California Struggles But Holds On

By: Dr. Jay H. Abrams
Chief Municipal Credit Analyst

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Paying debt service continues to remain a key priority for the State of California as its financial profile continues to erode.  With the State entering what the Governor calls  a “fiscal emergency”, many Californians are waiting to receive tax refunds, assistance payments, and student aid, while cash is horded to meet education, debt service, Medicaid, payroll, pensions, and certain other constitutionally required payments.

Recent failure by the State Senate to reach the necessary two-thirds approval on spending cuts and revenue measures, has only served to make California’s $26.3 billion deficit worse.  The Golden State has had to resort to the issuance of short term warrants (IOUs) to pay many non-priority payees.  The Warrants carry a 3.75% annual interest rate and are expected to be repaid on or before October 2, 2009.  The State plans to meet its cash flow shortage through bond issuance of $3 billion in July and $3.5 billion in August.

California’s chronic budget problems have been exacerbated by a severely weakened economy.  The state unemployment rate hit 11.2% in May.  Revenues have been seriously affected as capital gains and personal income taxes have consistently come in under forecast, necessitating constant budget revisions.

California has had great difficulty achieving budget balance in bad times due to the voter enacted propositions that have reduced the flexibility needed by the legislature to achieve compromise in budgetary matters.  Propositions have been enacted over the years restricting the ability to raise revenues while, at the same time, mandating funding for a variety of purposes. 

Property tax initiatives (Proposition 13) have constrained local governments from properly funding services. At the State level, budget agreement by a two-thirds majority of the Senate has made budget making difficult at best.

Rating agencies have followed California’s saga closely.  Standard & Poor’s recently affirmed its ‘A’ rating on the State’s $59 billion of general obligations while leaving the rating on CreditWatch with Negative implications.  Fitch lowered its rating on the State to ‘BBB’ from ‘A-‘, also with a Rating Watch Negative.  Both actions were accompanied by statements indicating that, despite budgetary deadlock, the potential of a default is low.  Moody’s rates California ‘A1’ with a Negative Watch as well.

As California continues its efforts to end the financial crisis, eyes will be on the Controller, John Chiang, as he attempts to manage day-to-day cash flow.  Like a number of other states, the timing of revenue receipts and spending are not level throughout the year, requiring the issuance of short term notes to carry the State over low revenue periods.  Such short term borrowing allows the State typically to make all payments due on a timely basis. 

This year, the budget impasse is severe enough that Warrants have become necessary as a payment instrument itself, promising recipients actual funds later in the year.  Using warrants to balance seasonal revenue shortfalls will allow constitutionally required payments to be made on time.  Bondholders hold priority status and market access for future debt and warrant issuance is of prime importance to California’s need to fund both capital and working capital needs.

Regrettably, until the State enacts major budgetary reform, the cycles of boom and bust are likely to continue in California, the world’s eighth largest economy.

7/8/2009