(Adds Calpers statement, background on case)
By Robin Respaut
SACRAMENTO, Calif., Oct 1 (Reuters) - The U.S. bankruptcy judge overseeing Stockton, California's municipal bankruptcy trial on Wednesday ruled that the state's public employee retirement system, known as Calpers, could be forced to absorb losses along with other creditors.
U.S. Bankruptcy Judge Christopher Klein said the city's contract with the California Public Employees' Retirement System could be rejected.
While the judge ruled the city may impose losses on Calpers, he has not yet ruled that it must do so as part of its financial restructuring.
The ruling follows a similar determination in the city of Detroit's bankruptcy case, in which that judge ruled that pensions could also be made to absorb losses along with other creditors. In that case, the city's pension plans have agreed to accept benefit reductions, but the Detroit bankruptcy is not yet resolved.
Calpers said it disagreed with the ruling.
"This ruling is not legally binding on any of the parties in the Stockton case or as precedent in any other bankruptcy proceeding and is unnecessary to the decision on confirmation of the City of Stockton's plan of adjustment," Calpers spokeswoman Rosanna Westmoreland said in an emailed statement.
"What's important to keep in mind is what the City of Stockton stated in court today: that they can't function as a city if their pensions are impaired."
Klein has wrestled throughout the trial with the question of whether to confirm the cash-strapped city's restructuring plan without imposing payment reductions to the California Public Employees' Retirement System, as well as other creditors slated to take a haircut.
The judge was still hearing arguments late Wednesday from city officials urging him to approve the plan as submitted, which contained no haircut for Calpers.
The city of Stockton opposes cutting public employee pensions, fearing a $1.6 billion termination fee threatened by Calpers, the world's largest pension fund.
Klein on Wednesday said the threatened fee could be avoided in the Chapter 9 bankruptcy process.
City officials also fear that pursuing such a line of restructuring would involve pension benefit reductions of as much as 60 percent, which would prompt many city workers, including police and firefighters, to quit.
City attorney Marc Levinson argued that the city has already unilaterally reduced health benefits to retirees. "They lost their health benefits. They felt pain immediately," Levinson said.
"Employees have an incentive to leave and they have an incentive to leave in six months," Levinson said. "The fear in the city is real."
Stockton filed for bankruptcy over two years ago, making it the largest city in U.S. history to seek Chapter 9 protection until Detroit sought bankruptcy last year.
Stockton's bankruptcy, as well as the Detroit case and another in San Bernardino, California, have been closely watched by the $3.7 trillion U.S. municipal bond market.
Bondholders, public employees, and state and local governments are keenly interested to understand how financially distressed cities handle their debts to Wall Street compared with other creditors, like large pension funds such as Calpers, during Chapter 9 protection.
The Detroit trial, centering on the feasibility and fairness of the proposed restructuring of some $18 billion of city liabilities, began last month and could stretch well into October.
Stockton's case has mainly focused on the collateral of a holdout creditor, two funds managed by Franklin Templeton Investments. In August, the judge ruled Franklin's collateral, which includes two golf courses, a community center and a park, was worth $4.1 million.
Franklin has also argued that pensions should not escape the bankruptcy intact while other creditors are forced to swallow significant losses. (Reporting by Robin Respaut, writing by Dan Burns; editing by G Crosse, Meredith Mazzilli and Bernard Orr)