In 2005 the city of San Bernardino borrowed $50 million using pension bonds in an effort to shrink its massive debt with the California Public Employees' Retirement Systems (CalPERS). Two years later Stockton floated nearly $125 million in pension bonds because it faced the same pressures as San Bernardino. Neither city reformed or reduced its pension benefits at the time in order to stop the continuing rapid growth of retirement liabilities. In fact, San Bernardino subsequently enhanced pensions.

Both cities are bankrupt today and their initial bankruptcy plans include suspending payments to bondholders, including to those who bought its pension obligation bonds. At the same time the cities are doing little to rein in pension costs. Stockton forecasts that its pension payments to CalPERS will nearly double by the end of the decade. In large part that's because CalPERS has threatened to tie up in court any California municipality that attempts to reduce its pension benefits to current workers.

Welcome to Chapter 9 in the 21st century. Ever since a fiscal tsunami began engulfing state and local budgets in 2009, bondholders and public employees have been on a collision course. That's because municipal budgets are largely made of employee costs. Some 70 to 80 percent of city, town and school district budgets consist of pay and benefits, and even as tax revenues have slumped, the cost of employing the average local government worker has soared thanks to skyrocketing benefit costs.

In Stockton, salaries account for $54 million of about $122 million in total worker compensation. The rest is largely benefits. The city employs fewer than 1,000 workers, so its average compensation cost is about $125,000 per employee. And despite being in bankruptcy, Stockton projects that salary and benefit costs will rise about $7 million, or 5 percent, next year, largely driven by $5.5 million in higher payments to CalPERS.

What's happening in San Bernardino and Stockton is especially chilling for investors who purchased California pension bonds. According to Thomson Reuters, nearly 100 California governments floated $9 billion in pension debt in the last decade alone. That's more than governments in any state except Illinois, though most of Illinois' pension debt is state obligations.

California cities, which are among the most fiscally stressed in the nation, rushed to issue so much pension debt after they followed their state government over the fiscal cliff by adopting expensive enhancements to worker retirements that Gray Davis and the legislature enacted for state workers in 1999. For Stockton, that included giving its public safety workers a "3@30" pension deal that allows fire and police force members to retire after 30 years with a pension that amounts to as much as 90 percent of final salary.

CalPERS, ironically, helped cities leap off the fiscal cliff by arguing that governments could afford the Gray Davis pension enhancements without much cost to taxpayers. CalPERS projected that its own investment returns could pay for the additional benefits. But CalPERs has fallen well short of its investment targets, and the result has been billions of dollars more in annual pension payments for California taxpayers and growing unfunded long-term liabilities.

Naturally, CalPERS now promises to fight tenaciously in court against any reductions in pension benefits that it led naïve city officials into promising. Two bond insurers, including one that backed Stockton's pension obligation offerings, are fighting back, arguing that Stockton shouldn't be allowed to remain in Chapter 9 if it doesn't make an honest attempt to reduce its pension costs.

Investors presumably snapped up this pension debt because they were hungry for its higher yields. Maybe investors also found it hard to believe that long-term retirement obligations would help bankrupt a city. Now these same bondholders and insurers are discovering that while pension payments to workers are considered little short of a sacred right, pension bonds carry weak protections. Stockton's bankruptcy papers call the pension bonds, "an unsecured obligation of the city, with no other collateral or pledged revenue stream committed to the payment of debt service."

Stockton officials argue they've made cuts to employee compensation in bankruptcy, just not to pensions. The city has ended its healthcare-for-life program, granted in the 1990s, in which employees and their families continue receiving city-sponsored health insurance after workers retired. But few workers in the private sector have this benefit anyway, and even without it Stockton workers have pensions that are far more generous than those of most taxpayers who are paying for these benefits.

In Rhode Island, another place where cities are under enormous fiscal stress, the state legislature enacted a law last year that says cities must pay holders of their general obligation bonds first in bankruptcy, before even pensioners. The state took that move, legislators said, in order to protect the ability of state and local governments to raise money in debt markets.

Ironically, in describing the Rhode Island legislation last year, the New York Times reported that a bigger, more vibrant state like California didn't need similar protections because it has "shock absorbers" that assure that bondholders will be paid, including "a big, diverse state economy that could bail out a distressed city if need be."

But Sacramento doesn't seem in much of a position to bail out its distressed cities these days. "At this moment, California is every bit as insolvent as the cities that are trooping to bankruptcy court," the Sacramento Bee's Dan Walters recently observed.

Contracts and covenants were made to be broken in federal bankruptcy court, and bondholders along with pensioners can't both be untouchables. But only one thing is certain. No matter who wins, taxpayers are already losers.