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Fitch comes out swinging on California

July 6, 2009

Fitch Ratings is at it again. The credit rating firm cut California’s general obligation bonds by two notches to BBB, leaving the rating just two notches above junk. Fitch had already cut the state’s full faith and credit bonds one notch on June 25.

The junk threshold is an important one to keep in mind. If it’s breached, fund managers who can only invest in investment-grade credits would be forced to sell, causing valuations to tumble further. It would also turn up the pressure on legislators to sort out their differences and close the $26.3 billion budget gap.

Fitch also warned that it could cut again by affixing a “Rating Watch Negative” to its California GO bond rating.

The Rating Watch Negative reflects the short-term risk, in Fitch’s view, that institutional gridlock could persist, further aggravating the state’s already severe economic, revenue and liquidity challenges and weighing on the state’s credit. Resolution of the Negative Watch will depend on actions taken to address the cash flow imbalance.

While the ratings action in recent weeks has been swift, the rating agency notes that the likelihood of default remains low.

The ratings action comes after the state started issuing IOUs last week when lawmakers failed to reach a compromise on how to plug the budget gap. If the crisis drags on, expect more ratings actions from Fitch as well as its rivals S&P and Moody’s and default fears to increase.

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