California Crisis

Not Another Scary Movie

Municipal Bonds Play Foil to State Budget Crisis

MCS Financial Advisors has purchsed for its clients taxable and tax-exempt bonds from a diverse array of California municipalities. We have no significant exposure to California general obligation (GO) bonds, the subject of much discussion in financial communities and the media. The state’s budget crisis and the dire commentary about the potential for default have investors naturally concerned about the safety of bonds issued in California.

Background and Plot Details

  • There are thousands of municipal bond issuers in California. The crisis is primarily about the State of California’s debt. A bond issued by a California municipality for sewage treatment has nothing to do with the state’s budget problems. The only similarity is that both the treatment plant and the politicians are full of the same substance, although the treatment plant is better at processing it.
  • California is a large, diverse economy. If it were a country, its economy would be the eighth largest in the world.
  • Under the California constitution, the state must pay its debt before other obligations, with one exception – under Article XVI, Section 8, the constitution requires that state tax revenue be apportioned to support public schools before it is used for anything else.
  • The state’s GO bonds are currently investment-grade on negative credit watch with all ratings companies.
    • On July 1, Standard & Poor’s affirmed California GOs as an A rating on negative credit watch.
    • Also in early July, Fitch cut California GOs from A- to BBB, their third downgrade this year.
    • On July 14, Moody’s lowered California GOs from A2 to Baa1.
  • Isolated California communities (Orange County, City of Vallejo) have filed bankruptcy – could the state? No. “States can’t file Chapter 9 bankruptcy protection,” said James Spiotto, a municipal bankruptcy expert at Chapman and Cutler LLP in Chicago. The municipal bankruptcy code limits filings to “municipalities” or an “instrumentality of a state.” “They (states) are sovereigns just like the United States, just like Brazil or any other country,” he said. “The federal government and state governments are separate and sovereign bodies under the 10th and 11th amendments.” Source: The Bond Buyer, January 12, 2009.
  • California does have structural problems that impede its budgeting process: 1) it requires a two-thirds majority to pass the budget, 2) it requires a two-thirds majority to pass a measure to increase state revenue, and 3) California voters can approve spending measures without approving the source of funding for the measure.
  • The City of El Monte recently decided not to declare bankruptcy after winning concessions from public employees. “Public employee unions agreed to give up contracted pay increases for the upcoming year, to accept furloughs for non-police employees that amounted to a 10% pay cut, and to pay more of their pension and health care costs, after the city threatened bankruptcy.” Source: The Bond Buyer, July 2, 2009.

Final Scene

The most likely ending: California’s large, innovative and diverse economy will muddle through its significant financial problems, which will worsen over the next five years. Some municipal bankruptcies would not surprise me, but I would expect losses to bondholders to be minimal in most cases. Unless the bankruptcy is caused by some sudden catastrophic event, bankruptcy – or the threat of it – will force municipalities to increase fee revenue, renegotiate labor contracts, and cut spending/services to balance budgets while continuing to service their debt on time.