http://www.reuters.com/article/2011/10/12/harrisburg-bankruptcy-idUSN1E79B0DS20111012 RPT-UPDATE 3-Debt-laden Harrisburg, Pa., files for bankruptcy * Bankruptcy tries to resolve debt, avoid state takeover * Chapter 9 prompted by crushing debt tied to incinerator * Move opposed by city mayor, state government * Harrisburg seeks to cut principal owed to bondholders By Edith Honan and Tom Hals Oct 12 (Reuters) - Pennsylvania's capital, Harrisburg, filed for a rare municipal bankruptcy on Wednesday in a desperate bid to resolve its debt crisis, but it now faces a showdown with the state over control of the city. Harrisburg becomes one of the most-high profile cities to opt for the little-used chapter of the U.S. bankruptcy code, most notably used nearly 20 years ago by Orange County, California. Alabama's Jefferson County last month settled with its creditors to avoid what would have been the biggest-ever municipal bankruptcy. The Pennsylvania capital's crisis has been a year in the making as the city of about 50,000 struggles to pay for critical services as well as roughly $300 million in debt that funded an incinerator project that failed to generate expected cash. Bankruptcy gives the city "bargaining power" with its creditors and with the state, which is considering a takeover, said Mark Schwartz, an attorney for the council. "They were tired of being humiliated and denigrated," he said of the council members who voted for a bankruptcy filing on Tuesday. Orange County, California, filed the largest Chapter 9 bankruptcy in 1994 after it suffered more than $1 billion in investment losses. Vallejo, California, with 120,000 residents, filed for Chapter 9 in 2008, and Central Falls, the smallest city in Rhode Island, the smallest U.S. state, filed earlier this year. Harrisburg's city council approved the bankruptcy filing in a 4-3 vote. It was opposed by the mayor, and many questioned whether the action, which appears likely to be challenged, was legal. The bankruptcy has the potential to stoke political passions as it will likely pit firefighters and police against municipal bond investors, who are often perceived to be wealthy retirees, said Peter Kaufman, president of Gordian Group and a financial restructuring specialist. Pennsylvania Governor Tom Corbett has said the city would be better off if it agreed to a rescue plan under the state's program for distressed cities, and his office stressed its opposition to the bankruptcy. Pennsylvania's state senate will vote on a bill next week that calls for an eventual takeover of Harrisburg and the forced implementation of a fiscal rescue plan. The state house has already passed the bill. The city council has rejected rescue plans, one backed by the state and one by the city's mayor. Those plans would have called on Harrisburg to renegotiate labor deals, cut jobs, and sell or lease its most valuable assets, including the incinerator and parking garages. The city council said those plans demanded too much of Harrisburg residents and did not ask enough of the county, bondholders and the bond insurer, Assured Guaranty. A spokesman for Mayor Linda Thompson said the council's actions could accelerate state approval of a takeover. "(The bankruptcy) is hugely unpopular, but the council ... is an independent body," said spokesman Robert Philbin. He also said the city's solicitor had raised questions about the legality of the vote during the meeting on Tuesday. The solicitor, Jason Hess, was not immediately available for comment. City Controller Dan Miller said on Wednesday, however, the filing was the right move for Harrisburg. "I think it's the only real option that we had," said Miller, adding that the previous plans rejected by city council would have benefited creditors at the expense of the city. "They wanted to sell all of our assets and make Harrisburg destitute for decades to come," he said. Harrisburg's bankruptcy filing wants to go where prior municipal bankruptcies have not: toward cutting the principal owed to bondholders, Kaufman said. "For perhaps the first time a municipality is talking about compromising its bondholders. That would be very big news, indeed, if it transpired," he said. Daniel Berger, senior market strategist at Municipal Market Data, said there was very little trading in Harrisburg's bonds on Wednesday. "Investors have written off these bonds for years as distressed credits," he said. WAVE OF MUNICIPAL BANKRUPTCIES? About a year ago, many restructuring specialists were gearing up for a wave of municipal bankruptcies to provide much needed work as corporate bankruptcies ground to a halt. The economy was barely growing, towns and counties were burdened with increased demands for services, and revenue was declining. Financial analyst Meredith Whitney, one of the few on Wall Street who foresaw the 2008 financial crisis, said last year she expected a wave of municipal bond defaults. Chapter 9 bankruptcies remain uncommon, however. The process is very expensive, and not all states allow local governments to file for bankruptcy. Governments also have a power ailing companies do not have: the ability to tax. Despite Harrisburg's filing, municipal bankruptcies will likely remain rare, said Richard Ciccarone, chief research officer and municipal bond specialist with McDonnell Investment Management LLC. "Bankruptcy proved to be a bad deal for Vallejo," he said. He said it left the city with fewer critical services, such as police protection. "I don't see governments jumping in to do it."