Investing in California
Municipal Bonds

July 24, 2009

By Howard J. Cure

Director of Municipal Research

California's financial problems are well documented. There are embedded obstacles in the state's financial management processes, including a requirement for a two-thirds supermajority vote of the legislature to pass a budget or raise taxes and the state's active voter initiative process where the electorate often places budgetary constraints on the legislature. The state has relied upon a progressive income tax system that fluctuates significantly depending on the economy. Currently, there is no mechanism for the state to establish a rainy day fund, leading to revenue booms and busts.

California legislative leaders recently reached a budget agreement — which must now be approved by the full Senate and Assembly — that closes the $26 billion deficit. Unfortunately, many of the gap closing measures in the deal merely transfer the burden to the next fiscal year and do not represent sustainable cuts or revenues. Furthermore, counties and cities are considering legal action over the withholding of certain revenues. The agreement calls for cutting spending by $15.6 billion, including $6 billion from schools; $2.1 billion of borrowing from underlying entities; $3.9 billion of new revenues; and $2.7 billion in accounting changes.

Due to our concerns over the structural budgetary imbalance, we have never purchased state general obligation bonds or appropriation debt. As exhibited in the below chart, spreads between California general obligation bonds and the AAA municipal bond in 10 years significantly widened beginning at the end of 2008 as the state's fiscal problems became more entrenched. Failure of the voters in May to pass the budget propositions and continued declines in revenues further exacerbated the problems, and has resulted in the most recent round of rating agency downgrades — making California the lowest rated state in the country. Despite these tempting spreads, we continue to avoid purchasing the state of California bonds.

However, we will monitor the situation for buying opportunities as we do not expect the state to default on any of its bonds. This is because of California's priority payment mechanics of debt service compared to other state budgetary obligations. The state has constitutionally prioritized certain payments, including:

1. Support for public schools and community colleges
2. Principal and interest on California State general obligation bonds and commercial paper
3. Reimbursement of general fund loans
4. State employee wages, state employee pension trust funds, state Medi Cal claims and state appropriated debt

We remain cautious about purchasing underlying California issuers but believe there are opportunities for good yields and stable credits. The impact of the state's budgetary crisis will be felt, to varying degrees, by the following entities:

• Essential purpose enterprises This sector — which includes water, sewer and public power bonds — is attractive because the state provides little funding for it and cannot dictate rates. Additionally, the state — unlike other municipal entities — cannot borrow or reallocate funding. There are typically legal protections such as a rate covenant and additional bonds test as well as monopolistic control over the service area. The one caveat is to make sure there are limits placed on transfers from these enterprise systems to a respective city's general fund. In this economic environment, it is particularly tempting to have the utility system subsidize municipal operations.
• Sales tax bonds To combat the inherent risks of this passive revenue stream and its economic sensitivities, there needs to be a strong additional bonds test to prevent over leveraging. We are very selective in purchasing these securities.
• The University of California System (UC) Comprising 10 Universities and five medical centers, this system receives revenue from multiple sources, including tuition, research grants and investment income. Student demand is strong with a significant draw from out-of-state students. State appropriations account for just 17% of operating revenues so even with expected funding cuts, the university system should not experience inordinate pain.
• The California State University system (CSU) In contrast to the UC system, the CSU system is more reliant on state aid. In addition, it lacks balance sheet resources, out-of-state student demand and revenue diversity. Consequently, while we still look favorably on the UC system, we would avoid this one.
• Cities and counties We are very selective in purchasing bonds of these entities. Reliance on property taxes has been significantly diminished due to limits placed on tax rates and assessments by Proposition 13. Cities and counties in California rely more heavily than most municipal entities in other states on other taxes including sales, utility, business as well as charges for services. While these revenues have suffered recently, due to the declining economy, they haven't dropped as precipitously as property values. Additional concerns are placed on these governmental units due to Proposition 1A. This proposition permits the state to borrow revenues collected by local governments but places limits on the total amount. Furthermore, these entities will face expenditure pressures as the state inevitably cuts certain social service programs. Counties particularly will have to show financial discipline by not overly burdening themselves by back funding programs as the state makes cuts.
• Community colleges While community colleges also rely heavily on state funding, they have additional operating and financial flexibility — compared to K-12 schools — to help close budgetary gaps. For example, community colleges can limit enrollment, raise tuition, fund raise and more easily eliminate faculty. As a consequence, we have selectively purchased general obligation unlimited tax pledge community college districts.
• School districts The greatest concern centers on local school districts. While a general obligation unlimited tax pledge would require the district to raise property taxes sufficient to cover debt service, cuts in state appropriations could result in a lower rating. Based on wealth levels of the district, state aid can vary from 30% to over 70% of the school's total general fund budget. State aid is driven formulaically through Proposition 98, which sets a minimum annual funding level for K-12 schools and community colleges. We have avoided buying these credits.
• Other special cases Other special cases. We are also selectively, but actively, pursing other opportunities in the municipal enterprise area, such as the Northern California Transmission Agency and John Wayne Airport in Orange County. Both enterprises have limited capital plans, strong customer bases and independent rate setting ability. Furthermore, neither project is dependent upon state funding.

Conclusion: We continue to actively monitor the situation in California for selective buying opportunities. However, we are cautious as $10 billion of the $26 billion budget gap is closed primarily with borrowing and accounting gimmicks. Furthermore, if revenues fall short of projections because of a continuing weak economy, the gap will widen further. This reinforces our bias towards essential purpose enterprise systems that are not overly dependent upon the state for funding.

Howard joined Evercore Wealth Management with over 23 years of experience in analyzing tax-exempt municipal securities. He can be contacted at Cure@evercore.com.

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Important Notice. Evercore Wealth Management, LLC ("EWM") is registered with the Securities and Exchange Commission under the Investment Advisors Act of 1940. EWM prepared this material for informational purposes only. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. EWM obtained this information from multiple sources believed to be reliable as of the date of publication; EWM, however, makes no representations as to the accuracy or completeness of such third party information. EWM has no obligation to update, modify or amend this information or to otherwise notify a reader thereof in the event that any such information becomes outdated, inaccurate, or incomplete. Specific needs of a client must be reviewed and assessed before determining the proper allocation for a client and must be adjusted to market circumstances. Any opinions herein reflect our judgment at this date and are subject to change. Upon request, we will furnish a list of all securities recommended to clients during the past year. This material does not purport to be a complete description of our investment services.