More California Towns Face Bankruptcy - RIO VISTA, Calif. -- California may soon have more bankrupt towns on its hands.

By BOBBY WHITE

RIO VISTA, Calif. -- California may soon have more bankrupt towns on its hands.

The city of Vallejo, Calif., gained national attention earlier this year by filing for Chapter 9 bankruptcy protection. Now, two neighbors are fighting to avoid the same fate, as the state's economic crisis spreads.

Isleton and Rio Vista, small towns roughly 50 miles northeast of San Francisco, say they have begun consulting with bankruptcy lawyers as they draw up plans to deal with their mounting budget crises. The towns' leaders say they hope to avoid bankruptcy, but concede the move may eventually be their only option.

"We're strapped for cash and by the end of March or early April we may not have enough money to pay for payroll," says Hector De La Rosa, Rio Vista's city manager.

A Rio Vista, Calif., street is empty after construction was halted at a housing development last month.

California's troubled towns can't expect much help from the state. A state board voted Wednesday to shut off $3.8 billion in financing to hundreds of infrastructure projects to preserve cash, as the nation's most populous state struggles under a budget deficit that officials say could balloon to more than $40 billion over the next two years.

"California's fiscal house is burning down," State Treasurer Bill Lockyer said in a statement.

The plights of Isleton and Rio Vista highlight the difficulties small California municipalities face as revenue falls. Vallejo, just a few miles west of the two towns, filed for bankruptcy in May after its tax revenue sank with the economy, while wages and benefits for police and other services rose. Vallejo instantly became the nightmare scenario for towns across the state facing a similar toxic mix of foreclosures, debts, pension obligations and the inability to raise money on bond markets.

California also makes it hard for municipalities to quickly raise taxes to cover shortfalls: In most instances, state law requires them to place increases in utility rates and taxes before voters for their approval.

Rio Vista began to see the trouble last year, when property-tax revenue began to falter. The city lacks revenue sources such as big-box retailers and depends heavily on two auto dealerships for sales-tax revenue, Mr. De La Rosa says. But the dealerships have hit hard times.

Rio Vista has cut a third of its city workers and slashed its recreation budget to $29,000 from about $250,000. The city is looking into selling more than 100 acres of its land for revenue. Since July 2007, Rio Vista has cut $1 million from its $7 million budget but still faces an $800,000 shortfall. "The fact we are a small town makes it more difficult to handle this slide we are on," says Rio Vista Mayor Jan Vick. "We don't have that much to cut."

In September, Rio Vista contacted law firm Orrick, Herrington & Sutcliffe, which handled the Vallejo bankruptcy, and requested guidance, says former Mayor Eddie Woodruff.

The thought of bankruptcy doesn't sit well with some residents. "When I first heard the council was considering bankruptcy, I was all for it," says Howard Lamothe, owner of Foster's Bighorn restaurant, whose family has lived here for seven generations. "But after I learned about what it means and how it affects business and service, I changed my mind," he says. "I can't support that."

John Knox, a partner at Orrick Herrington, says he expects to see several more municipal bankruptcies in California next year. But "there is no capacity at the state level to write a check to aid our financially burdened local governments," says Marie Ann O'Malley, a policy analyst with the state's Legislative Analysts Office, a nonpartisan financial and policy-advisory agency.

The state's Pooled Money Investment Board Wednesday halted the flow of money to highway, prison and schools projects, among others, until June, so the state can pay for public safety, health care and other crucial services for as long as Sacramento lawmakers remain stalemated over how to close the budget gap.

Ms. O'Malley says that distressed cities could turn to county governments to take over some services. But with many counties also hurting financially, that option is limited. Another option: Cities could dissolve themselves, she says. But dissolution also involves county officials taking over city services and orchestrating a recovery, and lenders would still be left holding the bag for debts.

Isleton's city manager, Bruce Pope, says the town owes $950,000 for an assortment of services including trash pickup and electricity. With Isleton's operating budget of about $1 million, interest on unpaid bills could overpower the city's budget, he says.

Some county leaders are pressuring Mr. Pope to dissolve Isleton. But the town, with about 1,000 residents, doesn't have the money to cover the fees to do so, he says.

—Jim Carlton contributed to this article.

Write to Bobby White at bobby.white@wsj.com