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Municipal bondholders put state law to the test

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Stockton, California 1; bondholders 0. Calpers TBD. A federal judge this week allowed Stockton's bankruptcy to proceed, over the protests of creditors. Municipalities have to pass through various hoops to go bankrupt, including proving that they tried negotiating with creditors first.

A pre-bankruptcy proposal from Stockton called for losses on bonds – Assured Guaranty, which insured some city bonds, stood to recoup just 17 per cent to 18 per cent on one issue – while preserving the city's obligations to Calpers, California's public employee retirement system. Assured argues that Calpers should feel pain, too, while Calpers says pensions are protected by state law.

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Historically, cities, towns and counties have repaid bond principal – even in bankruptcy – to ensure future access to capital. The ruling suggests that capital losses on muni bonds may become more common. But bondholders should know this by now (Jefferson County, Ala., and San Bernardino, Calif., have already threatened them with losses.)

The bigger issue is Calpers. Stockton is a test case for cutting existing pensions and whether state laws protecting pensions will stand up in federal bankruptcy court. The judge has put off the thorny questions about whether pensions can be "reeled in" but predicted that Stockton would be unable to finalize a plan without addressing them.

If wobbling municipalities around the U.S. are to regain solvency, all options, including pensions, must be on the table. Meanwhile, the kind of behaviour that created the problems continues. Stockton went bankrupt after promising generous pay and benefits while borrowing for an arena and a new city hall. Last week, Sacramento set out plans for an arena, including borrowing, and news reports revealed that an Alameda County official would receive over $400,000 annually for life.

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