Vallejo, California, postponed a decision on whether to reorganize under Chapter 9 of the federal bankruptcy code after reaching a cost-cutting agreement late Thursday with labor unions representing its police officers and firefighters.

City officials will take up the matter on Monday, after weighing whether the union concessions will be sufficient to keep Vallejo solvent.

The local economy has slumped so badly—particularly the real estate market—that elected officials said that taxes were no longer sufficient to cover the expense of running the city of 117,000 people 27 miles northeast of San Francisco.

In Vallejo, tumbling home sales and property values have driven tax revenues down, while payroll expenses have soared. The city's budget deficit is almost $10 million; it is expected to grow beyond $13 million during the fiscal year beginning July 1. At the current pace, Vallejo is expected to run out of cash by the end of March.

Neither the city nor its unions disclosed specifics of the cost-cutting agreement they reached to address the problem.

Chapter 9 bankruptcy is rare, but not unprecedented. A vote to declare bankruptcy on Monday would make Vallejo the first California city to declare bankruptcy because its revenues cannot cover expenses.

In 2001, Desert Hot Springs, a city of 20,000, filed for bankruptcy after it lost a lawsuit; Orange County, a wealthy enclave south of Los Angeles, declared the biggest municipal bankruptcy in U.S. history in 1994 after losing $1.6 billion on a bad interest-rate-derivative bet.

Nationwide, 32 municipalities have filed for bankruptcy since 1980, according to NPR, the most notable of which has been Bridgeport, Connecticut. The city of 140,000 filed for Chapter 9 protection in 1991 after racking up a $17 million deficit.

The specter of failing municipalities—considered some of the most failsafe repositories for investment—is enough to send a subprime shiver through markets already reeling from a mortgage crisis. Will insolvent governments be the latest nightmare to emerge as the credit crisis unfolds?

Amy Doppelt, a managing director at Fitch Ratings, said she doesn’t see a doomsday scenario for governments. She says smaller local governments are most susceptible to the kind of problems seen in Vallejo.

Their less-sophisticated budgeting practices have left them more reliant on volatile revenue streams like property taxes, real-estate-transaction taxes, and developer fees. In Vallejo, all of them contributed heartily to the city's income—and all of them plummeted as home sales slowed.

Further, Doppelt pointed out that Chapter 9 municipal bankruptcy and Chapter 11 corporate bankruptcy have differences in terms of the outlook for investors.

"Unlike corporate bankruptcy where there's a possibility that it may shut down and sell off assets, municipalities are in a much different situation because they can't just go out of business," Doppelt said. "Orange County was in bankruptcy and continued to pay obligations to investors."

Local police and fire contracts negotiated during more prosperous times now make up nearly 80 percent of Vallejo's $80 million general fund.

City officials have been negotiating to reduce pay and benefits to firefighters and police officers, as well as considering layoffs—but negotiations with unions broke down earlier in the week.

While municipalities nationwide feel the sting of the economic slowdown, Doppelt said most of the municipalities that Fitch rates—including Los Angeles and L.A. County but not Vallejo—have more conservative budgeting practices that anticipated declining tax revenue.

"Most of the entities we work with will be under financial strain but we don't anticipate the financial strain to be severe," Doppelt said.

She also noted that the level of hardship would differ greatly by region. The most pain will be felt in areas with a lot of speculative real-estate investment—Florida, Nevada, and Southern California—as well as financially challenged states like Ohio and Michigan.

Vallejo is in Solano County, an area heavily hit by the housing slump. Home prices in the county fell almost 20 percent in January from the same month a year earlier.

Whether or not it ends up declaring bankruptcy, Vallejo will probably have to cut services—from library hours to infrastructure improvements—as well as pare back city jobs and police and fire staff.

Filing for bankruptcy protection would allow Vallejo to renegotiate contracts with employees, vendors, and bondholders, and would protect it from lawsuits, but the move would damage its credit rating and lead to costly legal expenses.