CHELSEA, MASS. -- When Lewis H. Spence was named deputy receiver of this small city outside Boston three years ago, he asked local officials why they had never sent out penalty notices to collect $1.5 million in unpaid parking tickets.

There wasn't enough money for postage, replied the officials, somewhat incredulous that Spence should have to ask. Besides, they said, imagine the crowds that would fill City Hall paying the tickets, not to mention the piles of paperwork it would create.

So went Spence's introduction to Chelsea (pop. 28,000), which, until recently at least, was arguably one of the most dysfunctional cities in America and a symbol of urban decay and mismanagement.

Situated on only 1.8 square miles of land, much of it underneath the Tobin Bridge linking Boston and its northern suburbs, Chelsea long has been a caricature of a corruption-infested and down-and-out city. Two of its former mayors are serving prison sentences on corruption-related charges, and a third admitted to a grand jury that he accepted bribes but was not prosecuted because the statute of limitations had expired.

The corruption, many of Chelsea's residents say, extended to the police and fire departments. A few years ago, fed-up residents favored offering the city for annexation by Boston, just across the Mystic River. Chelsea already had surrendered its school system, which for the past 10 years has been managed by Boston University under a contract.

The city had not borrowed any money in more than 25 years, not because it was fiscally cautious, but because it had no bond rating and was kept afloat by state grants.

Now, however, a new wind is blowing in Chelsea, local residents and city officials say. Last week, armed with a Triple-A bond rating and a brand-new city charter approved by the state legislature and signed by Gov. William F. Weld (R), Spence flew to New York to present a $110 million bond offering for construction of new schools -- a step that three years ago would have been unthinkable.

For the third year in a row, Chelsea's $40 million annual operating budget is balanced -- a far cry from the $10 million annual deficits it regularly ran up -- and the city has embarked on an ambitious economic development program to rejuvenate its anemic tax base.

"It's a great urban success story, and we have the numbers to show it. This city is going to make it," said Spence.

Chelsea's is the story of a city coming back from the brink. But some residents also believe it offers an object lesson in how to overcome the growing malaise of disenfranchisement and alienation from government felt by many Americans.

"That's why this was so exciting," said Susan Podziba, head of a Brookline-based public sector mediation firm retained to help revive public participation here. "It was a way of engaging people who had checked out of the political process, who were so disgusted with politics that they just washed their hands of it."

A few years ago, none of this seemed remotely possible. Even worse than the corruption and fiscal mismanagement that characterized Chelsea, local residents say, was an angry, divisive atmosphere that seemed to permeate the entire community.

"It was like the government was run by a family. It made no sense trying to become involved in government unless you were in the family," said Vicente Avellaneda, the Argentina-born owner of Tito's Bakery in downtown Chelsea and a member of the volunteer committee that wrote the city's new charter.

Avellaneda and other Hispanics recalled -- and city officials confirmed -- that during the charter debate rumors were spread that even illegal immigrants would be allowed to vote. Spence described the rumors as an attempt to play on the prejudices of non-Hispanics and further divide the community.

Numerous theories have been offered to explain why Chelsea is such a contentious place, some of which involve the Tobin Bridge, a massive steel structure that literally overshadows this compact, densely populated city. When erected in 1950, it broke up several established ethnic neighborhoods that traditionally had a strong sense of community.

For years Chelsea has been a transient immigrant city, a first stop originally for Poles, Ukrainians, Russian Jews and other European newcomers. They settled here, saved some money and moved on to more prosperous ethnic neighborhoods in Boston.

More recently an influx of Hispanics, who now are 40 percent of the population, and Asians, who make up about 15 percent, has dramatically altered the ethnic mix and, in the process, exacerbated tensions between the community and the virtually all-white city government.

"The Anglos mourned the loss of the way it was before the Hispanics came, and the Hispanics mourned the country they had just left behind," said Spence. "Neither felt deeply invested in the future. All they did was shout and insult each other."

The turning point may have come in 1991, when Chelsea sunk so low it was placed into state receivership. In came James Carlin, a business executive and former state transportation secretary appointed receiver by the governor, and his deputy, Lewis Spence, with virtually unlimited powers in balancing the city's books and reorganizing the government. Almost immediately they fired 14 of the city's 17 department heads and streamlined many city agencies.

"There were amazing levels of incompetence, which increased the higher you went in government," recalled Spence, a former lecturer at Harvard and director of Boston-area housing authorities who later succeeded Carlin as receiver.

Carlin and Spence cut personnel, consolidated patronage-laden departments, negotiated new contracts with police and firefighters and launched an economic development plan that has generated more than $250 million in public and private construction projects.

But perhaps most important, Spence also hired Podziba, a public disputes mediator whose experience includes water rights conflicts between Arabs and Israelis in the occupied West Bank, and asked her to reach deep into Chelsea's fractious community and engage people who had withdrawn from local affairs.

Over the last year, through public meetings, surveys, call-in public television programs and focus groups, Podziba has helped Chelsea's residents hammer out a draft charter to replace the city's weak mayor-aldermen form of government with a city manager-council system. Drawing from leaders of political, religious, education and ethnic groups, Podziba formed an 18-member Charter Preparation Team and set it on a course toward achieving a consensus on a new form of government. She then trained the members how to organize and run their own focus groups.

Podziba said it is the first time a U.S. city has drafted a charter using a consensus-building process with so much engagement of the citizenry. Typically, city charters are drafted by an elected or appointed charter commission and presented to the voters for approval or rejection.

"We had to battle suspicion," she recalled. "We had to battle imagined conspiracies. There were screaming matches because that's how people have always dealt with one another in Chelsea. But we got a consensus."

Chelsea's new charter was approved in a June 21 special referendum by 60 percent to 40 percent, which Podziba said was a comfortably wide margin compared to most city charter referenda.

Chelsea still has to elect a city council, appoint a city manager and then demonstrate that it has the confidence to govern itself -- no small feat considering its long and troubled history.

"Good government takes a lot of work and a lot of cooperation among people of good will, and frankly I don't know yet whether we have enough of either. There's a deeply rooted lack of respect for diversity of views around here," said Alexander Nappan, a state prosecutor and lifelong resident. Nappan said he is thinking about running for the city council but wonders whether he should subject himself to "that kind of personal abuse."

"I wouldn't give Chelsea better than a 50-50 chance. It's not a success story yet," Nappan added.