Out of Control Policy Blog

California Budget Follies: IOUs and 1-in-4 Debt Default Risk

Per Forbes, the markets are betting that there's a 1-in-4 chance that California will default on its debt payments in the next five years:

What are the odds that California defaults on its debt payments? Using the market for credit insurance as a guide, one in four within five years. Those are amazing odds, signalling that those who buy insurance on debt think that the federal government will allow California to fail where it thought that AIG and Citigroup simply had to be rescued.

In the past month, rating agencies have warned that California’s $24 billion budget shortfall for the fiscal year beginning in July threatens its credit ratings -- its mark of A already makes it the lowest-rated state in the U.S. on Standard & Poor’s scale -- and the Obama administration has reportedly spurned requests for a bailout. The price of credit default swaps, a form of insurance on bonds, has made a predictable turn: a 5-year credit default swap on California’s debt jumped from a midpoint of 250 basis points on May 22 to 325 on June 23. On Tuesday, dealers asked for 339 basis points, which works out to $339 million on $10 million in debt, implying a 26% chance of default.

And in another ominous sign of the fiscal times, California is now issuing debt to cover ongoing operations. As I mentioned previously, yesterday California began sending out IOUs to contractors, vendors, local governments, and taxpayers. The first batch of 28,742 IOUs (called "warrants") totalled $53.3 million in value. Per the New York Times:

It was only the second time the state had adopted the emergency payment method since the Great Depression. The National Conference of State Legislatures had no record of any other state’s ever using them.

It was unclear whether the i.o.u.’s, known as warrants, would be accepted by all of the banks in California, which were caught off guard by the move and seemed hesitant to entrust the state to repay the them — at an interest rate of 3.75 percent — in October, as promised.

The controller, John Chiang, issued 28,742 warrants totaling $53.3 million. If state lawmakers fail to reach a budget agreement by the end of August, the amount would grow to $4.8 billion. [...]

So California is now just like a family that spends more than it takes in and holds off on the cable bill while paying the mortgage: its expenses are greater than its revenues. The state, which previously used i.o.u.’s in 1992 and 1933, will issue them rather than checks to those it can get away with not immediately paying.

Most warrants will go to Californians waiting for tax refunds, vendors doing business with the state and local governments, especially in social service areas. Federal and state laws prohibit i.o.u.’s from being issued to state employees, schools or Medicaid recipients.

While it is against federal law for a state to declare bankruptcy, California’s move Thursday will not go unnoticed by Wall Street or escape consequences. The state’s credit rating is already shaky, and any further downgrades from rating agencies could send interest rates on its bonds soaring, forcing deeper service cuts. Furthermore, if California comes up short on cash this fall, other creditors will have to wait behind the warrant holders, who would most likely end up in superior credit positions.

In a news conference here Thursday, Mr. Schwarzenegger did not apologize for the state of California’s fiscal affairs and instead stood defiantly against the people he had alternatively battled and wooed for the better part of six years — chiefly Democratic lawmakers, public employee unions and so-called special interests. “At the end of the day, they haven’t accomplished anything,” Mr. Schwarzenegger said, speaking of an effort by the Legislature to stave off the i.o.u.’s with stopgap measures to cut education financing. “So I sent the budget back, doing it forcefully and without any hesitation.” [...]

“We did everything in our power to avert the i.o.u.’s,” Darrell Steinberg, the president pro tempore of the State Senate, said in a news conference in Sacramento. “This was a strategic move by the governor and the Senate Republicans.”

Right..."everything in our power" except anything that would meaningfully reduce the price of California government and break the stranglehold that public employee unions—perhaps the largest obstacle to reform—have placed on budget and management decisions. I digress:

On Thursday, a few banks — including Bank of America, Wells Fargo and Bank of the West — indicated they would accept the i.o.u.’s but only through the middle of the month. The California Bankers Association offered less-than-overwhelming optimism that more banks would step up, citing the technical difficulties in managing the warrants coupled with fear of getting paid in early October, when the warrants are to mature. If California’s fiscal situation significantly improved before then, however, the state could repay the warrants earlier at a lower rate.

“In evaluating potential registered warrant acceptance, banks have been advised by regulatory authorities to consider such issues as credit quality, capital requirements and concentration limits,” the bankers’ association president, Rod Brown, said in a statement. “Given the poor credit rating of California, the worst in the nation, banks may be hesitant to extend credit to the state.”

So the Golden State dysfunction continues.

» Reason's California Research and Commentary

Leonard Gilroy is Director of Government Reform


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