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The klaxon horn went off this evening for California municipal bondholders when Moody’s credit rating service issued a report stating that the plummeting financial condition of many California counties, cities, school districts and other government agencies will soon result in large numbers of municipal bankruptcy filings. Concerned about their own potential liability for providing high ratings that encouraged conservative elderly Americans to invest in risky bonds; Moody’s announced they will undertake a wide-ranging review of municipal finances because of the growing insolvencies.

The Moody’s report comes just two days after we reported that “CALIFORNIA SALES TAX REVENUE NOSE-DIVES BY 33.5%.” Stock brokers have often recommended California municipal bonds as very safe investments, due to historically low default rates and relatively stable finances. But Moody’s said that outlook is changing after the Chapter 9 Bankruptcy filings of Stockton, San Bernardino and Mammoth Lakes.

Moody’s is especially concerned with the growing attitude among many cash-strapped cities that filing bankruptcy to avoid paying bondholders, is politically more advantageous than cutting spending. As a result, Moody’s will re-assess the financial condition of all California cities, which issues about 20 percent of the municipal bond volume nationwide, “to reflect the new fiscal realities and the governmental practices.”

The Moody’s report said the credit rating service will also examine the outlook for municipal bonds in other troubled states. Robert Kurtter, Managing Director of public finance at Moody’s, would not say which states they will review, though Kurtter mentioned Michigan and Nevada as possibilities.

Tonight’s report noted that many cities across the nation are in financial distress, but emphasized that agreater share of bankruptcies are expected to come from California. Local officials were quick to try to downplay this grim forecast. Chris McKenzie, Executive Director of the League of California Cities responded: “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.”

Tom Dressler, spokesman for California State Treasurer Bill Lockyer, cautioned against overacting to only three bankruptcies from California’s 482 cities: “No city’s going to blithely skip into bankruptcy court to avoid its obligations.” Mr. Dressler called the report “a little hyperbolic.”

Moody’s detailed that over 10% of California cities have already declared fiscal crises, with the most troubled areas lying inland in the middle of the state and east of the Los Angeles area. Mr. Kurtter said the declarations of emergency were “a reflection of the broader fiscal stress in the state” and went on to warn that Moody’s may issue an “across-the-board rating revisions are possible following a review of our ratings on California cities over the next month or two” for all California cities. Chris McKenzie acknowledged that such a move “would have a terrible impact on taxpayers.”

Moody’s highlighted growing doubts that cash-strapped cities are willing making good-faith efforts to pay their bonds debts in full. Former Treasury official Paul Rosenstiel, a Principal at DeLaRosa & Co municipal bond investment-banking firm in San Francisco stated: “Credit analysis is based on the ability to pay and the willingness to pay. Investors have historically assumed that cities are willing to pay their debts because they want continued access to the bond market” … “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?”

California cities already pay higher interest rates to borrow money from municipal bond investors because the state has the second lowest bond rating in the nation, only Louisiana is lower. But if any city’s credit rating is cut to the “junk bond” level, rates would rise so high that the city would be forced to file bankruptcy. Most cities are already are financially deteriorating, because of a steep drop in tax revenue.

The Moody’s report is raising alarms for city leaders who fear it may trigger a market panic. ”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.” Mr. Vossbrink emphasized that San Jose has cut laid off cops and closed libraries. Residents also recently voted to cut public pension benefits for city workers, but those cuts may not be enough prevent a downgrade.

Moody’s said it will conduct in-depth financial stress tests for all California cities in the coming weeks and issue appropriate downgrades in September. The timing of the Moody downgrades may be especially devastating for the California state budget. Governor Jerry Brown kicked off his drive this week to save the state’s solvency by encouraging voters to pass an $8 billion tax increase initiative on the November ballot. But bad press and rising bankruptcies is sure to undermine voter support.

(Chriss Street will be in Studio with Paul Preston on “The American Exceptionalism Radio Talk Show” streaming live Monday through Friday at 7-10 PM. Click here to listen.)