SAN FRANCISCO (Reuters) – The city of Stockton, California, faces a growing likelihood of defaulting on some of its debt obligations as the conclusion of confidential talks with its creditors aimed at averting bankruptcy nears, Moody’s Investors Service said on Wednesday.

Stockton is in mediation with its creditors, trying to obtain concessions to help close a $26 million budget gap before the July 1 start of its new fiscal year.

If the city of 292,000 people located 85 miles east of San Francisco in California‘s Central Valley cannot obtain sufficient concessions by the end of June, it may file for bankruptcy.

“The city’s ratings, even on secured obligations, could be subject to further downgrades in a bankruptcy,” Moody’s said.

Stockton is the first big city in California to test a new law requiring mediation after its leaders in February endorsed a restructuring plan for the city’s finances.

The law requiring mediation was approved in response to Vallejo, California‘s controversial bankruptcy filing in 2008. Vallejo emerged from bankruptcy last year.

Stockton‘s restructuring plan includes mediation and, to the shock of many in the U.S. municipal debt market, defaulting on some debt payments during the remainder of the current fiscal year through June.

Rating agencies have slashed Stockton‘s credit rating in response and the state controller office is investigating its financial practices.

Gregory Lipitz, a vice president and senior analyst at Moody’s, said he is concerned Stockton is running out of time to bring balance in its books.

“Since the mediation will conclude at the end of June, the parties involved will have very little time to ratify agreements before the city becomes insolvent,” Lipitz said.

Separately, a Moody’s report said Stockton “will likely chose to file for Chapter 9 bankruptcy primarily because the city says that it will run out of cash on July 1 and has indicated that it will file for bankruptcy if negotiations with creditors fail to provide material concessions.”

“Even if a bankruptcy filing is avoided through negotiation of a settlement with labor unions, bondholders, or a combination of the two, Stockton is likely to default on its unsecured debt, including pension and lease obligations,” the report added.

Moody’s said it expects Stockton‘s enterprise debt and special tax bonds to be considered special revenue obligations protected from default and loss of principal in bankruptcy.

(Reporting by Jim Christie, Editing by G Crosse)