A California default

By Felix Salmon
April 24, 2009

Thomas Pindelski  asks:

Given that CA now has the lowest credit rating of all the states, does that make the high rates CA is offering in recent auctions something to avoid, owing to the risk of default, or something to cherish on the lines of ‘too big to fail’.

This is something which came up in conversation today, unsurprisingly, in the wake of my talk to the regional bond dealers. One of them came up to me and indignantly told me that he’d been a muni bond dealer for 38 years, and that of course he knew all about credit risk, as had his forebears before him. To which the natural response is: well, if you’re pricing California debt at these levels, then you must reckon that there’s a pretty substantial probability of default.

The more interesting response was, basically, “my moral hazard trumps your moral hazard”. In other words, it’s true that because California has insured itself against default, there’s moral hazard there: whenever anybody is insured against anything, the likelihood of that thing happening goes up. But at the same time, there’s a bigger moral hazard at play: the federal government will never let California default, it’s too big to fail. And so when push comes to shove, California will get a federal bailout before it defaults on its bondholders.

I suspect, however, that the moral hazard seniority works the other way around: the fact that California’s bondholders are insured means that it’s not too big to fail, and that in fact a payment default by the state would have very little in the way of in-state systemic consequences. (I have no idea what it might do to the monolines, but if they can’t cope with a single credit defaulting, they really shouldn’t be in the business they’re in.) The federal government might step in to mediate the negotiations between the monolines and the state, but it’s not even obvious why it would want to do that.

The more powerful argument why California won’t default is that a payment default is illegal under state law: California’s simply not allowed to default on its bonds. But what are the monolines going to do, sue? If California defaults on say a $1 billion payment which the monolines have to pay, then California owes the monolines $1 billion. If the monolines sue the state and win, then California owes the monolines $1 billion. It’s not clear that they’ve advanced very far. Could they start attaching state assets? I doubt it, somehow.

My hope is that the monolines would get their money back reasonably quickly — the unintended consequences of a default would force California’s dysfunctional legislature to wake up to the pettiness of its actions, and serious fiscal policies might finally be able to be passed. But I can’t say that outcome is particularly probable: the California legislature has shown no signs of being grown-up in the past, or even of moving in that direction.

And indeed the really nasty unintended consequences of a Californian default might well be felt outside the state, with the closing down of the municipal bond market nationally. Once California defaults, it’s hard to see any other state raising private general-obligation funds at any kind of interest rate it would consider acceptable.

Which brings us back to the moral-hazard play: maybe the Feds would bail out California, not for California’s sake, but rather for the sake of the municipal bond markets as a whole. But it’s hard to see where they would get the money, or how Congress would ever approve such an appropriation.

Still, Treasury surely has some kind of traction here — maybe it can tell California that it won’t get any stimulus-bill funding if it’s in default on its obligations. Might that do the trick?

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
8 comments so far

Thank you.

Sharpening the focus on the political aspects, let’s not forget that the President is beholden to Illinois, Louisiana and California. Home town, empathy and campaign funds, respectively. All high default risks on paper.

So I wonder if that slants the argument in favor of TBTF?

I enjoyed your response. I think you are about 4-4 on ‘for’ and ‘against’ arguments!

Posted by Thomas Pindelski | Report as abusive

Thanks you for your article Mr. Pindelski, I was beginning to think that no one outside Calif. was aware of, much less willing to print, such an apt description of our legislature. I particularly appreciate your reference to their dysfunction. The majority has for too many years created programs to serve their personal contributors’ desires e.g. unions. It is no longer enticing to start a business and create jobs as I have done several times in my 70 years. The taxes and fees would preclude profit so I would be stuck with a business that no one in their right mind would buy.

Sorry, Mr. Salmon. It is to YOU that I should have posted my thanksgiving.

Felix, when it comes to the California legislature, I’m afraid this time around you are uncharacteristic optimistic (or even – dare I say – irrationally exuberant).

The state’s political system is dysfunctional for bigger reasons than that attitudes of the legislator. We have these propositions that funny the vast majority of the state’s revenues into pet projects before any elected official gets a say in where it goes. I doubt they will ever get serious about the budget without deep, fundamental changes to not only the state’s fiscal situation, but also to its political system.

Posted by Chris G | Report as abusive

The only relevant information I can find to answer the question of attaching California’s assets is from a World Bank report titled “Subnational Insolvency,” but the article primarily addresses municipalities below the state level. It reads, in part:
“In the Unites States, a prominent judicial doctrine holds that only proprietary property is attachable. ‘Proprietary property’, subject to debt foreclosure, was defined by the U.S. Supreme Court as ‘held in (the municipality’s) own right for profit or as a source of revenue not charged with any public trust or use.’ Property dedicated to ‘public use’ such as streets, hospitals or courthouses is exempt even in the absence of specific statutory protection, as are funds held in the local treasury for general use. As a result, the backstop of private creditors’ rights – the right to seize the property of the debtor – is often unavailable to subnational creditors.” (p. 15)

fascinating throughout: http://siteresources.worldbank.org/INTDE BTDEPT/Resources/468980-1207588563500/48 64698-1207775351512/PRWP4496.pdf

Now I’m curious how it will actually work when/if (i.e. when) California defaults…

Posted by Adam | Report as abusive

You say “But it’s hard to see where they would get the money, or how Congress would ever approve such an appropriation”.

You must be joking! This gov’t will simply print more green fiat paper money. 13 trillion so far and lots more to come.

Posted by Mike | Report as abusive

If it is illegal for California to default on its bonds, as you claim, then why would the state waste money paying insurance premiums against a default?

You simply MUST follow the money, sir. Some insurance companies are being paid to insure California against something that BOTH California state officials AND the insurance company know will never occur. That enriches, unjustly, the insurance companies at taxpayer expense.

Imagine for a moment that I’m an insurance broker, and I sell you insurance against the Sun going Supernova in your lifetime.

Would you buy that insurance? No? Let me sweeten the deal:

What if it was really cheap? Would you buy it now? No? Let me sweeten the deal:

What if you could purchase it with someone else’s money? Now you’re a little more interested. Yes? But maybe still not enough? OK then, let me sweeten the deal just a little bit more:

What if I could arrange for you, personally, to get a “rebate” on the premium.

I bet you’d buy that insurance now.

And that’s exactly what state officials in Sacremento are doing. They’re buying insurance with tax dollars and getting under-the-table kickbacks from insurers who know they’ll never have to pay a claim.

Everyone profits.

Except of course – us.

Posted by justwondering | Report as abusive

“And indeed the really nasty unintended consequences of a Californian default might well be felt outside the state, with the closing down of the municipal bond market nationally. Once California defaults, it’s hard to see any other state raising private general-obligation funds at any kind of interest rate it would consider acceptable.”

Is this necessarily the case? I would have thought that the bond markets can look at state’s budgets and financial situation and reach educated judgments differentiating most states from California. I.e. states that aren’t running comparably huge deficits, or whose revenues are not so sensitive to fluctuations at the top of the income scale (or in real estate valuation) would not suffer as badly as states like, say, New York. Or are these bonds priced on the assumption that the federal government will step in and print money whenever state governments screw up as badly as California has done?

Posted by Taeyoung | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/