California to Feds: Got a Spare $7 Billion?


The Golden State, which recently scrambled to fill a $15 billion budget gap, still may not be able to meet its payroll without help

Add the Terminator to the long list of people seeking a handout from Henry Paulson. Late on Oct. 2, California Governor Arnold Schwarzenegger sent a letter to the U.S. Treasury Secretary saying he may need a $7 billion short-term loan from the federal government to help the state make its payroll at the end of the month.

The governor's outstretched hand is just the latest sign of the severity of the financial vice squeezing the nation (BusinessWeek.com, 9/29/08). Everyone from small business people to homeowners to the largest state in the nation is finding it difficult to get a loan. "Right now this credit crunch impacts just about everyone who wants to borrow," says Doug Charchenko, head of the fixed-income department at broker Wedbush Morgan Securities. "New issues have not been able to get into the market. Institutions aren't buying bonds, they're hoarding cash."

Such a federal loan to a state would substantially broaden the federal government's efforts to stem the credit crisis—and could well lead to similar requests from other strapped states. Jennifer Zuccarelli, director of public affairs at the Treasury, confirmed that Californias request had been received but would not comment further on whether it is under consideration or when a decision might be reached.

Municipal Issues Seize Up

The $700 billion question is whether the bailout bill passed by Congress (BusinessWeek.com, 10/3/08) this week will restore confidence in financial markets and get investors buying again. "Hopefully this recovery plan will end the paralysis in credit markets and allow the state to conduct its short-term borrowing," says Thomas Dresslar, a spokesman for California Treasurer Bill Lockyer.

"There's a lot of disruption in the market," adds David Hitchcock, the head of municipal finance at credit rating agency Standard & Poor's. "That could change any day."

Municipal bond insiders say that while there is some interest from small investors looking to purchase municipal bonds that are already trading, the market for new issues has almost totally dried up. That's because there is no sign that banks, insurance companies, or other institutional investors are jumping back into the market yet. Matt Favian, managing director of Municipal Market Advisors, a research firm, figures some $15 billion in bonds from more than 150 municipal issuers are waiting to be sold. "To the extent people are more confident with banks, to the extent it helps confidence, [passage of the bailout bill] should begin to open up the markets so issuers can issue bonds," he says.

Where Are the Underwriters?

The frozen state of the municipal bond markets (BusinessWeek.com, 10/1/08) is a function not just of the lack of investors but also of the difficulties faced by many of the key players in the underwriting industry. Major investment banks that issued municipal bonds, including Bear Stearns and Lehman Brothers, are out of business. Municipal bond insurers, such as MBIA (MBI) and Ambac, saw their own credit collapse earlier this year when some of the riskier new investments they had been covering began to implode.

California's cash crunch is a symptom of its poor financial management in recent years, analysts say. The state has had multibillion-dollar shortfalls between its revenues and expenses dating back to the last recession in 2001. The state financed previous deficits with increased borrowing, but California's debt per resident has more than doubled over the past five years.

California is currently rated A+ by Standard & Poor's and A1 by Moody's (MC). As good as that sounds to most people, that makes it tied for last place with Louisiana in state credit rankings. "Most other states took the boom period to straighten out their finances and build some reserves," says Bob Kurtter, managing director of U.S. public finance at Moody's. "California did some of that but not enough."

California municipal bonds presently yield much higher rates than comparable Treasury securities, a reflection of both the state securities' higher risk and investor preference for the safety of federal bonds. A 30-year California bond yields about 5.5%, vs. 4.11% for a U.S. Treasury of similar length.

Revenue Shortfall

Walloped by lower-than-expected sales and income taxes, the Golden State faced a $15 billion deficit during this summer's budget negotiations. Schwarzenegger, a Republican, and the state's Democratic leaders tried to implement a 10% increase in sales taxes to close the gap. Republican legislators blocked the proposal, and it took until late September, two months past the due date, to get a budget passed.

Because California has often found the need to borrow money in the middle of its fiscal year, it has regularly had to issue what are called revenue anticipation notes. Those are short-term loans paid back after tax time in April. Without a formal budget, however, California couldn't borrow in that market. So the state's financing needs extended into the heart of the recent market turmoil.

Even if the state makes it through this short-term liquidity crunch, California faces long-term budget issues. California's recent budget was passed by keeping the state's $100 billion in annual expenditures flat with last year's and by introducing a number of temporary revenue generators, such as suspending the ability of corporations to use past losses to offset their current taxes. The spending cuts necessary to keep the budget flat meant layoffs for state workers and severe restrictions on spending for public schools.

"California always leads the nation in both good and bad ideas," says Jan Lazar, a financial consultant to municipalities. "They are in serious trouble."

See BusinessWeek.com's slide show of the states with the biggest budget shortfalls.


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