"The downgrade and outlook revision reflect the city of Gilroy's weakening financial profile and uncertain timing of recovery, given the city's dependence on development-related impact fees and sales tax revenue. The city's housing market now shows high foreclosure rates and a substantial sales price decline, which Fitch expects will keep property tax revenue gains at well below recent levels, and could result in year-to-year reductions in the near future," reads a press release on the company's Web site.

The millions worth of securities represent the amount Gilroy still owes investors after issuing nearly $46 million worth of the notes in 2003 to fund the construction of the Sunrise Fire Station, the new police station, the sports complex and improvements at the corporation yard. The city had the cash for the projects back then, but rather than spend its own money, it opted to externally finance the projects and pay a lower interest rate to investors than it expected to earn on its un-spent reserves.

And it worked, for a while.

The city netted more than $600,000 with the move until the sub-prime mortgage and credit crisis began to spread. Beginning in early 2008, demand for the COPs from new investors decreased to the point that Gilroy's 200-plus investors could not sell their notes and were required to retain them. This so-called "failed auction" automatically triggered higher interest rates the city could not afford.

Gilroy had $152,000 per month budgeted for the interest payments on its notes, which corresponded to an annual rate of about 4 percent. But an 8-percent interest rate - which the city experienced in October after a roller-coaster ride took rates up to 12 percent - cost the city about $300,000 a month, so the council voted 6-0 to stop the bleeding and buy back the notes, hoping to resell them in the future.

With the current credit crunch, though, the city has been unable to secure a letter of credit to refinance the notes. Finance Director Christina Turner told the council in October she hopes refinancing could occur by December 2009, but some council members remained skeptical.

Read the original story on the COPs, as well as another story outlining the declining state of the city's sewer and water funds.

Fitch went on to report that despite city layoffs, high public safety costs and shrinking tax and fee receipts will continue to drag on Gilroy's balance sheets. Officials expect this fiscal year's deficit to total $2.2 million by June 2009, but that is if City Administrator Tom Haglund and the city council can agree on another $1.5 million in cuts after saving the city $3.3 million this fiscal year and $6.7 million next year with the 44 layoffs.

"Fitch notes that the city is taking measures to curb expenses, laying off 44 employees in November 2008, deferring capital improvement projects, and reducing material and service costs. However, Fitch believes that the financial challenges are significant, including managing public safety expenses which have grown by over 21% since fiscal 2004," the press release reads.

With all this turbulence, the city's general fund reserve, which held $26 million a year ago, is expected to dip down to $8.2 million by the end of the fiscal year, and down to negative $12.9 million a year later thanks to infrastructure and capital projects that the city's general fund must insure in the absence of developer fees that were expected to pay for the work. The fund was expected to sink down to $4.9 million by the end of this year and down further to negative $23 million a year later, but the the ongoing savings of the layoffs prevented such a rapid fall.

"Weak tax performance is expected to continue this fiscal year, and a sizable operating deficit now is projected to exceed the budgeted amount. The operating loss also results from the use of general fund resources to cover expenses in other funds that historically have been supported by developer fees.

Fitch also reported that the city's unemployment rate mirrors the agricultural nature of the area: 9.9 percent in Aug. 2008, up from 7.6 percent one year earlier.

"Until recently, the city's financial operations were sound, marked by high year-end reserves. Fitch believes that above-average reserve levels are important for Gilroy given the potential for volatility in sales taxes and impact fees, as well as vulnerability to fluctuations in the agricultural part of the economy," the press statement reads.