Stockton, California, lays claim to a lot of undesirable superlatives: it’s America’s foreclosure capital, an annual contender on the Forbes “Most Miserable” list, and the United States’ largest bankrupt city.

Stockton built its downtown up on borrowed money

But the city might lose that last claim, depending on the outcome of a federal court hearing scheduled to begin Monday. Stockton would still be broke if a judge rules against it. It just wouldn’t be officially bankrupt. A group of bond insurers is arguing Stockton didn’t do everything it could to balance its books before declaring for Chapter 9 protection last June. Therefore, they say, it violated state bankruptcy laws. The insurers want the city to raise taxes and cut pension payments, among other steps.

How the federal judge rules – and how the city pays off the hundreds of millions of dollars it owes – will provide clues for how other financially stressed municipalities across California and the country will deal with pensions and employee benefit programs they can no longer afford.

How Stockton Got Here

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When you visit Stockton, it isn’t always obvious you’re in America’s largest bankrupt city. The city of 300,000 boasts a gleaming riverside arena and baseball stadium. Last weekend, fans decked out in St. Patrick’s Day outfits streamed into the downtown entertainment complex to watch the Stockton Thunder hockey team take on the Bakersfield Condors.

Stockton closed its Fair Oaks library branch in 2010, to save money

Drive a couple of miles from downtown, though, and it’s a different picture. The Fair Oaks Public Library sits abandoned and forgotten. Its doors are boarded up, its signs are whited out, and neighbors say its parking lot attracts homeless people at night.

The city closed Fair Oaks Public Library in 2010. The closure has more in common with the downtown hockey arena than you might think.

Things were going pretty well for Stockton in the early 2000s. Revenue was up after a decade-long slump, and property values were exploding. Median home values jumped from around $100,000 to more than $400,000. It felt like a renaissance, so the city borrowed more than $100 million to build the arena, the adjoining baseball stadium, and a brand new waterfront.

“They were all excellent projects,” said City Councilwoman Kathy Miller, “but it was a huge amount of debt. “

The borrowing – along with employee benefits that grew more generous by the year – put Stockton on the hook for a lot of money.

And then the bottom fell out.

“The recession hit and revenue plummeted,” said Miller. “We went from a high of about $205 million to, last year, around $155 million. So no matter how you slice it that is a huge reduction.”

Stockton's leaders slashed and slashed, cutting $90 million from the budget between 2010 and 2012.They reduced employee pay and benefits. They shuttered the Fair Oaks Library, and cut hours at other library locations. City officials cut the police department’s staff by a quarter, and laid off more than 30 fire fighters.

But last year, Stockton still faced a $26 million dollar deficit. So it declared bankruptcy, becoming the largest American city to do so.

“You Expect That To Hold Water”

Stockton’s decision attracted international attention. Al Seibel worked for Stockton for 33 years, maintaining the city's parks and golf courses. One recent morning, he searched his shelves for a DVD as he talked to a reporter about the city’s bankruptcy. He was looking for the recording of his recent interview with a French television station. Seibel has also talked to journalists from Belgium, Japan and Switzerland.

The international press wants to talk to Seibel because he’s one of more than 1,000 Stockton retirees who suddenly lost their health insurance when the city declared bankruptcy.

In the 1990s, Stockton started offering lifetime health care benefits to city employees as part of a bargaining strategy aimed at keeping salary increases down. But Stockton never set aside the money required to properly fund the health care program. When the recession hit, it couldn’t afford the plan, and the city council voted to eliminate it.

“If we were to properly fund the program and make it available to everyone, we need to immediately set aside 30 percent of our payroll now and into the next 30 years,” read city manager Bob Deis’ letter to Stockton retirees.

The city allowed retirees to stay on its plan for another year, at a much higher rate. So Seibel had two options: pay a monthly premium of more than $1,100, for health care, or go without insurance. At age 61, Seibel is still years away from receiving health coverage through Medicare.

“I only get $2,100 a month [in pension payments],” said Seibel, who has heart and ulcer problems. “By the time I’d pay that insurance and my mortgage I’d have nothing left. It really wasn’t a choice. It was forced on me.”

The decision left Seibel and other retirees outraged and unprepared. Mark Anderson, who worked for the Stockton police department for 22 years, said his health care plan now boils down to “hoping we’re OK.” His wife Joni recently fell down the stairs.

“Luckily all I ended up with was some bruising," she said. "If I would have required surgery or something without having medical care, it would have killed us. Financially we would have lost everything.”

“When you’re given something in a written contact that you’ve worked for 33 years, you expect that to hold water,” said Seibel. “If I had known 20 years before I retired, 'OK, I’m not going to have medical,' I would have started an account putting money away.”

Stockton’s city manager and mayor both turned down repeated requests for interviews. Councilwoman Kathy Miller voted to eliminate the retiree health care. She says the city didn’t have any other option.

“I think that, more than any other decision, was the toughest for the council to make," she said. "That was a budget expense that was going to go from $9 million to $14 million in 12 months and just grew exponentially.”

A Court Challenge

Stockton justified eliminating retirees’ health care by saying it was the only way to protect pension payments, which weren't cut. But the insurance companies that are holding the bag on the hundreds of millions of dollars that Stockton owes in bond payments are now challenging the city’s decision to keep pensions intact. In a federal court filing, the insurers claim that before the city filed for Chapter 9 protection, it should have cut pension payments and raised taxes.

Their argument boils down to this: the state’s public employee retirement system, CalPERS, is Stockton’s largest creditor. By refusing to negotiate reduced payments into the retirement system, Stockton is negotiating in bad faith with its other creditors.

“What the bond insurers want to say is you can't do anything to us unless you're making cuts everywhere you can,” explained University of Pennsylvania Law School professor David Skeel, a bankruptcy expert. “And the elephant in the room is Stockton's pensions, which they have suggested they're not going to cut.”

Stockton pays into three CalPERS-administered pension plans. These obligations totaled a bit less than $24 million in 2011, the last year a full financial report is available for the city. Stockton and CalPERS’ legal response to the creditors’ argument: CalPERS acts as a trustee, not a creditor, and the city has a legal obligation dictated by “a well-developed, substantial body of state law” to continue its payments.

The bond insurers are using the dispute to challenge Stockton’s eligibility for bankruptcy. Skeel doesn’t expect the argument to prevail at next week’s hearing, but thinks the insurers may be able to force the city to cut pension payments during later negotiations. Skeel said the insurers are pressing the issue hard, because they're worried about the growing number of cities going broke.

“If you're a bond insurer," said Skeel, "you say, ‘Oh my, I didn't think this could happen. It's happening in a significantly-sized city -- Stockton; it could happen almost everywhere.’”

And if a federal judge ultimately rules cities can scale back pension benefits for retirees – a move legally prohibited for decades – other financially troubled cities may take similar steps.

Skeel said local governments across the country should “take note as carefully as they can” while Stockton sorts through the major issues at the heart of its problems, and looks for solutions.

“When is it OK to go back on promises that you made to these employees?" mused Skeel. "What limitations ought there be on that? Who should be held responsible and how widely should the sacrifice be shared? These are big questions, I think.”

In the meantime, Stockton continues to negotiate with its numerous creditors. It agreed on a $22 million repayment plan with a bond insurer last month, and people involved in talks say an agreement on a more limited retiree health care plan isn’t out of the realm of possibility.

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“At the end of the day nobody’s going to be happy,” said former City Manager Dwane Milnes, who has represented retirees in negotiations. “You just hope they’re all equally unhappy. I think that really is the best outcome."

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