By Mark Shade

Harrisburg, Pa., Nov 28 (Reuters) - Pennsylvania's capital city Harrisburg, neck-deep in more than $340 million debt, is on the verge of getting a powerful negotiating tool with creditors: the threat of bankruptcy.

A state ban that prevented Harrisburg from filing for municipal bankruptcy protection is set to expire after Nov. 30.

A year has passed since Harrisburg first tried filing for bankruptcy in October 2011. The city is now deeper in debt and there is no guarantee that it will not seek court protection once again.

"They're still having a problem bridging the revenues and the liabilities they have to pay," said Emanuel Grillo, chair of the financial restructuring group at the law firm Goodwin Procter.

"They haven't gotten bondholders or other constituencies to take a big enough hit," he said. "Waving the bankruptcy option out there is really an important tool, even if [the state-appointed receiver] never uses it."

When Harrisburg first attempted bankruptcy protection, the cash-starved city became a poster child for U.S. cities still trying to recover from years of lower, recession-hit property tax revenues while faced with growing pension obligations, healthcare costs, salaries and other expenses.

Harrisburg, like some other cities, took out significant debt to finance a project -- an incinerator -- that later failed to make enough money, bringing it to the verge of financial collapse.

Since last October, Harrisburg's debt has swelled from $300 million to $340 million.

Its receiver, William Lynch, had to skip a $3.4 million general obligation debt service payment in September in order to pay city employees. Harrisburg still faces a projected cumulative deficit of $14.8 million by the end of fiscal 2012.

Harrisburg is closer to selling some assets such as its trash incinerator and public parking system to raise money as a key component of its recovery plan, Still, any potential agreement with buyers must still be approved by the state court overseeing the plan.

LAWMAKERS NOT LIKELY TO EXTEND BAN

The capital city accumulated its mountain of debt during several rounds of multimillion-dollar bond deals to finance the repair and retrofit of its incinerator.

About two weeks after Harrisburg's city council first filed the bankruptcy petition, Pennsylvania Governor Tom Corbett declared a state of fiscal emergency for the city of nearly 50,000 residents, about a third of them living in poverty.

A federal judge later blocked the city council's Chapter 9 petition after state lawmakers banned it. Urged on by veteran Republican state lawmaker Jeff Piccola, the Pennsylvania legislature later extended the ban.

Piccola represented Dauphin County, which guaranteed some of Harrisburg's incinerator debt and is now one of the city's creditors.

But with Piccola retiring and a Democrat taking his place, many city and state officials believe state lawmakers won't extend the ban a second time - especially since state lawmakers are not scheduled to consider any new legislation until January

"The lack of threat from Senator Piccola and the legislature to reinstate the bankruptcy ban is going to be an effective tool for negotiations. There's no doubt about it," said Harrisburg City Councilman Brad Koplinski.

CREDITOR PRESSURE

Lynch -- the only one who can put the city into bankruptcy -- has said he should be allowed to do so if he needs to.

Bankruptcy "is an option that needs to be on the table," said Cory Angell, a spokesman for Lynch, who was unavailable for comment.

The threat of bankruptcy could get creditors, including bond insurer Assured Guaranty Municipal Corporation, or AGM, to return to negotiations and consider forgiving as much as a third of the city's debt.

Harrisburg skipped several incinerator debt service payments due in September, leaving AGM to cover the $1.4 million in payments.

Altogether, AGM has $155.2 million of net par exposure to Harrisburg and had paid out $8.6 million as of June 30 on claims.

The bond insurer declined to comment on the expiration of the city's bankruptcy ban.

AGM, along with creditors TD Bank and bondholder trustee M&T Bank, won county court approval in March for a separate receiver, who oversees the cash flow of Harrisburg's incinerator and operate independently of Lynch.

Attempting to implement the recovery plan is an important step in case the city does go bankrupt, so that it can show it tried other remedies before asking a court for relief from creditors, according to Angell.

"I think if we were to go into a bankruptcy situation, of course that court is going to ask you what have you done to meet your obligations and I think the answer to that should be we've tried to implement this recovery plan," Angell said.

(Corrects fifth paragraph to "Waving" instead of "Waiving.")

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