Stockton, CA: Eligible To File For Bankruptcy

On Monday of this week, Stockton, California won permission from a state judge to remain under court protection after it was found that creditors did not negotiate in good faith with the city. This decision will allow the city to go forward with bankruptcy proceedings.

The fact that Stockton is now eligible to file for bankruptcy is unusual. For all the headline risk, the actual number of municipal bankruptcies is quite small, and for good reason: most municipalities have assets to sell, taxes to raise, or other paths to avoid bankruptcy. Vallejo is the other California city to file successfully for bankruptcy recently.

We do not yet know what bankruptcy means for Stockton’s creditors. This is just the first step in the process, but it is important because it is now clear that many parties will be impacted.

Bondholders will most likely take a haircut. This is new ground for general-obligation bondholders. We think it sends a shot across the bow even to financially sound municipalities in California.

One of the creditors is Assured Guaranty, which insured some of Stockton’s pension obligation bonds. Assured argued that the city had not taken steps to prevent insolvency, such as raising taxes and cutting services. It is worth noting that Assured Guaranty’s stock has hardly budged since the ruling, a fact which constitutes a striking example of why bond insurance has very real value.

CalPERS – the California Public Employees Retirement System – refused to negotiate with Stockton, claiming that they are not authorized to reduce the city’s contributions.

What does all this mean for investors?

It means waiting it out. Bondholders, CalPERS, and other creditors may all be sharing in the pain as Stockton enters bankruptcy. It is unclear what this path will lead to.

What is clear is that other financially strapped cities may view Stockton’s success in entering bankruptcy as an avenue for regaining financial equilibrium.

In our opinion, the Stockton development strengthens the case for owning essential-service revenue bonds and their attendant claims on revenues and reduces the appeal of general-obligation bonds, particularly on a local level and especially in California. Cumberland does not own any California general-obligation debt.

We will update our readers on developments.

BY John Mousseau