California's Budget Deficit Crisis: Improving Conditions for Bondholders
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WellsCap Municipal Bond Series
California’s Budget Deficit Crisis:
Improving Conditions for Bondholders
April 2010
California: A Compelling Investment Coverage for GO Bonds
As we highlighted in our last comments published in July 2009, The state’s GO debt payments are continuously appropriated,
we are highly confident that investors are ultimately going to be even with a late budget or no budget at all, and are
paid on their California General Obligation (GO) bonds, despite constitutionally guaranteed. Still, the state’s recent budget
the state’s economic, fiscal, and political challenges. crises prompted investors and market participants to investigate
the technicalities regarding state GO debt service payment.
In reality, the state’s budget crisis reflects more of a political As a result, investors better understand the state’s priority of
issue than an ability to pay problem, and we feel the budget payments and are more comfortable with the state GO security.
situation and the ability to service GO debt are really separate
issues. Historically, the state’s budget negotiation process has General Fund revenues (net of payments) for education are
been structurally challenged, mainly by the two-thirds majority expected to provide strong coverage of GO debt service. More
requirement to pass the budget and raise taxes and legislative specifically, the state expects to receive $83 billion of General
districts that are highly polarized and vote along party lines. Fund revenues in fiscal 2011. Under the governor’s budget
proposal, the state will spend about $47.8 billion on education.
In this paper, we discuss two factors that are favorable to Debt service, projected to be about $5 billion this year, is the
GO investors: very first priority to be paid from the remaining $35.2 billion
w Priority of payments make GO payments such a high priority of revenues. Additionally, a portion of debt service will be paid
that one can be confident that political issues will be resolved from secondary funds, creating an effective GO debt service
before GO payments are in doubt, and coverage ratio greater than seven times. Therefore, plenty of
w California GOs are attractive at current spreads even though cash is available to meet GO debt service obligations.
spreads have come in from their near wides.
Cash Management Tools Available
We also discuss the important signposts to follow in the short The state has many cash management tools available to ensure
term leading up to the state budget proposal. debt service is paid on a timely basis. Some market participants
have concerns that the state may run out of cash during the
Priority of Payments Favors GO Investors course of the year if expenditures come in higher than expected
California’s priority of payments under state law suggests a or revenues fall short of forecasts. In July 2009, to avoid running
low probability of default in its GO bonds given that GO debt out of cash, the state controller’s office began issuing, for the
service is second in priority after education payments. This, first time since 1992, more than $3 billion of registered warrants
coupled with the state’s ability to insulate priority payments (IOUs) to pay some of its July bills. The state repaid the IOUs
through utilization of cash management tools, continues to in September 2009, about a month earlier than anticipated.
provide a good deal of protection to GO bondholders. These
cash management tools, as well as the recent bill that formalizes The controller has several ways to delay non-priority of
payment delays, are a means of preserving GO bond payments, payments, principally by the issuance of these IOUs. In order
regardless of unresolved budget and political issues. to ensure there is adequate cash for education, debt service,
and other General Fund payments that are deemed by the
state constitution, federal law, or court rulings as having a|
priority claim on available General Fund cash, the controller of up to $250 million in payments to CSU, and authorizes the
must begin delaying non-priority payments (e.g., businesses deferral of a total of $50 million for HUTA.
that contract with the state, income tax refunds, Student Aid
Commission, social service programs) in order to ensure that Positively, the state has decided that no deferrals under the
priority payments, including debt service, are made on time. We bill were necessary in March. Previously, even with the state’s
agree that these strategies are not long term and have resulted slowly recovering tax revenues, the state was planning to put
in negative headlines, but they do ensure the full and timely the bill to use, implementing at least some of the deferrals.
payment of GOs while the political theater is resolved. Projections showed that, without major changes in the state’s
budget, the state’s cash position would reach dangerously low
The state also has other means of ensuring that money is levels in March and July.
available for primary obligations, including payment deferrals
and internal and external borrowing. The state regularly makes This bill, combined with the state’s positive cash flow, may
use of the latter two, as evidenced by current internal borrowing lessen the state’s chance of issuing headline-making IOUs
from special funds of $13.8 billion and $8.8 billion of short- (though the bill does not preclude the state from issuing IOUs).
term Revenue Anticipation Notes (RANs) that are due in According to the state, it is unlikely to issue IOUs through June
May and June 2010. The fact that cash flows are turning more 30, 2010, due to cushion provided by the currently implemented
positive suggests the state’s RAN issuance size may be less for cash management mechanisms, including the RANs due in May
fiscal 2011 than the budgeted $10 billion amount contained in and June, internal borrowing from special funds, and the recent
the governor’s January budget proposal. cash management bill.
Bill Formalizes State’s Ability to Delay Payments Credit Spreads
In March 2010, the governor signed a bill into law (AB X8 5) We find California GO bonds to be attractive at current
that formalizes the state’s ability to defer payments in fiscal spreads even though spreads have come in from near historical
2011, which further strengthens the position of the state’s GO wides as shown in Exhibit 1. Changes in spreads highlight
bond payments. negative investor assessment specific to the state, including:
underperforming cash flows; persistent, large budget deficits;
We view this plan positively as it demonstrates the strength of delayed budget passage due to political impasse; and prolonged
the state’s ability and willingness to delay payments in order economic weakness. They also reflect negative investor reaction
to manage its cash flow quickly to ensure that adequate cash is external to the state, including the instability with Greece and
available for GO debt service and other priority payments. Now the widening of those sovereign credit spreads. In addition,
the state can defer payments to: the pending supply of California paper, of which the state has
w K-12 schools already issued $6 billion of tax-exempt and taxable GO to date,
w Community colleges has negatively influenced spreads. While political tangles over
w California State University (CSU) this year’s budget cannot be ruled out, spreads take into account
w CSU and the University of California System via a “payment this possibility and we expect that any problem would not be as
smoothing mechanism” severe as last year.
w State and local government social services
w Transportation programs Taxable California GO Build America Bonds (BABs) have
w Trial court operations also been trading wider relative to other taxable municipals,
w Highway Users Tax Account (HUTA) as shown in Exhibit 2. This chart further underscores spread
changes due to state budget and political events. According to
The bill additionally limits the K-12 deferral to no more than Barclays Capital, these bonds, issued in April 2009 at +365
$2.5 billion at any given time, authorizes the deferral of a total basis points (bps), hit their wides in late June at +421 bps
of $300 million for community colleges, authorizes the deferral following the state’s announcement that, because of a budget|
impasse and projected cash shortfalls, it would be forced to Exhibit 2: California 2039s versus Long Credit Index and Taxable
issue IOUs for certain expenditures beginning in July. As the Municipals Index (OAS, bp)
Legislature made progress on passing a balanced budget, which 450
was enacted in late July, spreads began to tighten, ultimately 400
350
reaching +265 bps in late September. Spreads have widened
300
approximately +80 bps since then, as the state announced
250
weaker-than-budgeted cash flows and the current estimated $20
200
billion combined budget gap for fiscals 2010 and 2011.1 More 150
recently, California GO BAB spreads have come back in and 23-Apr 23-May 23-Jun 23-Jul 23-Aug 23-Sep 23-Oct 23-Nov 23-Dec 23-Jan
now trade around +240. California 7.55% due 4/1/39 U.S. Long Credit Taxable Municipals
Source: Barclays Capital, as of February 17, 2010
Exhibit 1: CA GO vs. AAA General Market Spreads
The market has typically anticipated rating agency actions. In addition, 10-year California credit default spreads (CDS)
200 have been progressively tightening, as shown in Exhibit 3,
175 Moody’s downgrade to Baa1(07/09)
another important indicator of the state’s improving credit.
150 S&P downgrade Downgrade by both
to BBB (07/03) Upgrade by agencies to A2/A
125
both agencies (02/09 & 03/09) Even in the absence of of an improving credit situation,
100 to A3/A (05/04
Upgrade by both agencies California GO ratings are expected to benefit from migration
75 & 08/04)
to A1/A+(05/06) S&P to a new global scale ratings system (discussed in insert).
50 downgrade
to A- California GO bonds are now rated “A1” by Moody’s and “A-”
25 (01/13)
by Fitch on the global scale, two to three notches higher than the
0
Moody’s downgrade to Baa1 (12/03)
previous municipal scale ratings. California’s GO bonds were
(25)
previously rated Baa1 (stable) by Moody’s and BBB (stable) by
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Fitch. S&P continues to maintain an “A-” rating with a negative
outlook. The state’s recalibrated GO ratings have resulted in
5-year 10-year 30-year
initial spread tightening, but the long-term effects on pricing is
Source: UBS WMR, as of January 25, 2010 uncertain given the likelihood that the state will continue to be
subject to cyclical fiscal and economic vulnerabilities.
Exhibit 3: 10-Year Muni CDS Spreads
2006–Present
500
450 CAL GO TXS GO FL GO MD GO
400
350
300
250
200
150
100
50
0
6
07
3/ 7
07
07
07
07
07
07
1 0 07
08
3/ 8
08
08
08
08
08
08
10 8
09
3/ 9
09
09
09
09
09
09
10 9
10
3/ 0
10
10
11 7
12 7
7
11 8
12 8
8
11 9
12 9
9
0
0
0
0
0
1
/0
/0
/0
/0
/0
/0
/0
/0
/0
/0
1/
2/
4/
5/
6/
7/
8/
9/
1/
2/
4/
5/
6/
7/
8/
9/
1/
2/
4/
5/
6/
7/
8/
9/
1/
2/
4/
12
Sources: Citigroup and Thomson Financial Data, as of April 26, 2010
1
Source: Barclays Capital Municipal Credit Research|
Rating Agencies’ Recalibration taxes that made up for declining sales taxes. State cash flows
Both Moody’s and Fitch are in the process of recalibrating their have continued to be positive, resulting in total General Fund
respective U.S. municipal bond issues and issuers to a global scale receipts of $2.3 billion over budgeted estimates year to date
rating during April 2010. The purpose of these recalibrations is to and may eventually help reduce the state’s budget deficit. April
enhance comparability of credit ratings across rating agencies’ universe is the peak month for state General Fund receipts given the
of rated debt. The recalibrations are part of an acknowledgement by spike in personal income taxes, one of the state’s major revenue
the rating agencies that municipal issuers were being held to a different sources. The April revenue surge typically means that the state
standard from corporate and sovereign debt. Municipal issuers have also collects more of its receipts during the final quarter of the
exhibited stronger repayment histories than corporate borrowers in the fiscal year than during any other time of the year. Therefore,
same credit rating bracket. As a result, the recalibration is a measure to April revenue collections are crucial in determining if a recov-
maintain alignment with other sectors. ery is truly evident—led by a recovery in personal income tax
revenues—or if the uptick in General Fund receipts is due more
Rating agencies are careful not to characterize their respective to a timing difference with major General Fund receipts, such
recalibrations as “upgrades.” The recalibration of ratings represents as personal income taxes, coming in the earlier months.
a move from their expression on one scale to another and does
not represent a change in the opinion of the credit quality of the May is another important month, as the release of the May
affected issuers. Revise will provide an update on the size of the state’s budget
deficit and cash flows, the status of pending lawsuits, and the
About 70,000 sale-level ratings will be subject to the recalibration from state’s economy. The May Revise typically signifies the start of
Moody’s, and about 38,000 municipal bond issues will undergo the true budget negotiations.
migration from Fitch. The recalibrated municipal sectors include state
and local governments, tax-supported and appropriation debt, water Additional signs of improved cash flows to look for include:
and sewer, public power (distribution only), public higher education, w Avoidance of a cash crunch that would lead to greater
and special tax. Additionally, Moody’s is recalibrating tax increment probability of IOUs and other cash management techniques
financing and municipal utility districts, mass transit, grant anticipation w Decrease in size of RAN issuance
revenue bonds, and public university foundations. w Easier budget negotiations going into the May Revise,
possibly leading to on-time budget adoption with perhaps
Signposts to Follow in the Run-up to the 2011 Budget Key Months some reduction in the structural deficit
As of this writing, we have not witnessed the last budget
imbroglio encouraged by political gamesmanship that has We characterize the proposed budget solutions to close the
defined previous budget negotiating sessions. However, more currently projected budget gap of $19.9 billion (including a
negative budget news may occur as we get closer to the May $1 billion reserve) through fiscal 2011 as mostly one-time in
Revise and June deadline for budget adoption (e.g., increase in nature, mainly consisting of federal assistance. The amount and
budget deficit, delay in budget passage). progress, if any, of such assistance will be carefully monitored.
Although they continue to preserve the state’s ability to make
The state’s cash flows began to show signs of stability in October debt service payments on the GO and lease debt, the proposed
2009 when the state’s General Fund revenues beat estimates solutions may be difficult to implement and therefore may not
for that month due to higher personal income and corporate be implemented at all.|
Reasons for the Current Budget Gap w $ 2.3 billion of one-time revenue increases
The current budget gap results mainly from the following factors: w $847 million of other solutions, mainly through further fund-
w Lower General Fund revenue estimates ing of state mental health services with Proposition 63 funds
w Inability of the state to achieve previous budget solutions, including: that would require voter approval, along with a Proposition
w State prison system 63 fund shift
w Medi-Cal savings
w State Compensation Insurance Fund sale The remainder of the budget proposal relies on the following
w Increase in Proposition 98 funding guarantee for K-14 education solutions that may require federal flexibility or voter approval:
w Adverse court rulings w $8.5 billion of expenditure reductions (43 percent)
w General Fund inability to benefit from transportation funds w $3.9 billion of alternative funding solutions (20 percent)
w Population and caseload growth w $572 million of fund shifts and other revenues (3 percent)
w Creation of the $1 billion reserve
w One-time and temporary budget solutions approved in 2009 set Therefore, proposals to close the budget gap, while relying
to expire in 2011 much on federal government support, also contains many other
w Temporary sales and personal income tax increases uncertainties, resulting in a high probability that the budget
w Vehicle license fee increase deficit will persist into at least the next fiscal year. Ultimately,
debt service is second in priority only to education, and the
Much of the budget proposal relies on $6.9 billion, approximately Legislature will need to find other solutions to balance the
35 percent of total solutions, of federal funding that may not budget and not impair bondholders.
materialize. The majority of the $6.9 billion of federal funding
is mostly related to funding for Medi-Cal and Medicare, with Summary
the remainder for general expenditures, including: Long term, California has the ability to pay, and we believe the
w $1.8 billion from increasing federal funding ratio for Medi-Cal high constitutional priority of GO payments means the needed
w $1.2 billion from extending federal stimulus provisions for political will can be found. The state continues to demonstrate
Medi-Cal Federal Medical Assistance Percentage its strong ability to delay payments and preserve cash for prior-
w $1 billion from funding for Medicare services and prescription ity payments (including GO bond debt service). These factors,
drug costs particularly passage of the cash management bill, are main con-
w $1 billion from increased reimbursements related to special tributors to the improving position for the California GO credit
education despite perception that is dominated by headline attention to
w $880 million from increased reimbursements for undocu- the state’s continuing economic, fiscal, and political challenges.
mented felons There are key events to monitor and watch in the run-up to the
w $1 billion from other federal funding requests budget season beginning in May, which may lead to some fiscal
stress in the short run, but we remain confident that the long-
In the event that $6.9 billion of federal funds do not materialize term credit outlook is positive for California GOs.
by July 15, the state proposes additional spending reductions
and revenue increases that would occur through an automatic
trigger, although full details of the proposed trigger mechanism
are yet to be released. These include:
w $3.8 billion of generally permanent expenditure reductions,
including elimination of various social services programs
and further employee salary reductions|
Progress Report: State Budget Deficit Is Reduced by $1.1 Billion
As of March 5, 2010, the Legislature passed legislation intended to own lagging economy, providing incentive for any further federal
reduce the budget gap by about $3.2 billion. The governor vetoed $2.1 support. In any case, reliance on federal stimulus funds speaks to the
billion of the legislation, which included expenditure reductions primarily state’s management and that reliance on these moneys also delays/
involving prison healthcare costs and employee compensation savings. suppresses tough budget decisions.
The governor did approve the remaining $1.1 billion of reductions that
would be achieved through legislation intended to reduce the sales tax Remaining Budget Risks
on gas and replace it with a higher excise tax, a portion which would be In addition to uncertainty of the total amount of federal funds to be
applied to offset General Fund costs for transportation expenses. Initially, received by the state, the budget deficit could also re-open, as has
the governor planned to veto the gas-tax swap proposal because he did been the norm, as a result of the following items with outcomes yet to
not receive any job creation bills. The Legislature agreed to send him two be determined:
of the three bills he demanded, a tax credit for homebuyers, and a sales w $1.7 billion shift of redevelopment agency funds to pay costs
tax exemption on purchases of manufacturing equipment by environmental otherwise payable from the General Fund, which is still awaiting
technology firms, which the governor hopes will attract more companies court decision
to California. In addition, the governor signed into law budget-related bills w $1.3 billion potential General Fund impact from the governor’s
providing for more than $200 million of General Fund relief. furlough of state employees that the state is continuing to appeal
w $489 million potential General Fund impact from certain vetoes by
Further reduction to the budget deficit may occur with encouraging the governor in connection with the fiscal 2010 budget
signs of the state receiving at least $2.9 billion of federal funding mainly w Potential court orders for the state to expend moneys for prison
for state Medi-Cal relief. As noted, Medi-Cal relief accounts for a healthcare improvements in excess of amounts included in the fiscal
majority of the $6.9 billion federal funding included in the state’s budget 2010 budget
deficit solution. Though the current amount estimated to be received is
far less than the budgeted amount, we believe the federal government Also, much of the more difficult budget decisions regarding proposed
will not leave the state unsupported, as it has 55 electoral votes and is education and social service cuts will not be discussed until the summer
responsible for 13 percent of U.S. GDP. Also, any progress that the rest when more clarity is provided regarding the economy and revenues.
of the nation’s economy is making may be hampered by the state’s|
Appendix The state has $49 billion of authorized, unissued debt. The
State’s Debt Ratios Likely to Increase as Significant Additional state has planned to issue up to $14 billion of GO debt through
Debt Issuance Planned calendar year 2010. Currently, the state issued $2.5 billion of
As of January 1, 2010, the state had $76.4 billion of General tax-exempt GO and $3.4 billion of taxable GO debt in March,
Fund–supported debt outstanding, consisting of $65.2 billion of the latter which included $2.5 billion of BABs. The state had
GO debt and $11.2 billion of revenue bonds. GO debt includes planned to issue $7 billion of GO debt before June 30, 2010,
$1.3 billion of outstanding commercial paper. Revenue bonds and another $7 billion between June and December 2010. The
include $9.3 billion related to facilities that are leased to a state state is still deciding the amount of tax-exempt and taxable
agency, CSU, or UC under a long-term lease that provides the GO bond issuance going forward for 2010. The state estimates
source of payment for debt service on the bonds. Another $1.9 relatively high amounts of annual issuance of General Fund–
billion of revenue bonds relates to the state’s borrowing of local supported debt through fiscal 2028 of at least $9 billion in 2019
property taxes from local municipalities. These bonds mature and as high as more than $16 billion in 2013.
June 2013.
As noted above, the state is planning its annual RAN issuance,
General Fund-Supported Debt but the amount is yet to be determined. The state’s positive cash
General Obligations 1/1/2010 F’11 Debt Service flows may help to decrease RAN issuance size.
Bonds 63,902 5,212
Commercial Paper 1,292 NA In November 2010, voters will be asked to approve $11.1
Total GO Debt 65,195 5,212 billion of bonds to overhaul the state’s water system. The bond,
combined with federal and local moneys, would finance $40
Revenue Bonds 1/1/2010 F’11 Debt Service billion of projects, such as building new dams and below-ground
Lease Revenue Bonds 1
9,346 934 water storage and a canal to circumvent the Sacramento-San
Proposition 1A Receivables Program 1,895 91 Joaquin Delta, which supplies water to two-thirds of California’s
Total Revenue Bonds 11,241 1,025 36.7 million people.
Total General Fund-Supported Debt 76,435 6,2372
Self-Liquidating Debt 1/1/2010 F’11 Debt Service
General Obligations
Special Revenue Fund Self Liquidating2 8,061 782
Enterprise Fund Self Liquidating 3
1,498 153
Source: Barclays Capital
Total Self-Liquidating Debt 9,560 936
1
Predominantly bonds backed by lease payments from University of California, California
State University, etc.
2
Economic Recovery Bonds; backed by 0.25 percent sales tax. Source: California State
Treasurer, 7 percent of GF revenues.
3
Predominantly Veterans Housing bonds; backed by home loans to veterans.
WellsCap Municipal Bond Series Contributors
Melanie A. Tung Terry J. Goode
Senior Research Analyst, Municipal Fixed Income Head of Tax-Exempt Research, Municipal Fixed Income
Wells Capital Management | 525 Market Street, 10th Floor, San Francisco, California 94105 | www.wellscap.com
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