By Peter Henderson and Jim Christie
SAN FRANCISCO (Reuters) - Two bond insurers challenged the eligibility of Stockton, California, for bankruptcy, arguing that the city can cut pension benefits, a move that could have profound implications for the state.
The court filings set a roadmap for a battle, in or out of bankruptcy court, in which Wall Street takes on the largest public U.S. pension fund, the California Public Employees' Retirement System (Calpers), as troubled cities and counties watch closely.
A unit of MBIA Inc told the court that the city's failure to ask for concessions from its biggest creditor, Calpers, showed that it had not negotiated in good faith, and it argued that the city's plan for recovery was doomed because it did not touch pensions.
Assured Guaranty, in a separate filing provided to Reuters, also contended that the city undermined its case by favoring Calpers and said Stockton had not proven insolvency.
Calpers has used warnings of court battles to dissuade municipalities from considering pension cuts, but retiree benefits are constricting many cities. San Bernardino, California, also faces major pension obligations and is following Stockton's bankruptcy path.
"It's the equivalent of a declaration of war (on pensions)," Karol Denniston, a San Francisco lawyer who helped draft California' bankruptcy process law, said of the filing.
The calls for pension cuts do not take into account the city's "heart wrenching" layoffs, salary cuts of 9 to 23 percent, new employee contributions to pension and health, and a plan to drop retiree healthcare, said city spokeswoman Connie Cochran.
"The city has struggled to maintain public safety in a city that is plagued by one the highest violent crime rates and the lowest police officer to citizen ratio in the nation," she wrote in an email.
A federal judge must approve Stockton's eligibility for Chapter 9 protection before the city can reorganize its debts under court protection, and a primary criterion is whether the city made a real effort to avoid a bankruptcy filing.
"The city has not presented evidence that it negotiated with its creditors equitably and thus, in good faith," National Public Finance Guarantee Corp, a unit of MBIA, wrote in its filing. (http://link.reuters.com/zyv89s)
The company, which insured nearly $94 million of the city's revenue bonds, said Stockton had not negotiated with Calpers at all, and that its initial proposal to creditors showed a financial shortfall for 2013-14, even after bond payments were cut.
The insurer blamed pension costs for the shortfall. Those pension payments represent a financial liability, like debt service payments, and should be treated equally, it said.
"The protection of Calpers benefits for the mayor, city council and other city employees is clearly not in good faith," it added.
Debt service savings of $11.3 million account for 44 percent of concessions in 2012-13, it said. Calpers obligations amount to $17 million that year and rise to over $30 million by 2020.
Assured argued the plan was especially unfair because the city issued pension obligations bonds to make payments to Calpers and now wants to abandon the bonds. That would leave the insurer covering $100 million of principal.
"The city took the bondholders' money to give to Calpers, and now proposes to leave those funds with Calpers and pay Calpers everything else Calpers decides the city owes," it wrote. Moreover, Stockton had not provided reliable data on its finances or even polled residents about raising taxes.
National also insures $18 million of bonds backed by San Bernardino's general fund, the main budget, and it is represented in that case by the same law firm that filed the Stockton objection, Winston & Strawn. A lawyer declined to comment further on San Bernardino, which went straight into federal bankruptcy court without negotiations, saying it did not have enough resources to last during the negotiating period.
Credit ratings agency Moody's Investors Service said the rush to bankruptcy by San Bernardino, following on the heels of Stockton and another city -- Mammoth Lakes, could signal a major change in city governments' attitudes.
"Historically, U.S. cities have considered bankruptcy as the very last resort to managing fiscal problems. The recent uptick in bankruptcy filings in California could signify not only a lack of ability, but a lack of willingness to pay debt service at the expense of other financial obligations," the agency said in a Thursday note.
Stockton is a city of nearly 300,000 in a traditionally agricultural area on the edge of San Francisco Bay, which burst at the seams with new houses a decade ago.
Its growth outstripped that of the state and now its foreclosure and unemployment rates are among the worst in California, while infrastructure deals like a new city hall and riverfront development have failed.
The case is In re: City of Stockton, California, debtor, U.S. Bankruptcy Court, Eastern District of California, No. 12-32118.
(Additional reporting by Hilary Russ; editing by Padraic Cassidy, Gary Crosse and Bob Burgdorfer)