By Michael B. Marois – March 21, 2011 00:01 EDT

March 21 (Bloomberg) — California’s cities and counties may face bondholder lawsuits if state lawmakers abolish redevelopment authorities to get at their money, a lawyer for some of the agencies said.

About $5 billion in taxes now going to the agencies would be blended together in a caretaker fund, run by local governments, that would pay investors holding more than $20 billion of bonds. The move may damage the credit quality of the securities, causing their value to fall, said William Marticorena.

“Even a small decline in secondary-market value could produce significant investor losses and possible damages for state and local government,” Marticorena, head of public finance at the Orange County law firm of Rutan & Tucker, said in an analysis distributed March 18. “The market-value declines may not be small and the damages could be immense.”

Governor Jerry Brown proposes to abolish about 400 agencies, which have revitalized downtown San Diego and spruced up a Palm Desert golf course, to help bridge a $26.6 billion budget deficit through June 2012. The plan, opposed by mayors of some of the biggest cities, fell short of passing the Assembly last week by one vote. Democrats who control the Legislature plan to bring it back for another try.

“The notion that there is going to be securities fraud and lawsuits and all manner of legal chaos if the governor’s plan is adopted is a fairy tale,” said Tom Dresslar, a spokesman for Treasurer Bill Lockyer.

Brown’s proposal would shift about $3 billion from the revitalization agencies to school districts and other local aid.

‘Gutting’ System

Bondholders may sue cities and counties to recoup losses and seek damages, claiming securities fraud, Marticorena said. Trustees who distribute bond payments to investors and bond insurers that guarantee against default may also have reason to sue, if they have to cover losses, he said.

“Given that you are completely gutting the current credit- analysis system and replacing it with something else, you can’t avoid coming to the conclusion that this is going to create uncertainty,” Marticorena said in telephone interview. “Market uncertainty is a really bad thing.”

Under a 65-year-old California law, if a city or county designates a redevelopment area to eliminate urban blight, the agency in charge receives any increase in property-tax revenue that results, known as the tax increment.

Bonds sold by redevelopment authorities are backed by such tax increments from those areas. The credit quality of the securities, which helps investors determine default risks, is based largely on the strengths and weaknesses of each project, Marticorena said.

Pooling Funds

California’s redevelopment agencies had about $20 billion of debt outstanding in 2008, according to figures from the state controller’s office. Pooling the tax increment from all the projects into a single fund may weaken the credit quality of bonds that had received high ratings and boost bonds with poor credit, Marticorena said.

“A statutory commitment to pay debt service from a commingled pool could well be viewed by the marketplace as less valuable than the specific pledge of tax increment from the project area,” the lawyer said in his analysis.

Credit-rating firms may be forced to remove grades on those bonds if the money is pooled, Marticorena said, because the securities would no longer have the same debt-service ratios promised to investors when they were sold. Ratings require an issuer to keep on hand enough reserves to pay bondholders if the primary revenue source declines for some reason.

‘Just Not True’

“It’s false to say that tax increment is going to be abolished by the governor’s plan, that’s just not true,” Dresslar said in an interview. “What is going to be abolished is redevelopment agencies. And the plan makes sure that debt service is fully covered.”

Brown’s proposal would use $2.2 billion in revenue freed by shutting the agencies to pay off debt and devote the rest, almost $3 billion, to schools, health care and the courts. The state ordinarily sends $1.7 billion to schools to make up for property taxes allocated to development agencies.

Mayors of some of California’s biggest cities, led by Antonio Villaraigosa of Los Angeles, oppose the governor’s plan, saying the agencies provide a critical economic tool.

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