California Nears the Crossroads: Budget Debacle
June 30, 2009
By: Steve Shutz, CFA, Vice President

As California entered a new fiscal year on July 1st, lawmakers appeared no closer to an agreement on a plan to deal with the state’s $24.3 billion budget deficit.  Following the legislature’s inability to pass a comprehensive budget solution, Governor Arnold Schwarzenegger exercised his executive authority by proclaiming a state of fiscal emergency. Under the terms of the declaration, a special session is declared and the Legislature has 45 days to pass and send a bill(s) to the governor’s desk addressing the budget crisis.

Despite closing a $42 billion budget shortfall in February, relying principally on a variety of one-time budgetary solutions, sharp declines in April tax receipts and a continued deterioration in the economy presents the state with an additional $24.3 billion gap to fill. Since an agreement was not reached by the June 30, 2009 fiscal year end, the state’s controller has now begun issuing registered warrants, a form of IOU, for certain non-priority payments.  An estimated $3.2 billion in IOUs will be issued in July as payment to vendors, tax refunds, and certain social services.

With the issuance of IOUs for non-priority payments, the state’s controller is preserving cash for the state’s mandatory contractual obligations – including debt service payments for California General Obligation (GO) bondholders. However, the longer the legislative gridlock persists, the more IOUs that will have to be issued, and the thinner the margins for meeting the constitutionally required payments.  If lawmakers are unable to enact a balanced budget by the end of September 2009, the state’s cash deficits will expand dramatically to $16.1 billion, well beyond the non-priority spending of only $10.6 billion.

State officials already project the need to borrow up to $13 billion of short-term debt for cash-flow purposes by the end of this summer. Cash flow solutions, including the ability to access short-term borrowing, are inextricably tied to reaching a timely agreement on an effective and credible budget proposal. In order for the state to achieve a tolerable rate of interest on its upcoming short-term Revenue Anticipation Notes (RAN) offering, the capital markets will require a balanced FY 2010 budget.

From an investor’s perspective, it is necessary to clarify that merely being late on a budget does not threaten the state’s ability to make timely debt service payments. GO debt in California has a constitutional prior claim on all of the state’s revenues, second in the capital structure only to primary education. The state’s appropriation debt has a lesser legal claim, but the controller prioritized payment directly after GO debt service, ahead of other mandatory payments such as Medicaid, employee payroll and employee pensions.

POTENTIAL FOR A FEDERAL BAILOUT?
Speculation has been made that the federal government would stand ready, perhaps with funds from the Troubled Assets Relief Program (TARP), to assist California in accessing the notes market. Such a federal rescue would be imprudent without California exacting the structural reforms necessary to alter the state’s fiscal governance going forward. Even the U.S. Treasury, if federal assistance in the form of loan guarantees was forthcoming, would demand some assurance that federal taxpayer money would be repaid according to schedule.

In our view, Federal support for California would be a last resort for the government. Federal relief could impair the motivation of governors and legislatures in other states beset by fiscal problems, let alone the residents of those states shouldering higher state and local taxes.

IS CALIFORNIA A DEFAULT RISK?
California, which already has the lowest credit rating of any state in the country, continues to face sharp downward rating pressure. On July 7th Fitch Ratings downgraded California GO bonds to BBB.  They were the first rating agency to downgrade California’s GO bonds below single-A. This represents a four-notch downgrade by Fitch over a two week period. Standard & Poor’s recently affirmed its single-A rating for the state, keeping them on CreditWatch with negative implications. Last month, Moody’s Investors Service put the state’s A2 GO rating on watch for a possible downgrade. Without a credible remedy to both the FY 2010 budget and the state’s depleted cash position, the state’s credit ratings will most likely fall below the “A” category by each of the rating agencies.

States are not eligible for bankruptcy under the federal code, and they have an extremely strong incentive to maintain payments on their debt even under the most extreme of circumstances. Or face drastically reduced access to future financing, and at sharply increased costs. Even considering the magnitude of California’s cash and revenue problem, and the limited amount of time left within which to make meaningful budget reform, the state remains very likely to maintain adequate protection for servicing its debt obligations.

State of California GO Bond debt service requirements comprise a small fraction of monthly revenues and internally borrowable resources. Repayment of GO debt is based on a full faith and credit pledge of the state. We continue to view the probability of a California default on its general obligation bonds as very low.

Citing a recent FY 2010 budget analysis conducted by Standard and Poor’s – Even after spending $35.97 billion on the state’s contractually required bills for primary education, the state will have $53.15 billion in resources available for only $5.74 billion required on all outstanding debt service (for both GO and lease revenue bonds). This represents a 9.3x coverage ratio.

In our view, the concern is not default on state GOs, but more on the long-term economic vitality of the state, and on spill-over effects to credits in weaker economic areas of the state.

LOCAL SPILLOVER
Six of the state’s cities are among the 10 with the highest foreclosure rates in the U.S. If weaker local entities in the state do encounter a debt-payment crisis, we question the state’s capacity to step in as they might have, and many other states have, in the past. It also remains to be seen how severely the cuts and claw backs in state moneys will be for various local governments. Under Proposition 1A passed in 2004, California is legally allowed to borrow up to 8% of local property tax revenue from local governments. As expected, local governments have protested against this, stating that they have their own budget problems to deal with. Yet, the governor was quick to enact this proposition during the February budget crisis, and is expected to draw on these borrowed funds for the current FY 2010 budget revision.

In our view, California’s local governments, especially those in areas such as the Central Valley, will feel the greatest pressure from the political problems in the statehouse. Small local issuers and school districts rely primarily on property tax revenue to make debt service payments on their outstanding debt. Property tax receipts and real estate related transfer taxes are down sharply across the state. If the state begins borrowing against those already depleted revenues, many local issuers could face very difficult budget decisions of their own.

NATIONAL MARKET IMPLICATIONS
There has been some consideration, given the externalities, of a prospective California default, particularly the stability of the municipal bond market. These same fears were prevalent in 1983 when the Washington Public Power Supply System (WPPSS) veered toward default, and in 1975 when New York City was on the verge of default.

There is no doubt today that a California default would reverberate through the capital markets. The municipal bond market would be closed to the State of California for some time. Such an event would most likely significantly impair market access for the state’s political subdivisions. At the very least, a substantial borrowing premium would exist for the state and its local governmental issuers for an extended period of time.

There would likely be collateral damage to other states and municipalities with recurrent budget problems. While the California crisis appears to be the deepest and most difficult to overcome, the state is not alone. There are still fiscal year-end impasses of varying severity in Illinois, Arizona, Indiana, Ohio, Connecticut and Mississippi.

FRAMEWORK FOR A BUDGET RESOLUTION
The heart of the structural problem in California’s legislature is the state’s constitutionally required two-thirds majority vote necessary to pass a budget or increase taxes. The political makeup of the state’s legislature, which is controlled by Democrats, appears to make the prospect of significant revenue increases unlikely. California already holds the honor of the country’s highest personal income tax rate of 10.3%, combined sales tax rates higher than 8%, and corporate income taxes just shy of 9%. With these already sky-high rates, the legislature has somewhat limited ability to increase revenues via the traditional method of hiking taxes. As a result, budget deliberations currently revolve around program and expenditure cuts. Republican lawmakers are proposing draconian spending cuts to essential services like welfare and health insurance for low-income children.

Is it possible for California’s lawmakers to agree upon the difficult decisions necessary to reconcile the state’s growing budget gap and stop the cash flow bleeding? We believe that it is possible, but the legislature will have to put aside political differences and focus on the state’s utilitarian interest in preserving access to the capital markets. The budget solution will likely contain a combination of substantial spending cuts, one-time tax increases, and cash flow borrowing from the short-term note market.

CALIFORNIA OUTLOOK
We believe that while the magnitude and severity of the California fiscal crisis is staggering, the probability of a default on California’s state general obligation debt remains extremely remote. California is at the forefront of the painful reality that many state and local governments are being forced to apply discipline to their budgetary process for the first time in many years. Many did little to maintain budgetary discipline while revenues were cascading higher, as they did in particular during the housing boom. So, for the first time, state and local governments are being forced to adapt new, more responsible spending habits. The question in many cases is whether legislatures and state and local executives are able to adapt to the challenge.

For the State of California, even amid economic calamity, its residents remain relatively wealthy, and the state’s economy is an impressive engine. If California were a country, it would have the eighth-largest economy on Earth. Given those advantages, the notion that California might default on its government debt might seem farfetched.

In the bond market, prices on California GO bonds have already been discounted to the expected rating reductions well into the “BBB” range. 10-year non-callable CA State GO bonds are currently trading around 5.25%, which represents a spread of about 200 basis points over AAA-rated GO bonds like Maryland State GOs. This yield spread represents the perceived credit risk, including the probability of default, and the potential loss given default – the higher the spread, the greater the perceived risk. California yield spreads are currently higher than they have been at any point in recent history. In fact, they are higher than the yield spreads of any State GO debt in recent history.

As mentioned, California GOs hold the lowest credit rating of all 50 states, and 10-year debt trades at a spread close to +200/AAA. The yield spread on the nations next two lowest rated states, Louisiana (A1, A+) and Illinois (A1, AA-) are +90 and +80, respectively.

So, if California is not likely to default on its general obligation debt, at what price do you consider purchasing CA State GO bonds?

To answer this, we analyzed the trading history for 10-year California GO bonds through the past market cycle. As evidenced in GRAPH A, spikes in yield spread have generally correlated with the final downgrades by the rating agencies. Prior to 2008, 10-year CA State GO spreads were at their widest point of +93/AAA on July 11, 2003, this trade was within days of the S&P downgrade to BBB on July 24, 2003. Following the S&P downgrade spreads gapped tighter within two months, reaching +44/AAA on September 19, 2003. Moody’s followed with its own downgrade to Baa1 on December 9, 2003, where yields sold off again to a spread of +75/AAA on December 17, 2003. Both of these credit downgrades were virtually the best time to buy, or the worst time to sell, CA State GO debt. After which time, the bonds outperformed the overall high-grade State GO universe for the next several years. This emphasizes the reality that markets are always forward looking and should efficiently price in all available information.

GRAPH A:

It is our view that the prolonged impasse at the statehouse will continue to create more sellers than buyers of CA State GO debt. This will likely continue to erode the price on the state’s bonds and push yield and yield spreads higher. We believe that there is an acceptable price for taking the risk of holding CA State GO bonds, and the optimal entry point will likely correlate with the ultimate downgrades by S&P and Moody’s.

The high profile nature of California’s fiscal problems and the headline risks associated with holding the debt has already forced many investors hand, including ours, to getting out of the bonds. However, we feel that there will likely reach a point where the reward, in terms of taxable equivalent yield, will outweigh the risk. If 10-year CA State GOs reach a yield of 6.00%, for example, the taxable-equivalent yield for a non-California resident, paying the max federal tax rate would be 9.23% (+580/U.S. Treasury). California residents paying max federal and max California taxes would yield close to 11.00% (+755/U.S. Treasury) on a taxable-equivalent basis. If the California legislature is able to make the structural changes necessary to resolve its budget deficit and pull itself back from the brink, you can be assured that the opportunity to buy a 10-year State GO yielding double digit taxable-equivalent yields will be long gone.