SACRAMENTO, Calif. -- One of the nation's top credit rating agencies said Friday it will begin a wide-ranging review of municipal finances in California because of what it sees is a growing threat of increased city bankruptcies and bond defaults.
Moody's Investors Service issued a report saying that the growing fiscal distress in many cities in the nation's most populous state was putting bondholders at risk.
It noted that some municipalities were considering bankruptcy as a new strategy to address budget deficits and avoid obligations to bondholders, an emerging dynamic that could have ripple effects throughout the investment community.
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.
"To summarize, we expect ... more bankruptcy filings and bond defaults among California cities reflecting the increased risk to bondholders as investors are asked to contribute to plans for closing budget gaps," the report said.
The report noted that the municipal bond market has long been characterized by low default rates and relatively stable finances, an outlook that is beginning to change as bankruptcy becomes a tool for cash-strapped cities. That requires Moody's to reassess the financial position of all California cities "to reflect the new fiscal realities and the governmental practices."
The agency will review other troubled states where financial difficulties may have put a strain on local governments, according to Robert Kurtter, managing director of public finance at Moody's.
Kurtter would not say which states the agency will be examining but mentioned Michigan and Nevada as examples of states that have been struggling. Friday's report noted that cities across the country are in financial distress but said that a greater share of bankruptcies were expected to occur in California.
The report also noted the potential for ratings downgrades to fiscally distressed cities, counties, school districts and special districts throughout the state.
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.
Moody's floated the idea Friday of an across-the-board ratings adjustment for California cities, a move that McKenzie warned "would have a terrible impact on taxpayers."
A spokesman for the California state treasurer's office also cautioned against overacting to three bankruptcies among California's 482 cities and called the report "a little hyperbolic."
"No city's going to blithely skip into bankruptcy court to avoid its obligations," said agency spokesman Tom Dresslar. "Moody's will make its decisions and cities will have to live with them, but we hope that Moody's bases its decisions on facts and evidence, not optics."
More than 10 percent of California cities have declared fiscal crises, according to the report.
"It is a lot," Kurtter said. "A declaration by 55 cities is a reflection of the broader fiscal stress in the state."
Lower bond ratings will increase borrowing costs for those entities at a time when many of them are struggling financially because of a steep drop in tax revenue.
Because of that, Friday's report is raising alarm in many California cities where leaders fear that a crisis of confidence in the municipal bond market could 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. If the investment community perceives greater risk, you may not be able to borrow as much for public purposes."
San Jose has shuttered libraries and laid off police officers to cut costs, and residents voted overwhelmingly this summer to cut the pension benefits they give 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, Vossbrink said.
"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," he 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.