In California's Central Valley, an agricultural area hard hit by the economic downturn, cities are paring back their budgets, moving some municipal bonds closer to serious trouble.

Early this month, a 30-year, $1.89 million bond issued by Chowchilla, a city of 19,000 known for a pair of state prisons for women, went into technical default after the city council opted to make payments from its reserves for the current fiscal year.

Wayne Padilla, who's a year into his job as assistant city administrator, tells a familiar story when he explains Chowchilla's debt woes. The city used the bond, issued in 2005, to build a new civic center. It planned to lease part of the space to for-profit and nonprofit groups to help finance the project. There was a housing boom on, and city officials bet on an expansion.

"There was a lot of over-construction, and a lot of space got built on spec," he says. "There turned out to be a lot of competition from the private sector trying to lease commercial space, and there was a lot of optimism that didn't bear fruit."

The housing market is at the heart of much of the new concern over municipal bonds. As foreclosure rates have climbed, property tax revenues have dropped, leaving cities with insufficient funds to cover costs. Municipal Market Advisors, which keeps a database of distressed municipal bonds, shows a 6% increase in all forms of default from last month. That doesn t mean payments are being suspended in every case. Moving to reserves has accounted for the largest increase in muni defaults.

In Chowchilla, the city council approved the pre-emptive measure of a technical default on June 28. Padilla says the option was a way to make the best of difficult circumstances.

Chowchilla is facing several economic pressures. The city, which has an operating budget of $15 million to $17 million, has laid off all but two parks employees; turned youth sports programs over to community groups; negotiated with its police union to defer raises; and changed auditors to help correct what Padilla said were earlier budgeting errors.

"Right now, we're trying to figure out how many baffles to put into the air conditioning system to stop the air flow to empty offices and save on energy costs," he says.

Even with the move to reserve payments for the civic center bond, there's still a projected $1.2 million revenue shortfall for fiscal 2010-11, he says. A planned sale of some city property could help.

The extraordinary cutbacks in staff and services are representative of the fiscal gymnastics many cities have had to perform in the downturn, and Padilla hopes better economic times return to help right Chowchilla's finances.

After the notice of technical default, Padilla said he spoke with representatives of Piper Jaffray, the civic center bond underwriter, who were "very concerned." Padilla says he plans on keeping them well-informed as the city tries to outlast the downturn because current bondholders and the wider municipal bond market will be affected if things get worse.

"We've had to take a bath, but we fully appreciate the implications of the effect on the bondholders and the need for the community" to straighten out its budget woes, he says. "In future forecasts, we'll certainly factor in the need to restore those reserves within our abilities."