July 2, 2003, Bloomberg Terminal, Californians Should Stop Flirtation With Unthinkable, by Joe Mysak,

July 2, 2003, Bloomberg Terminal, Californians Should Stop Flirtation With Unthinkable, by Joe Mysak, columnist,

 

July 2 (Bloomberg) -- California is the scariest place in the U.S. municipal bond market.

 

The state is looking at a $38 billion budget shortfall -- a gap bigger than the budgets of all other states except New York -- for 2003-2004. The state's lawmakers are deadlocked over what to

 

do about it.

 

This is the same state that only two years ago surpassed France as the world's fifth-largest economy, at $1.33 trillion,

 

and gave Britain (at $1.4 trillion) a run for its money. Now some Californians are talking about bankruptcy.

 

States can't declare bankruptcy. James Spiotto of the law firm Chapman & Cutler in Chicago, the nation's foremost municipal bankruptcy specialist, says so. Bruce Bennett, who helped engineer the bankruptcy of California's Orange County, says so. John Moorlach, who blew the whistle on Orange County's investments and is now the county treasurer, says so.

 

And yet. And yet. There is an old expression about how new ideas in public finance blow in from the West. John Hallacy, head of municipal research at Merrill Lynch & Co., put it another way: "Isn't California always the test case?"

 

States toying with insolvency isn't a good or new idea.

 

Try to Remember

 

"The posturing of no new taxes is not helpful in finding a solution," Dan Heimowitz, then director of public finance at

 

Moody's Investors Service, told the New York Times.

 

A financial adviser had another take. "They don't want to raise taxes, that is not a viable option," said Thomas Hayes, former California state treasurer. "It will take a two-third's vote to enact more taxes and that is not going to happen,'' he told the Times.

 

They aren't referring to what's going on in California now. They were saying that in 1994 when Orange County declared bankruptcy, a move that stunned everyone in the municipal market.

 

Perhaps you remember. Here was one of the wealthiest counties in the nation bankrupt, the result of the county treasurer's wrong- way bets on interest rates.

 

This kind of thing just wasn't done. Bankruptcy was the refuge for the municipal market's sickest cases, not the healthy and wealthy temporarily caught up short just because they weren't wise when it came to investments.

 

Lack of Will

 

The Orange County bankruptcy rocked the municipal market because it went against all the rules. The No. 1 rule is that a municipality must do everything to repay its debts. That's what the pledge of a municipality's "full faith and credit" means, when it sells general obligation bonds. Orange County had the ability to repay its debts. It lacked the will.

 

California's lawmakers apparently don't have the will to pass a budget with a little pain.

 

What is happening in California isn't much different from what has been going on from coast-to-coast, although the numbers are larger and scarier and the legislative inaction inexplicable.

 

Government is in the business of providing services. The more money comes in, the more services government can provide. This is what took place in the 1990s. The stock market boomed, people made more money, and tax revenue swelled.

 

What did states do? They put aside more money in rainy day funds. They cut taxes. They increased services. They introduced new services.

 

Spending More

 

Here's what has happened in California, according to figures provided by the State Controller's office.

 

-- Spending: $67 billion in 1997-1998, $72.5 billion in 1998-1999, $81.9 billion in 1999-2000, $92 billion in 2000-2001, and $96.9 billion in 2001-2002.

 

-- Revenue: Stock market-related personal income tax revenue declined from $17.6 billion in 2000-2001 to $8.6 billion in 2001- 2002, and to $5.2 billion in 2002-2003.

 

Between 1997 and 2002, spending increased by almost 45 percent. The state's population didn't grow by 45 percent. It grew by 8.6 percent. In 1997, 32.5 million people lived in California. In 2002, 35.3 million people lived there.

 

Let's not even bring up the whole electric power crisis, which ravaged the state in 2000 and 2001 and bankrupted its largest utility.

 

We all know what has to happen next.

 

It's not insolvency.

 

It's not a debt moratorium.

 

It's not setting up a separate czar to run the state and make all the decisions.

 

Wall Street Ready

 

The state has to spend less, or it has to get more money through increases in taxes and fees.

 

Wall Street will help, if those in Sacramento can pass a budget. California, which has the lowest state ratings at Standard & Poor's (A) and Fitch Ratings (A) on its general obligation bonds, and is tied with New York and Louisiana at Moody's (A2), still has access to the municipal market.

 

In June, the state sold $1.7 billion in bonds. It paid more to do so, on a comparative basis, than any other state -- 0.64 percentage point more than triple-A.

 

The only reason people haven't said more about how much more California has had to pay to borrow is because yields in the municipal market are so low. Even with the penalty, California still paid only 5 percent to borrow money for 30 years.

 

Bad Karma

 

And once California lawmakers stop posturing (Republicans want to cut spending, Democrats, who control the Statehouse, want to raise taxes), the state will be able to sell $10.7 billion in bonds to help cure its $38 billion shortfall.

 

For all its problems, California began the year with plenty of capacity to sell bonds, ranking 20th in terms of debt per capita, according to Moody's.

 

That said, California is still the scariest place in the municipal market. I keep returning to Orange County, and what

 

Bruce Bennett told the Times in 1995: "Even though the tax base of the county is very wealthy, the county government doesn't have unrestricted access to it." Some Californians might say the same thing concerning the state.

 

Joe Deane, who oversees more than $7 billion of municipal bonds at Citigroup Asset Management in New York, perhaps explained it best: "There's just a lot of negative karma going on out there right now."