Cash-strapped California city goes belly-up

A federal judge granted Stockton, Calif., Chapter 9 bankruptcy protection yesterday, making it the largest city in the country to fail financially. Now the fight begins to see how the city’s money will be distributed between creditors and its unfunded state pensions.

For the first time, the Stockton bankruptcy raises questions about whether federal bankruptcy law trumps the California law that requires cities to repay all pension fund debts. Stockton owes California Public Employees Retirement System (CalPERS) $900 million. It’s the city’s biggest debt.

The city of nearly 300,000 has tried to restructure some debt by stopping bond payments, slashing employment, renegotiating labor contracts, and cutting health benefits for workers. It also cut the Police Department by 25 percent, a drastic move for California’s second-most-violent city.

Since cities can't liquidate assets, those that declare bankruptcy must come up with a plan for creditors to forgive some of their debt. That upset creditors, who argued during the three-day bankruptcy hearing it was unfair to let the city only partially repay its debts while paying CalPERS in full.

“The creditors got a big black eye today,” attorney and municipal restructuring expert Karol Denniston told the Los Angeles Times. “Now the stage is set for the real dog fight.”

Experts believe the issue will end with an appeals court deciding whether the 10th Amendment makes states rights more powerful than federal bankruptcy law.

And how the issue plays out has implications far beyond the city of Stockton. Nearly two dozen California cities, including San Jose, San Bernardino, and Compton, face either bankruptcy or financial emergencies based in part on immense pension debts. In the entire state, the $225 billion CalPERS is underfunded by $87 billion.

"The fear is that there is going to be a run on the bank," said bankruptcy attorney Michael Sweet, who has been monitoring the Stockton trial. "Everyone is going to be cutting CalPERS" payments if Stockton is allowed to do it.

In hopes of halting the growing pension debt, Gov. Jerry Brown pushed through pension reform last year, raising the retirement age, lowering benefits for employees hired after January, and changing how pensions are calculated. But the powerful California unions have pushed back, taking the law to court in Merced, Alameda, and Contra Costa.

State Assemblyman Luis Alejo, D-Salinas, has also proposed exempting transit workers from reductions because he claims they infringe on collective bargaining rights.

Unions will take another blow if Stockton is allowed to restructure pension payments, but the city has few other options.

"There's not one thing that will fix the pension system,” Denniston said. “The net message is you can't see a restructuring when the largest creditor isn't being restructured."