California faces its moment of truth

June 29, 2009

agnes1The California budget impasse comes to a head one way or the other this week, with state lawmakers needing to make nice by June 30 to close a $24 billion budget gap. If they don’t, rating agencies have threatened to downgrade the state’s credit ratings.

California’s Comptroller said he would begin handing out IOUs on July 2 and the Treasurer said the state will draw on reserves to service the debt of all economic recovery bonds on July 1. (These bonds were created in 2004, when voters gave the state government the authority to raise $15 billion through bond issuance to plug another budget deficit.)

While a slump in real estate and tax revenue are very real factors behind California’s disastrous finances, the San Francisco Chronicle also bullet-points more entrenched problems that have made it difficult if not impossible for the state to surmount extreme dysfunction.

Partisanship: California’s gerrymandered legislative districts tend to protect incumbents and encourage more political extremes – Republicans on the right and Democrats on the left with less incentive to reach out to the political middle, much less compromise at the Capitol.

Term limits: Proposition 140, passed in 1990, limits legislators terms to six years in the Assembly and eight in the state Senate.

Ballot-box budgeting: Initiative-loving Californians mandated set-aside funding for all kinds of single-interest issues, from education to stem cell research.

Prop. 13: The 1978 landmark law slashed commercial and residential property tax rates, shifting state reliance to other more volatile sources.

The two-thirds majority rule: The Golden State is one of just three states that require a two-thirds majority vote from each legislative house to pass budgets.

Fitch Ratings cut California’s ratings to A-minus last week from A, and warned that further action could be forthcoming if there’s not a budget agreement beyond June 30.

California general obligation bonds have been getting hit as a result of all the uncertainty. In May, the bonds were trading roughly 37 basis points above AAA-rated munis, according to Municipal Market Advisors. Now they stand at 105 basis points. It’s also helping to drag down the overall market, though returns for the year are still in the black at 5.2%.

The big fear of course is default, but there are many gradations about what they could mean for bondholders.  The worst case scenario would be repudiation, or simply walking away from its debt obligations, though this seems extremely unlikely given the size of the California economy (eighth in the world if it stood alone) and its dependence on future credit market financing. Then there’s defaulting on the debt servicing or paying only part of it.

There’s still some hope that the federal government would step in if it came to default, but the Obama Administration has been reluctant to prop up state and local governments, especially when it has its hands full with the auto industry and the financial system. It also would open up the federal government to petitions from a long line of states and municipalities also getting squeezed.


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