Federal Judge Christopher Klein's ruling Monday that Stockton, the nation's largest city to seek bankruptcy protection, is indeed insolvent sets the stage for what could be a landmark case that determines who takes a haircut.
Will it be the bond holders, especially the mutual funds, who invested in the city without properly vetting its finances? Or the firms that insured those bonds without adequately assessing the risk?
Will it be the California Public Employees' Retirement System, the nation's largest pension fund, which misled Stockton and local governments across the state about the cost of benefits? Or the workers, whose labor unions pushed for more when they knew, or should have known, that fattened pensions could eventually break the budget?
At the center of the showdown over debt write-offs looms the question of whether public employee pensions remain untouchable even at times of financial crisis. California retirement systems work under the legal assumption that a public employee's pension formula can never be reduced, not even for future work.
The protection stems from the state and federal constitutions, which say government agencies shall not impair contract obligations. While the California Supreme Court has upheld the state protection, the U.S. Supreme Court has said the federal provision is not absolute.
But what happens when a California pension showdown reaches federal bankruptcy court? This is new legal territory. "There are very complex and difficult questions of law that I can see out there on the horizon," Judge Klein said, in what can only be described as understatement.
We would not be here but for the irresponsible behavior of past Stockton officials. They thought the housing boom would never end, that the level in the property tax well would continue to rise.
So they promised fat salary and benefit packages to their workers. They borrowed to fund a new City Hall, an events center and arena, housing projects, parking garages, marina improvements, a fire station, a police communications center and parks and street improvements.
And then, as Stockton became the poster child for the foreclosure crisis, tax revenues sank rapidly.
It was the sort of bet against future income that has become a standard form of school and municipal finance: Promise employees benefits that will become more costly with time. Pay for construction with bonds that depend on rising tax revenues for repayment.
Self-interested bond-sellers and shortsighted labor leaders, who don't think about repercussions down the line, enable this taxpayer-funded scheme. Campaign-contribution-hungry politicians carry it out.
For those who think public officials have learned their lesson, think again. As they watch Stockton, how many will offer their employees compensation increases that depend on rising revenues? How many will float bonds with aggressive repayment schedules?
And how many of them will someday meet the same fate as Stockton?