California: After Pain, A Formal Feeling Comes

Please accept my apology for a somewhat gloomy entry today, but recent events have led me to be concerned about impact on the municipal bond market; California's financial situation is dire and will likely result in a significant deterioration in it's credit status in the near future. This presages tough choices to follow elsewhere.

With tax receipts falling way below expectations, California is facing a budget deficit that's likely in the $20-30 billion range for the current fiscal year's $111 billion budget. In order to prevent reductions in public services, the state legislature and the governor have implemented ballot initiatives that would allow for the redirection of mandated funds (Propositions 1A through 1F) to cover underfunded programs. However, it appears California voters are likely to defeat the initiatives. The

Should there be an adverse outcome on May 19th. The LA Times and the Wall Street Journal are reporting that the politically powerful public sector unions and the Administration are making matching funds conditional on no significant state government layoffs.

Likely, the explicit argument presented by the Administration and unions will relate to controlling unemployment (a powerful argument depending upon one's perspective on these things). The administration's opponents will argue that reductions in government spending are required. Both sides regard this situation as dramatically important.

It's reasonable to expect California to bend to the will of the unions regardless of the outcome of the ballot initiatives. In addition to their softer influence within government, their membership votes and their resources are formidable.  This will result in a combination of tax, fee increases (some of which are already coming as a consequence of budgetary issues that have plagued the state since 2001) and a downgrading of California's debt by the major ratings agencies. Whatever the outcome, the various accounting gimmicks that have been used will not substantially prevent significant downgrades in public services. 

It's realistic to expect that, barring the press exerting substantial pressure on Moody's or S&P, the rating agencies will be unwilling to anger politicians and public unions by initiating a ratings downgrade during the crisis, but they will certainly do so once the matter is resolved. This pattern was established earlier during the banking crisis. Barring some miracle, later this year, California will find itself firmly . This will cause bond prices to fall, the state's borrowing costs to increase and more unpleasant budget cuts to follow. Expect maintenance to suffer dramatically in most public buildings and services.