cities, which grew during the housing bubble will likely not return to pre-recession levels “in the next few years,” Moody’s said. San Bernardino is the anchor of the part of the state known as “The Inland Empire,” while Stockton sits in the Central Valley.

Coastal cities, meanwhile, are recovering faster.

Across the most populous state in the country, though, pent-up spending demands will likely eat up improving revenues.

“After declining for two consecutive years, expenditures picked up again in 2012, and on average this increase in expenditures more than offset the modest revenue gains,” Moody’s said.

In Los Angeles, the state’s biggest city, Mayor Antonio Villaraigosa has proposed raising revenue, cutting spending, and reducing funds for many city employees, to help close a $216 million budget gap. San Francisco also faces a shortfall, of about $124 million, and officials expect costs to outpace revenue growth over the next five years.

Another major rating agency, Standard & Poor‘s, said earlier this month that it does expect to see more bankruptcy filings this year.

Nonetheless, rating agencies are closely watching for the effects of a rate increase approved by California’s public pension fund last month. The California Public Employees’ Retirement System, known as Calpers, changed the methods for calculating future pension obligations and amount of money to set aside to cover costs. In some cases contribution rates could rise as much as 50 percent.

“Retirement costs, which are growing at disproportionate rates to cities’ general revenue growth, are an additional and likely longer lasting pressure on expenditures,” Moody’s said.

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