Tuesday, June 23, 2009

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.


John (Ad Orientem) said...

Excellent post as usual (even if I disagree with you on inflation). I think you hit the nail on the head. My own crystal ball says...

The Democrats in the legislature will throw a fit over the governor's budget cuts but will in the end cave. They really don't have a choice and several of them have said as much both on and off the record. They will first go through the motions of passing their own budget which contains tax hikes as well as budget cuts, This will be vetoed before the ink is dry. Their honor having been thus satisfied they will "with profound reluctance and under extreme duress" pass most if not all of the governor's budget.

There will be no stop gap spending bills. Arnold has vowed to veto any, and I think he means it. So do the Democrats.

Long term I am for the first time ever reasonably optimistic that some of the things you mentioned which contribute to California's governmental dysfunction might be addressed. Both political parties seem to agree on the need for a state constitutional convention. Hopefully this will eliminate or at least severely curtail public ballot initiatives which have been horribly abused by special interest groups for decades now. And the need to strip minority parties of the ability to obstruct the normal business of government is imperative as well. All of this will I believe gain in popular support as the reality of the draconian spending cuts dawns on the citizens of California in the coming months.

Everyone in theory likes limited government. We will see how well the people of CA like the reality the next time they want to go to a state park or a public library dependent on state aid. As for the poor... well screw them. They are used to it anyway.

Lockstep said...


Great post. I think you underestimate the sheer stubborness that abounds here. Republicans out here are rabid anti-tax zealots. The Democrats are consistently balk at balancing the checkbook if there is a social cause to attend to.

I am really hoping for a constitutional convention because the state will never be able to make tough choices with "direct democracy" method of government. When are more taxes and less spending ever en vogue enough to carry the ballot box?

It is amazing how little coverage this gets. It will turn into a nasty media brawl next week. I actually commend Arnold for all he has done to try to bring realism to a fairyland budget process. I wish him luck in the WWF (World Wrestling Fairies) match next week.

In Debt We Trust said...

What about a population/business exodus from California b/c of higher taxes, poor job prospects, unfavorable business conditions or any number of bearish scenarios?

Lockstep said...

Also, we had a "reserve fund" measure on our last ballot. Shot down without a fighting chance.

So AI, I understand the spending priorities too. Education, Bondholders, everything else, in that order. Any projections on the impact to California unemployment if they cut $2B in social services for the poor and $10B health care spending? Or how about potential crime statistics when the prisons let 10000 people on the street due to prison budget cuts? This is just not pretty.

Accrued Interest said...


I can't even guess what the impact is. I'd like to think that "leaders" wouldn't allow that to happen, but the percentage of politicians who actually qualify as "leaders" is disgustingly small.


Such an event is credible, but not immediately. And given that there is like 9x coverage for bond holders, even a severe decline in the tax base should leave bond holders whole.

Unknown said...


Everything you want to know about California property tax propositions.

What are the main Propositions that affect property taxes? Some of the nutty ones are below. Shifting tax benefits across generations. Nuts.

Proposition 58 Reassessment Exclusion for Real Property Transfers Between Parents and Children

Propositions 60 and 90 Senior Citizen's Replacement Dwelling Benefit

Proposition 193 Reassessment Exclusion for Real Property Transfers from Grandparents to Grandchildren

Lockstep said...

From the LA Times today


"Chiang, meanwhile, described the state's money troubles as unlike anything "since the Great Depression," with an anticipated $2.8-billion shortfall in July that could grow to $6.5 billion by September.

"IOUs are almost an admission of guilt that we can't pay our bills," said Garin Casaleggio, Chiang's spokesman.

Without a budget solution, the controller expects next month to issue more than $3 billion in IOUs to some of the state's most vulnerable citizens. Those would include the aged, blind and disabled, college students who receive state grants, welfare recipients and patrons of regional centers for the developmentally disabled."

In Debt We Trust said...


"The 10-year muni-Treasury ratio is back to normal. Whether it will stay there is debatable.

The standard valuation metric for benchmark 10-year municipal bonds for decades has been the relationship between its yield and the yield on the 10-year Treasury.

The credit crisis that began last year challenged all perceptions about this relationship. Some said the market was in an anomalous period and the ratio would eventually revert to its traditional range. Others said it was forever changed.

Last week, the 10-year triple-A yielded 3.32%, according to the Municipal Market Data scale, while the 10-year Treasury yielded 3.81%.

At 87.1%, this ratio is at a level that, while historically on the high side, is within the bounds of traditional normalcy.

John Derrick, who manages both Treasury and muni funds at U.S. Global Investors, thinks it will stay there"


baumgrenze said...

Thank you for the entry.

I would appreciate an expert's comments on the reliability of VRDNs based on California municipal debt. Mutual funds seem to consider actual municipal bonds and municipal VRDNs to be equivalent. Take Fidelity's California Municipal Money Market Fund
(FCFXX)which held 77% VRDNs as of 4/30/09. Is this stance justified? Am I correct in concluding that the VRDNs are backed by the insurance provided by the liquidity bank? How do these obligations fit into Al's analysis that there is a cushion to cover bonds?


Accrued Interest said...

A VRDN's put feature is backed by some bank's credit. But ultimately the credit is based on the underlying credit. Bear in mind, though, that most of the credits within that money market fund aren't going to be State of CA obligations. It could be anything within the state. From the City of San Diego to a school district in San Jose to some random hospital in Oakland.