SACRAMENTO, Calif. (AP) -- One of the nation's top credit rating agencies said Friday that it expects more municipal bankruptcies and defaults in California, the nation's largest issuer of municipal bonds.
Moody's Investors Service said in a report that the growing fiscal distress in many California cities was putting bondholders at risk.
The service announced that it will undertake a wide-ranging review of municipal finances in the nation's most populous state because of what it sees as a growing threat of insolvency.
The report has both investors and government leaders worried.
Three California cities - Stockton, San Bernardino and Mammoth Lakes - have filed for bankruptcy so far this year. They are not likely to be the last, Moody's said.
Moody's reports that some cities are turning bankruptcy as a new strategy to take on budget deficits and avoid obligations to bondholders, an emerging dynamic that could have ripple effects throughout the investment community.
The municipal bond market has long been characterized by low default rates and relatively stable finances, Moody's said, but that outlook is beginning to change as bankruptcy becomes a tool for cash-strapped cities.
As a result, the agency will reassess the financial position of all cities in California, which issues about 20 percent of the municipal bond volume nationwide, "to reflect the new fiscal realities and the governmental practices."
The agency also will examine the outlook for municipal bonds in other troubled states, according to Robert Kurtter, managing director of public finance at Moody's.
Moody's would not say which states it will review, though Kurtter mentioned Michigan and Nevada as possibilities. Friday's report noted that cities across the country are in financial distress but said that a greater share of bankruptcies are expected in California.
In California, officials rushed to downplay the report.
"Moody's has an obligation to review changing circumstances, but we would just suggest that their assessment of the framework and ground activities is perhaps exaggerated," said Chris McKenzie, executive director of the League of California Cities.
The state treasurer's office also cautioned against overacting to three bankruptcies among California's 482 cities.
"No city's going to blithely skip into bankruptcy court to avoid its obligations," said treasurer's office spokesman Tom Dresslar, who called the report "a little hyperbolic."
More than 10 percent of California cities have declared fiscal crises, according to the Moody's, with the most troubled areas lying inland in the middle of the state and east of the Los Angeles area.
Kurtter said the declarations of emergency were "a reflection of the broader fiscal stress in the state."
Moody's floated the idea Friday of an across-the-board ratings adjustment for California cities, a move McKenzie warned "would have a terrible impact on taxpayers."
The agency will consider ratings downgrades for embattled counties, school districts and special districts.
The report highlighted growing doubts in some corners about whether cash-strapped cities are making good-faith efforts to pay their debts.
"Credit analysis is based on the ability to pay and the willingness to pay," said Paul Rosenstiel, Principal at DeLaRosa & Co., a San Francisco-based municipal bond investment-banking firm.
Investors have historically assumed that cities are willing to pay their debts because they want continued access to the bond market, Rosenstiel said.
Now, some are not so sure.
"What is being considered is whether the willingness to pay is something that needs to be factored in more than in the past - and if so, how would you measure it?" he said.
Lower bond ratings would increase borrowing costs for cities at a time when many already are struggling financially because of a steep drop in tax revenue. Because of that, Friday's report is raising alarms for city leaders who fear that it could trigger a crisis of confidence that would hinder their ability to borrow for needed projects.
"Every city in the state is looking on with some concern," said Dave Vossbrink, spokesman for the city of San Jose. "Governments of all kinds borrow money, usually to build infrastructure that lasts a long time. It's like getting a mortgage to build roads, a sewage plant, whatever it might be."
San Jose has shuttered libraries and laid off police officers to cut costs, and residents voted this summer to cut the pension benefits for city workers. But while the city is taking steps to reassure investors of its fiscal health, there is frustratingly little it can do to control larger fears about the municipal bond market.
"We know that even though we have a good reputation for our own affairs, if you are in a marketplace where some of your counterparts may be in a less desirable position, then it could have some bearing," Vossbrink said.
Moody's said it will review all California cities in the coming weeks and conduct in-depth reviews of stressed cities in September, with reports issued as the reviews are completed.
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