In a provisional but uncompromising ruling, U.S. Bankruptcy Judge Christopher Klein held bankrutpcy law does not permit CalPERS to protect its workers’ pensions even when municipal coffers run dry.

An end to business as usual

Typically in federal bankruptcy proceedings, the judge has almost total discretion to dispose of assets and restructure contracts. But CalPERS, reported Bloomberg Businessweek, “has long argued successfully that California law provides extra protection for public pensions when a city struggles financially, allowing Calpers to use special liens to force cities to pay up.”

Such liens have been one of CalPERS’ most powerful weapons in the face of potential bankruptcies. According to The Wall Street Journal, the particular lien CalPERS demanded from Stockton has reached an eye-popping amount. In the event Stockton defaults on its pension contract with its public workers, CalPERS said, the fund will see a $1.6 billion “termination fee.”

Klein, reported Bloomberg Businessweek, called the unique law a “golden handcuff” that “is simply invalid in [the] face of the U.S. Constitution.” But his ruling was verbal, not written, and its practical impact will hinge on whether Stockton proposes — and the judge accepts at the end of the month — a restructuring plan that does not slash public pensions.

National attention, national stakes

On the other hand, even Klein’s incomplete decision made for a landmark ruling in California, with important implications nationwide. As the Sacramento Bee observed, Wall Street analysts hailed the ruling, which rebuffed CalPERS claims that Detroit’s municipal bankruptcy proceeding should not have been considered a precedent because Michigan lacks the Golden State’s additional pro-pension legislation. Moody’s Investors Service, reported the Bee, called Klein’s holding “a positive sign for investors that pension obligations will not be given preferential treatment over debt” in a city’s financial restructuring.

The financial and investment industry has watched Stockton’s case carefully. What happens there could not only affect future city bankruptcies in California, but influence the scope of legal remedies against public employee unions across the country. Where pension funds have been protected, the pressure on creditors, taxpayers and shareholders has increased substantially.

As the Journal detailed, Stockton’s bankruptcy took a painful toll on virtually every other major financial player in town. “The city last year raised its sales tax by 0.75% to cover rising labor costs and hire more police,” the paper wrote. “Creditors are taking big haircuts. Assured Guaranty, which insures about $121 million in pension obligation bonds, will recover about 50%. Franklin Templeton Investments has been offered a penny on the dollar for $35 million in bonds for public works.”

More embarrassment

At the same time as CalPERS has struggled to advance its claims in court, its public image has taken another slam on an unrelated matter. After being hit with over $10,000 in fines for years of filing and disclosure violations, CalPERS board member Priya Mathur recently incurred the wrath of the California Fair Political Practices Commission.

That body is poised to slap Mathur with another $4,000 in fines, quadruple the originally agreed-to amount. CalPERS had already stripped Mathur of her chair on the health committee and suspended her travel privileges. But, as the Los Angeles Times reported, members of the agencies making up the CalPERS system voted last week to return Mathur to a fourth four-year term in office.

More troubles

What’s more, in August an irate Gov. Jerry Brown ordered state Controller John Chiang’s office to investigate what his administration could do to “protect the integrity” of a law meant to prevent pension spiking.

In September, Chiang revealed California lacks the resources to oversee and crack down the spiking, which involves deliberately boosting work that counts toward union members’ retirement packages. The practice increases costs to CalPERS and reduces its fiscal solvency.

By Wayne Lusvardi

In his absurdist play, “Endgame,” about a chess game where there are few pieces left on the board, Irish playwright Samuel Beckett wrote: “The end is in the beginning and yet you go on.”

And so it may be with the City of Stockton’s — and California’s — absurd public pension and municipal bankruptcy endgame.  The beginning will cast the mold for the end.

It’s only a few days after the ruling by Christopher Klein, the U.S. bankruptcy judge, allowing the Stockton bankruptcy to proceed. So it’s difficult to tell what California’s public pension and municipal bankruptcy end game might look like.  But what does California history tell us?  We may be able to tell something about the future in the legacy of former Gov. Gray Davis and how the California Electricity Crisis of 2000-01 ended up.

The Wall Street Journal says that bond investors will take a loss.  Walter Russell Mead writes that pensions are also likely to be cut. Steven Greenhut sees that “pensions will be protected above all else.” Who knows what will happen?

According to Klein, the “day of reckoning” for the bankrupt City of Stockton will come on the “day of plan confirmation.”

Many are predicting that cities allowed to leave lucrative pension plans untouched — and bondholders wiped out — will face either no credit or ultra-high bond interest rates.  But the bankrupt cities may not care that much.  Here’s plausibly why.

Bigger bond pool on the horizon?

Financially distressed California cities may be hoping that the initial bankruptcy court “day of plan confirmation” in Stockton will leave pension obligations untouched. They may be counting on the state eventually creating a statewide borrowing entity to provide debt financing for public works projects for bankrupt cities.  Instead of the “full faith and credit” of each city, the credit rating of the state would back these bonds.

If California should create a bigger bond pool to aid distressed cities, the federal government also might be pressured to create similar bond pools for struggling states to continue to borrow in the bond markets.

In California, this is likely to mean that wealthier suburbs with good credit ratings are more likely to end up paying higher bond interest rates partly to pay for the unmet pension gap in struggling California cities.  This might be called indirect tax sharing.  Or in this case it might result in a premium on all California cities’ bond interest rates.

By analogy, the solution to your family’s unpayable credit card debt would be raising interest rates on the credit cards of those with good credit reatings.

Gray Davis’ legacy

Something like this happened with the California Electricity Crisis of 2000-01, after Gov. Gray Davis botched the management of the crisis just two years after he signed the pension-spiking bills that now are leading to the municipal bankruptcies. Although Davis’ recall was followed by the disastrous Schwarzenegger administration, it’s worth remembering that voters had good reason to give Gray the boot.

The electricity crisis ended up with Gray Davis panicking and signing long-term contracts at the height of market prices for energy. The state then imposed electricity rate premiums on customers to pay for 58 long-term power contracts totaling $42 billion to essentially amortize the losses from that crisis over some 15 years.

In recent years, California Democratic legislators have been eager to create regional governments to supplant Red-controlled cities and counties.  Proposition 31, which would have created unelected regional Strategic Action Councils to overrule local government, was defeated at the polls last November.  Prop. 31 would have authorized the governor to intervene in the event of a “fiscal emergency” to create such regionalized government entities.

The bond market may take losses now in bankruptcy court only to see bond interest rate premiums paid to bond investors in the future.  This may be why bond insurance companies refused to negotiate with Stockton “in good faith,” according to Judge Klein.

In other words, the end game may be that the cost of bloated city public pension plans will be socialized to all cities in the state through higher bond interest rates.   Should this result, wealthier coastal suburbs might end up disproportionately picking up the tabs for distressed cities.

History repeats

If history repeats itself, look for there to be some mild, mostly symbolic reductions in pension benefits, but with the remaining unmet pension gap to be reflected in higher long-term bond interest rates.

Back in 2010, bond expert Meredith Whitney predicted a wave of municipal bond defaults.  What she could not have foreseen was that, in the moves of a grand chess master, the bond market might end up with losses today for higher interest rates tomorrow.

In Samuel Beckett’s play, one of the characters asks another with a telescope what can he tell of the future from what is on the horizon of the sea.  The lead waves don’t signal much and the sinking sun looks like nothing but a big zero.  Instead of the black of night coming, all that the man with the telescope can see is, as he exclaims, “Gray…Gray!…GRRAY!!”

Look for California’s pension and municipal banking crises to end up with a very Gray outcome for California’s future.