Analysis: Grim prospects for Stockton as bankruptcy looms SAN FRANCISCO (Reuters) - A costly mess, including court battles with employees and lenders that could stretch over years, is likely to await Stockton, California, if it cannot reach a last-minute deal with creditors and becomes the largest U.S. city ever to file for bankruptcy. "A Chapter 9 bankruptcy proceeding is complicated, expensive, time-consuming and uncertain," said James Spiotto, a lawyer and municipal bankruptcy specialist at the Chapman and Cutler law firm in Chicago. More likely than not, you're not going to get your desired result. Stockton on Wednesday provided an initial outline of what a "bankruptcy budget" might look like for the city of 292,000 as a June 25 deadline for mediation talks with bond holders, employee unions and others approaches. The city proposes to stop payments on much of its debt and impose wage and benefit cuts including the elimination of all retiree healthcare benefits after a one-year transition period. Stockton has already slashed its workforce sharply in recent years, cutting the police force by 25 percent, the fire department by 30 percent, and all other departments by more than 40 percent. But it still must find a way to close a $26 million gap in its $162 million budget for the fiscal year beginning July 1 -and people involved in the mediation sessions consider a bankruptcy filing to be all but inevitable. Stockton appears to have already thrown in the towel on the mediation process by announcing its contingency plan, said Dwane Milnes, a former Stockton city manager who represents retired city employees in mediation with the city. "I hope that in five days they stick their heads up and say they've herded all the cats but every public action they've taken indicates that won't be the case," he said. The mediation, which includes 18 parties, was mandated by a state law passed the wake of the bankruptcy case of the San Francisco Bay area city of Vallejo. In Vallejo, which filed for bankruptcy protection in 2008, public employee unions, led by the police, fought a pitched legal battle against the type of cuts that Stockton is now proposing, but ultimately lost in court. Vallejo has emerged from bankruptcy, but crime has soared, businesses have fled and property values have plunged as the city struggles to maintain basic services. For Stockton's city workers, the only silver lining in the Vallejo case is that Vallejo chose not to challenge payments to the California Public Employees' Retirement System (Calpers), which handles employee pension plans for many cities and counties around the state. Calpers has made it clear it believes pensions have iron-clad legal protection even in a bankruptcy. That belief has never been tested in court - but with the same bankruptcy lawyers who represented Vallejo now acting for Stockton, pensions may again be off the table. "It's left off the table because they knew they would lose the fight," said Mark McLaughlin, a Stockton detective and board member of the city's police officers union. Milnes said a legal fight over pensions would prove costly for Stockton and complicate any bankruptcy case. "Do you want to be on the bleeding edge or on the cutting edge?," he asked. If you want to take this thing on you could stretch your bankruptcy on for years and take on more cost. Stockton runs its own retiree medical program, making it a far easier to target for costs savings, McLaughlin noted. Stockton officials have repeatedly said the city faces a crushing liability of $417 million for its retiree medical expenses and that those costs must be reined in. In its statement Wednesday, the city also contended that altering pensions would make it "nearly impossible" to recruit and retain good employees, but that cutting healthcare benefits would not have such consequences. The extent to which government employers in California may alter pensions for current employees is the central issue in a lawsuit launched by police officers in San Jose this month following voter approval of a measure to overhaul the city's pensions. San Jose's firefighters also have launched a court challenge to the measure. The municipal bond market is all but resigned to a Stockton default - the city has already skipped some payments while it negotiates - and ratings agencies continue to downgrade various bond issues. Stockton has more than $700 million in debt across its various agencies. Moody's since February has cut its issuer rating for Stockton to a junk level Ba2 from Baa1. Standard and Poor's Ratings Service over the same period has dropped its issuer rating on the city from BB to SD, one notch above its D default rating. "Even if a bankruptcy filing is avoided through negotiation of a settlement with labor unions, bondholders, or a combination of the two, Stockton is likely to default on its unsecured debt, including pension and lease obligations," Moody's said in a recent note. The rating agency said it could drop its ratings on the pension obligation and lease bonds by several notches, possibly to the Caa category or lower, based on the experience of bondholders in Vallejo's bankruptcy, who suffered losses of at least 25 percent on their principal. The defaults have already allowed the trustee for one of Stockton's bond insurers to seize a building slated to be a future city hall, along with three parking garages. Still, much of Stockton's debt is backed by user fees and other guaranteed revenues and thus would not be eliminated even in a bankruptcy. Standard and Poor's sees just over $300 million of Stockton's various bonds issued since 2003 at risk of default. Under Stockton's plan for managing its finances in bankruptcy, the city would stop $10.2 million in payments owed on its debt. The Vallejo bankruptcy case dragged on for three years and cost the city about $10 million in legal fees - and Vallejo is a much smaller city than Stockton. Because municipal bankruptcies under Chapter 9 of the federal bankruptcy code are rare, especially for larger cities, a Stockton bankruptcy could set important precedents on how various different types of creditors are treated in such cases. That creates an added incentive for the parties to fight rather than settle - even though that could mean a bad outcome for everyone. Stockton's predicament stems from years of fiscal mismanagement and the collapse of a once red-hot housing market. The city has already cut spending by more than $90 million annually, to $162 million in the current fiscal year. With the police department budget slashed by 25 percent, homicides have spiked, and the city has eliminated almost half of all jobs outside of police and fire. Sacramento-based lawyer Joseph Rose, who represents Stockton's office worker employees in the mediation, said he believes Stockton will be unable to avoid bankruptcy: "I really genuinely hope to get a deal with the city by the end of this month if possible, but I maintain bankruptcy is inevitable." Reporting by Jim Christie and Peter Henderson in San Francisco; Editing by Jonathan Weber and Eric Walsh