SACRAMENTO, Calif. (AP) -- On its first official day in bankruptcy, the city of Stockton now must grapple with the hard part of reorganizing its financial affairs -- how to share the financial burden equitably among creditors while meeting its massive state pension obligations.
At the conclusion of a three-day trial, a judge on Monday formally granted the city Chapter 9 protection, over the objections of creditors who questioned whether it was fair for the city to fully meet its obligations to the state pension system while other debt holders go partly paid.
The issue -- whether federal bankruptcy law trumps the California law that requires pension fund debts to be honored -- could have huge implications across the state and the rest of the nation, experts say.
"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.
California's $225 billion Public Employees Retirement System already is underfunded by $87 billion, which means there are more payments due to retirees than there is money in the system.
Stockton's biggest creditors insured $165 million in bonds the city issued in 2007 to keep up with CalPERS payments as property taxes plummeted during the recession. Stockton now owes CalPERS about $900 million to cover pension promises -- by far the city's largest financial obligation.
Nearly two dozen California cities, from San Jose and Watsonville to San Bernardino and Compton, either are facing bankruptcy or financial emergencies -- and their hefty pension costs are getting heightened scrutiny.
"This is just the beginning of a multi-dimensional.... well, I can't say chess game because it's not a game," said attorney Karol Denniston, a municipal restructuring expert. "There's not one thing that will fix the pension system. The net message is you can't see a restructuring when the largest creditor isn't being restructured."
Last year, the Congressional Joint Economic Committee reported that unfunded pension obligations across the nation amount to more than $2.8 trillion and may be as high as $4.4 trillion. Illinois lacks funds for nearly 72 percent of the pensions it guarantees, while California and Texas are short by more than half. North Carolina's debt is lowest but is still more than a third short of what its system has promised to pay out.
Experts say that state pension funds are acting like the banking industry before the financial collapse by engaging in risky behavior and racking up unsustainable obligations.
"In the private sector there is insurance," said Sweet. "CalPERS is working without a net. If they fail and if Stockton is allowed to impair the CalPERS payments, then who knows who's next?"
A major focus in the next phase of Stockton's bankruptcy proceedings will be whether pensions negotiated in good economic times can be cut.
"I don't know whether spiked pensions can be reeled back in," U.S. Bankruptcy Judge Christopher Klein said during his ruling on Monday. "There are very complex and difficult questions of law that I can see out there on the horizon."
Attorneys for CalPERS at times attempted to speak to the creditors' assertions that the pension fund should share any pain in Stockton's recovery plan, but the judge said their time would soon come during proceedings.
"It's no secret (creditors) have CalPERS in the crosshairs of the dispute," Klein said.
The city of nearly 300,000 has tried to restructure some debt by slashing employment, renegotiating labor contracts, and cutting health benefits for workers. Library and recreation funding have been halved, and the scaled-down Police Department only responds to emergencies in progress. The city crime rate is among the highest in the nation.
Since cities can't liquidate assets, those that declare bankruptcy must come up with a plan for creditors to forgive some of the debt.
So far, Stockton has kept up with pension payments while reneging on other debts, maintaining it needs a strong pension plan to retain its pared-down workforce.
Legal observers of the first-ever Chapter 9 bankruptcy case questioning state pension obligations expect an appeal to decide whether the 10th Amendment that gives rights to states is more powerful than federal bankruptcy code.
Either the judge will decide that CalPERS obligations must be cut and the state will appeal, or he will say state law forbids CalPERS from negotiating and the creditors likely will appeal.
"We're going to get new precedent no matter what happens," Denniston said.
Contact Tracie Cone at http://www.twitter.com/TConeAP.
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