California Munis: What is it? Some kind of local trouble?

Lots of people have asked my take on California. Speaking strictly from a bond holder perspective, there are two issues. First, what are the possibilities for missed or delayed payments? Second, apart from actual missed payments, what could cause spreads to tighten or widen?

In terms of California bond holders actually missing a payment, those odds are remote. S&P points out in their report coinciding with putting CA on negative watch:

An austere analysis of the state's ultimate capacity, from a budgetary perspective, to service its debt suggests to us that at $35.97 billion, constitutionally required spending on education (Proposition 98 expenditures) for 2010 leaves $53.15 billion in resources available for debt service (estimated at $5.74 billion) on general obligation and lease revenue bonds.

So if it came down the state actually running out of cash, first certain education spending would be met, then bond holders. On that basis, there is plenty of coverage. I think this leaves the likelihood of a payment completely missed as extremely low.

Now a payment delayed is a different matter. If the legislature were to not pass a budget by June 30, the state wouldn't be able to sell short-term notes to restock their checking account. At that point, I really don't know what the protocol would be. If, in theory, the state literally ran out of money, they obviously couldn't forward coupon payments on to bond holders. This would be a form of default. But of course, bond holders would eventually get their payments, most likely when the next quarterly payments were made by tax payers.

We have to imagine what such a world would look like. You think Californians are pissed off now? Imagine the state is literally unable to make payroll. The political backlash would be severe. The fact that bond holders get cash first would put tremendous pressure on legislators, not the least of which would come from powerful public employees unions. So I imagine the most likely scenario is that some kind of budget is passed in the next few days.

Unfortunately, the odds also seem high that the budget will include some one-time revenue measures to help close the gap. As S&P noted, that's a problem, since it will likely mean the state will be in the same budget situation next year. Revenue items like sales tax might improve next year, but even in an optimistic economic scenario, unemployment will still be very high and property tax revenues will likely fall again. Its very hard to imagine how California's revenue would experience organic growth in 2010 or 2011.

If the budget is passed with significant stop-gap measures both the ratings agencies and bond holders will react negatively. I'd wager that right now players in CA GOs are unusually tilted toward speculators, hoping for a pop. A budget which doesn't address long-term problems will fail to create a pop, and most likely cause speculative players to sell.

What the legislature should do is create some mechanism for funding a reserve fund, even if the reserve won't be funded this year. For example, some kind of provision by which revenue flows into the reserve if revenue grows naturally by some percentage.

Ideally, there would also be work done on reforming CA's budget process. The combination of referendum-based spending with no attached revenue source is just silly. The corresponding need for super majorities to pass tax increases is similarly dumb. Its an obvious recipe for runaway spending without any reasonable means of funding the expenditures. A start would be to require all spending referendums to either have an explicit revenue tied to them, or to result in an automatic increase in sales tax. That would make voters think twice about voting an increase in stem cell research funding.

There is substantially more risk in local California credits, especially smaller school districts. One of the one-time measures the legislature is likely to use is borrowing/curtailing local aid. Combined with the fact that school districts take most of their funding from (gulp) property taxes... I think we're in trouble.