California's Financial Crisis:
Year Two

March 1, 2010

By Howard J. Cure

Director of Municipal Research

Summary and Investment Conclusion

California is a role model for how not to manage a large state. It combines an ever-widening budget deficit with a lack of government discipline. Default risk for California's general obligation bonds and appropriation debts is extremely low, and the state's fiscal problems are well known. But the risks of ratings downgrades and further price erosion are high, we believe, both for the state and for underlying entities that rely heavily on it for funding. Investors must therefore remain highly selective and research thoroughly the security for debt-service payments.

We prefer issues of essential-purpose entities and some public higher education systems, and we are selectively purchasing both sales tax bonds and issues by certain cities, counties, and community colleges. We are avoiding the California State University system and many school districts, entities that are highly dependent on the state for financial support. Despite the high state tax burden, California-based investors might have opportunities to buy secure credits outside the state without sacrificing after-tax income.

How did California get into this mess?

• California is the only state to require a two-thirds supermajority for the legislature to increase taxes or pass the budget. This makes fiscal responsibility very difficult.

• The state relies on a progressive income tax system and a high capital gains tax that fluctuates significantly with the economy. The high income-tax burden gives California's wealthiest citizens more reason to relocate.

• With no mechanism to build meaningful reserves for recessionary periods, the state's budget swings between exaggerated surpluses and deficits.

• California has a very generous safety net for its citizens that exceeds federal minimum standards — and one that it cannot currently afford.

• The electorate sets constitutional requirements through initiatives that often require minimum funding without providing additional funding. These stipulations also limit the state's operating and budgetary flexibility.

Failure to make debt service payments is not a concern

Concerns that a late budget could delay debt service payments are overblown. The state's constitution ensures that money is set aside for servicing debt. The first obligation is payments to education, and the second is payment of debt service. Debt service is "continuously appropriated" and does not depend on adoption of a budget. The state controller also has various tools to ensure that money is available for primary obligations, such as deferrals for other expenditures, special fund or short-term borrowing, and the use of IOUs with maturity dates.

What is California doing to get out of this mess?

The economy is improving, but California's fiscal management will likely remain a problem. The three major revenue sources — personal income, corporate, and sales and use taxes — show positive trends. But the governor's budget proposal relies heavily on federal government funding ($6.9 billion) or operating flexibility ($1 billion) that would let the state cut expenses and services. Like the state's non-partisan Legislative Analyst's Office (LAO), we are more pessimistic than the governor about the prospect for additional federal funds given Washington's ongoing operating deficit.

What is the long-term view of the state's financial situation?

Spreads between California general obligation bonds and the AAA municipal bond index widened significantly at the end of 2008 as the state's fiscal problems became more entrenched. The voters' failure in May 2009 to pass budget propositions and continued revenue declines exacerbated the problems, prompting rating downgrades. Facing a budget impasse and projected cash shortfalls, the state began issuing IOUs for certain expenditures in July. Spreads began to tighten as the legislature made progress and enacted a balanced budget in late July. But they have widened since, as the state announced weaker-than-expected cash flows and $20 billion in estimated budget gaps for FY 2010 and 2011.

New ballot propositions have not been the answer

The electorate is unwilling to accept harsh measures to fix the situation. Voters failed to authorize a constitutional convention to change what is one of the country's longest and most complex state constitutions. Despite the outrage last summer when the state ran out of cash to pay bills and began issuing IOUs, the public demand for change that fueled momentum for a constitutional convention has faded. Proponents may have had difficulty keeping voters focused on complicated prescriptions for California.

Other fiscal initiatives that could be on the November ballot include the following:

Potentially Positive	Potentially Negative
Freeing the hostage budget: A proposal to lower the requirement to pass a budget or raise taxes from two-thirds to a simple legislative majority could reduce gridlock.	An expensive upgrade: The ballot will include an $11.1 billion proposal to upgrade California's water system. The LAO estimates the bond would cost the strained general fund between $600 million to $800 million in annual interest.
Savings from labor and business: There are competing proposals to reform and limit public pensions and to repeal corporate tax breaks, raise business property taxes, and block corporate political donations.	More university funding: A proposal to guarantee about 10% of the state'sbudget for the University of California and California State University systems (while scaling back prison funding) would make balancing the budget increasingly difficult.

Purchasing opportunities

• Essential-purpose enterprises. This sector — which includes water, sewer and public power bonds — is attractive because the state provides little funding, it cannot dictate rates, and it cannot borrow or reallocate funding. Rate covenants and additional bonds tests typically offer additional protection, as does monopolistic control over the service area. Investors must ensure that there are limits on transfers to a city's general fund, given temptations in the current economic climate to have utilities subsidize municipalities. Although the state has little control over rate setting, it can enforce environmental standards such as improved water quality or renewable energy minimums that could increase capital costs.

• Sales tax bonds. Considering the inherent risks of this passive revenue stream and its economic sensitivities, we look for a strong additional bonds test whereby the issuer is mindful of revenue fluctuations to prevent overleveraging. We are very selective in purchasing these securities.

• The University of California system 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 funding cuts, the university system should not experience inordinate pain.

• Cities and counties. We are very selective in purchasing bonds of these entities. Proposition 13's limits on tax rates and assessments have significantly diminished their reliance on property taxes. In contrast to other states, cities and counties in California rely more heavily on sales, utility, and business taxes as well as charges for services. While these revenues have suffered with the declining economy, they haven't fallen as precipitously as property values. Still, these entities will face expenditure pressures as the state cuts social service programs; counties in particular must show financial discipline and avoid back-funding where the state cuts.

• Community colleges. While community colleges rely heavily on state funding, they have more operating and financial flexibility than K-12 schools to help close budget gaps: They can limit enrollment, raise tuition, raise funds, and more easily eliminate faculty. As a consequence, we have selectively purchased general obligation bonds of community college districts with unlimited tax pledges.

• Other special cases. We are also selectively, but actively, pursing other opportunities among municipal enterprises, such as public power agencies financing transmission projects or renewable energy generators. We also favor certain airports that attract lowcost carriers and have an affluent customer base and limited capital needs. An independent rate-setting ability is also an important criterion for us, as is minimal dependency on state funding.

Conclusion

We are pessimistic about the long-term fiscal situation in California, and we consider future rating downgrades likely. Overly optimistic assumptions in the Governor's budget may place additional burdens on the state. In an election year, we don't expect a compromise in the complex dynamic of increased federal funding, shifting revenue assumptions, voter initiatives, and assumed savings. Investors should monitor the electorate's ire and the possibility of another attempt at a constitutional convention. Our analysis of California general obligation debt, notes, or lease appropriation instruments weights the possibility of rating downgrades heavily.

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.

Download: California's Financial Crisis: Year Two (PDF)

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