Lambasting the hardball tactics of the city's Wall Street creditors, a U.S. bankruptcy judge Monday refused to bar Stockton from seeking bankruptcy protection.

U.S. Bankruptcy Judge Christopher Klein dealt a blow to creditors who had sought to block the city's bankruptcy on grounds that Stockton improperly claimed insolvency while refusing to cut its massive pension obligations.

Declaring that Stockton has met the burden to continue in Chapter 9 municipal bankruptcy, Klein said, "The city of Stockton was by any measure insolvent" and "unable to pay debts as they came due."

He said Stockton, which last year endured a record 71 homicides, needs bankruptcy protection for both its fiscal and social well-being. "It is clear that the city would not be able to perform its obligations to its citizens, such as fundamental matters of public safety," he said.

The judge's ruling preserved Stockton's standing as the most populous city in America to file for bankruptcy protection.

But it was hardly a celebratory moment for officials in the city of more than 290,000 residents. Stockton slashed $90 million in staff and services over three years and laid off a quarter of its Police Department as it slid to insolvency.

On Monday, Stockton City Manager Bob Deis, who was hired in 2010 to help guide the beleaguered municipality, noted that Stockton still faces "a crime rate that competes with Third World countries."

After spending more than $4 million in legal fees to fight the creditors' bankruptcy challenge, the city must negotiate terms to resolve hundreds of millions of dollars in debt. Even with bankruptcy protection, it faces budget deficits estimated at $100 million over the next 10 years.

So Deis hinted at a Pyrrhic vindication as he lauded the judge Monday for recognizing "the unvarnished truths" – that Stockton was broke, that it had tried to work with creditors and that it made budget cuts to the point where its community health and security were in jeopardy.

Wall Street bondholders, including Assured Guaranty Corp. and National Public Finance Guaranty Corp., argued that they were targeted for financial harm as Stockton refused to negotiate down employee pension obligations with the California Public Employees' Retirement System.

"The city embarked on a path towards Chapter 9 (bankruptcy) before even engaging the capital market creditors" in negotiations, argued Matthew Walsh, a lawyer for National Public Finance, as creditors sought to upset the bankruptcy case last week. National Public Finance had issued bonds on the city's $68 million downtown arena.

Guy Neal, an attorney for Assured Guaranty, which insured the city's pension bonds, charged last week that Stockton stiffed its creditors in favor of "the unfunded gorilla in the room" – pension obligations that include Stockton's $29 million annual payments to CalPERS.

But in his ruling Monday, Klein criticized the behavior of the two major bondholder creditors. He said it was the Wall Street creditors – not the city – that engaged in bad-faith negotiations before Stockton's bankruptcy filing.

Klein concluded that National Public Finance and Assured Guaranty "each took the position that there was nothing to talk about" unless the city sought concessions from CalPERS.

"The translation: If you don't intend to impair CalPERS, we're not going to talk to you," Klein said of the creditors' stance. "They absented themselves from all discussions. ... And, having voted with their feet, there was no point in talking to them further."

The judge ruled that Stockton made a good-faith effort to negotiate its bond debt but received "nothing but a stonewall on the other side."

He also chastised the creditors for refusing to pay their share of pre-bankruptcy mediation costs, declaring, "The capital market creditors did not negotiate in good faith. And therefore, they do not have the ability to complain."

In a sobering analysis, Klein chronicled Stockton's historic slide toward bankruptcy. Overbetting on tax revenue from a real estate boom, the city bankrolled a downtown redevelopment and doled out generous employee benefits. Notably, the judge said the perks capped a "multi-decade, largely invisible pattern of above-market compensation for public employees."

Klein took the city to task for enabling "pension spiking" – in which final year employee compensation is inflated with unused vacation time and sick leave to boost earnings for pension calculations. The city later put in stricter pension calculation rules but said it would continue making its payments to CalPERS.

Another city, San Bernardino, has temporarily halted its pension payments – over CalPERS' protests – after filing for bankruptcy protection last August.

Klein said in court that Stockton had no requirement to negotiate with CalPERS, which has said the city's pension obligations must be met. But he did not specifically rule on whether cities must meet their obligations to the state pension fund.

"This is not to say there is not a serious issue involving CalPERS," said Klein. "But at this point, I don't know what that is."

In a statement Monday, CalPERS CEO Anne Stausboll applauded the judge's decision to allow the Stockton bankruptcy to continue.

"Today's action gives the city the opportunity to propose a forward-looking plan ... that will allow them to restore long-term financial stability and to provide essential services," she said.

Meanwhile, Stockton officials disagree on how to get there.

Last week, Stockton Mayor Anthony Silva announced he would pursue voter approval for a local sales tax increase to add 100 police officers – but not pay city creditors.

On Monday, Deis said that was a "dangerous move" with Stockton in bankruptcy court.

"We're supposed to sit down with our creditors and negotiate in good faith," the city manager said. "How can we negotiate in good faith and talk about a tax increase where nothing goes to creditors?"

NATION'S BIGGEST MUNICIPAL BANKRUPTCIES

Cities and counties that have filed for Chapter 9:

Jefferson County, Ala.: Filed November 2011, the county located in and around Birmingham had $4.2 billion in debt, the result of a botched sewer project and corrupt credit-default swap deals.

Orange County: Filed in 1994, the $1.7 billion bankruptcy blamed on bad investments tied to interest rates was the largest municipal bankruptcy until 2011; it would amount to $3 billion today when adjusted for inflation.

Stockton: Filed June 28 with $1.03 billion in liabilities, it's the most populous city in U.S. history to seek bankruptcy protection.

San Bernardino: Filed Aug. 1 after the city tapped out its reserves; the Southern California city's debt totals $492 million.

Vallejo: Filed in 2008, the city asked for protection from $175 million in pension obligations.

Source: Bee research, NPR, Chapman and Cutler LLC

Call The Bee's Peter Hecht, (916) 326-5539.

• Read more articles by Peter Hecht

Order Reprint