Jul. 18–The state is facing an increasingly skeptical Wall Street as legislators fail to resolve a $38.2 billion budget deficit — raising the prospect that Californians could pay millions ofdollars in extra borrowing costs in the future.
Unless a budget is passed, the state is expected to run out of cash in early September, a prospect that is raising alarms on Wall Street. Two major credit rating agencies are reviewing the state’s creditworthiness and could reduce it in the next two to three months if the legislature does not pass a budget that actually balances spending with revenue.
“What we will be looking for is a budget that makes significant progress in addressing the state’s structural imbalance and doesn’t just push it out to the next year,” said Ray Murphy, chief analyst for California at Moody’s Investors Service.
California already joins Louisiana and New York as the states with the nation’s lowest credit rating. On Standard & Poor’s scale, these states have a middle-range A rating, and on Moody’s Investors Service, they have an A2.
Depending on the budget resolution, the state’s rating could be cut one or two credit levels, making it the lowest among the 50 states.
If this happens, the state would have a harder time lining up buyers for its bonds. It also would raise the cost of two separate borrowings the state is discussing, a $10.7 billion issue to finance the deficit, as well as $3 billion in temporary notes to keep the state operating.
In addition, a rating cut would add anywhere from $405 million to $850 million in interest expense over 30 years for the 30-year $24.6 billion in bonds the state has authorized but not yet sold, according to the state treasurer’s office.
Also at stake is $34.4 billion in bonds the state already has issued. A lower credit rating would prompt some risk-averse investors to sell bonds, reducing overall prices.
“You’d have a lot of unhappy Californians, because Californians own the existing debt and that would crash in value,” said Ted Gibson, former state economist who was appointed during Republican administrations and served under Davis. “The train wreck is visible now.”
This may turn out to be the worst-case scenario, because Wall Street investors remember last year, when the state did not agree on its budget until September. So far, bond holders have not dumped their investments.
“The bonds are still trading really well,” says Joseph Jasper, director of fixed income strategy at U.S. Piper Jaffray investment firm.
The bond market is an enormous marketplace where corporations and governments go to borrow money over long periods. Because banks usually lend money for shorter periods of time, major corporations and governments sell bonds to hundreds and thousands of investors who pool their money and lend it for up to 30 years.
Like shareholders, bond investors hold the issuing entity accountable for its behavior.
“The bond market forces the government to behave,” says Joe Corona, former bond trader who now trades stock options at a hedge fund operated by well-known options expert Anthony Saliba in Chicago.
“They vote with their feet. If they don’t like what you’re doing, the bond market reacts,” Corona said. “The whole thing is: Am I going to get paid back? Am I being compensated for the risk I’m taking?”
Most people who own state bonds want to save on taxes — income from state bonds is exempt from taxes — and are generally among the most conservative investors.
Some institutions are prohibited from investing in bonds that carry a lower rating, so if the state credit rating is reduced, it would cut down the number of borrowers.
If the state’s bond rating were reduced a total of four levels — a serious downgrade — the bonds would be considered “non-investment grade,” better known as junk.
Corporate junk bonds are currently yielding 11 percent to 12 percent interest, while tax-exempt junk bonds are yielding about 8 percent. The state’s general obligation bonds are around 5 percent, considerably lower.
The budget impasse and the battle to recall Gov. Gray Davis are causing bond prices to fall. The yield on the state’s bonds — which moves in the opposite direction of prices — has risen to 5.35 percent, about a half-percentage point higher than the 4.76 percent for comparable bonds.
Already, the state is facing a logjam of new debt. In June, the state had to line up six banks to back the state’s credit, known as “credit enhancement,” to convince bond buyers to accept $11 billion in bonds. To sell these bonds, the state had to agree not to issue any more debt with longer maturity unless the state agreed on a budget.
Now, even if it passes a budget, the state could suffer a cash crunch this fall. The state treasurer’s office needs six weeks to prepare its $3 billion in temporary borrowing to pay for operations in September — and that six-week clock just started ticking.
To conserve cash, the state controller’s office plans to end its $200 million a month payments to community colleges starting July 29 to conserve cash. And it is changing its computerized payroll system to pay 295,000 state workers at the minimum wage starting at the end of August if there is no budget and no money.
At this point, most Wall Street investors consider it unlikely that the state will wind up in the kind of crisis that plagued Orange County in the 1990s. California has enormous resources, making it the fifth-largest economy in the world. Because of that economic strength, the state’s bonds are unlikely to drop substantially in value, says Jasper.
So far, California has only a moderate debt burden, says David Hitchcock, state analyst at Standard & Poor’s. California’s general fund has $1,286 in debt for every person in the state. That is a “moderate” debt burden, he says.
Other states range from Colorado and Arizona, which have no general obligation debt, to Connecticut, with $2,500 in debt per capita.
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(c) 2003, San Jose Mercury News, Calif. Distributed by Knight Ridder/Tribune Business News.
