Stockton, Calif.: largest city bankruptcy ever

The people of Stockton, Calif., will feel financial fallout for years after a federal judge ruled Monday to let the city become the most populous in America to enter bankruptcy.

But the case is also being watched closely because it could answer the significant question of who gets paid first by financially strapped cities — retirement funds or creditors.

Stockton, a 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 America.

The potential constitutional question in the Stockton bankruptcy case is whether U.S. bankruptcy law trumps a California law that says money owed to the state pension fund must be paid.

In making his ruling, U.S. Bankruptcy Judge Christopher Klein disagreed with creditors who argued that Stockton failed to pursue all avenues for straightening out its financial affairs.

A statement released by creditors said the group "respectfully disagrees with the court's ruling." The legal team for those creditors declined to say whether it would ask Klein for permission to appeal his decision — a requirement of bankruptcy code.

Since cities can't liquidate assets, those that declare bankruptcy must come up with a plan for creditors to forgive some of the debt.

Holders of the biggest portion of Stockton's debt insured $165 million in bonds the city issued in 2007 to keep up with payments to the California Public Employees Retirement System 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. Many struggling cities across California are in the same situation.

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.

Attorneys for creditors argued that it was unfair for their clients to accept reduced payments while the pensions negotiated in flush times went untouched. They argued that employees who shared the wealth during good times should bow have to endure some of the pain with cuts to their pensions.

Legal observers expect the creditors to aggressively challenge the repayment plan presented by Stockton in the next phase of the process.