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Bankruptcy steep price for weak local U.S. governments

ANALYSIS: U.S. cities and other local governments stung by sour regional economies and deep housing crises are most at risk of becoming the next Stockton. But they will do all they can to avoid following the California city into federal bankruptcy court.

Stockton, just 135 km east of San Francisco, is on the verge of bankruptcy after its housing boom went bust.

Officials of this city of nearly 300,000 people say the court filing for Chapter 9 bankruptcy is likely by Friday afternoon. When that happens, Stockton will become the largest U.S. city to file for bankruptcy protection from its creditors.

That protection will come at a steep price. The economic and social fallout will last for years. After the Chapter 9 bankruptcy filing, Stockton will find it hard - if not impossible - to tap America's $3.7 trillion US municipal bond market.

Although Stockton is poised to make history as the largest U.S. city to file for bankruptcy, it is unlikely to be the last.

Roughly 90,000 U.S. cities, counties, towns and other local governments are still battling fallout from America's Great Recession, which ran from December 2007 through June 2009.

Beyond Detroit and other high-profile governments mired in financial crises, institutional investors, traders and analysts worry that Providence and Woonsocket in Rhode Island and Scranton, Pennsylvania, may also be at risk.

Moody's Investors Service focused heavily on local governments in Michigan, Rhode Island, New York and New Jersey last fall when the credit rating agency published a list of speculative-grade credits, including Camden and Salem in New Jersey, and the Philadelphia School District.

Moody's cited high unemployment in New York's Gloversville, and several years of budget deficits in East Greenbush, a suburb of New York's capital of Albany.

BOOM, BUST AND MAYBE BANKRUPTCY

Many of the Eastern and Midwestern governments listed by Moody's have deteriorating local industries or other enduring economic problems.

But wobbly local governments in California and elsewhere in the West appear more affected by economic cycles.

"In the West, it was due a lot more to community boom and bust," said Richard Ciccarone, managing director of McDonnell Investment Management. "They ramp up spending commitments in the rising times and cannot change the commitments when it reverses itself."

So far this year, six governments have filed Chapter 9 bankruptcies, compared with 13 during all of 2011, according to data from law firm Chapman and Cutler.

"Chapter 9 is not a victory for anyone; it comes with hardships for the community, as well as bondholders," Ciccarone said. "It's no positive for economic development."

Business leaders in Alabama's Jefferson County, which last year filed the biggest-ever $4.23 billion U.S. municipal bankruptcy, have said the bankruptcy has deterred industrial investment.

INFRASTRUCTURE, PENSIONS FIRST TO GO

Worried about financial fallout on other local governments, Pennsylvania's state government passed a law that prompted a federal judge to block a bankruptcy filing by the state capital of Harrisburg.

Local officials lose a lot of autonomy in a Chapter 9 bankruptcy and may be forced into a workout with creditors to make cuts in police forces and other essential services that damage quality of life and are harmful over the long run, according to Ciccarrone.

"Spending on infrastructure and pension fund payments are often among the first to go," Ciccarone said. "Neither is a healthy thing."

In Jefferson County, home to business hub Birmingham, county officials are spending millions in legal fees in disputes with Wall Street creditors over control of the sewer system at the heart of the county's financial crisis. They show no sign of negotiating a deal. The case may take years to resolve.

Chapter 9 gives municipalities fewer tools than businesses get in much more common corporate bankruptcies, according to George South, a bankruptcy lawyer and a partner in DLA Piper in New York.

"Municipalities don't generally sell assets" to reduce debt, South said. "They usually don't sell a public service. There's also politics. In Chapter 9, you may need legislative help to get new revenue sources."

Cities and counties that have filed for Chapter 9 bankruptcy protection will have trouble for years borrowing in the muni market, the main financing arena for U.S. local governments, according to John Mousseau, managing director and portfolio manager at Cumberland Advisors.

"You look at Chapter 9 as a last resort," Mousseau said.

That's the bad news.

Now for some good news: In at least one headline-grabbing case, the sting of Chapter 9 bankruptcy didn't last forever.

In December 1994, Orange County, California, filed what was then the biggest-ever municipal bankruptcy as a result of its treasurer's bad bets on derivatives and other investments.

Orange County, California, is now considered a solid credit. Standard & Poor's, which dropped the county's rating to the lowest level of D in 1995, has rated it AA-minus since 2007.

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