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