California Budget Talks Falter as Treasurer Warns of Junk Debt

California Budget Talks Falter as Treasurer Warns of Junk Debt

By Michael B. Marois and William Selway

July 17 (Bloomberg) -- California Governor Arnold Schwarzenegger and lawmakers failed to resume talks last night over how to solve a $26 billion deficit, even after the state’s Treasurer said crippling penalties from Wall Street loom.

Negotiations between Schwarzenegger and legislative leaders stalled late July 15, mostly over proposed cuts to school funding. That prompted Treasurer Bill Lockyer yesterday to warn that the impasse could leave the state with a junk rating on its debt and unable to borrow money.

“With every passing day, the state’s credit rating moves closer and closer to the junk pile,” Lockyer said in a statement. “If the Governor and Legislature dump us on that pile, they will end indefinitely the state’s financial ability to build schools, highways, levees - all the critical public works we need to rebuild California. If our credit rating sinks to junk status, the state will find the door to the infrastructure bond market locked shut.”

The deficit in the $100 billion annual budget brought on by the longest recession since the 1930s and a political stalemate over how to fix it has drained California of cash, forced it to pay some bills with IOUs and caused credit assessment companies to cut their ratings on the state’s bonds.

Schwarzenegger told reporters yesterday he thought they might be able to “close the outstanding issues very quickly.” A meeting of the so called “Big 5,” consisting of the Governor and top Democrat and Republican lawmakers from both the Senate and the Assembly, never materialized by day’s end.

School Funding

At issue is the Governor’s proposal to suspend a constitutional amendment that sets a minimum level of funding for schools, which absorb more than 40 percent of the state’s general fund. Democrats want legislation to ensure that schools are repaid all the money that is cut, as well as guarantees spending would be increased when the economy recovers.

“We are close, but until Democrats find a way to fund education without constitutional changes that lock the state into future spending, we will remain stalled,” said Schwarzenegger spokesman Aaron McLear.

Controller John Chiang this month began issuing IOUs to businesses and others set to receive state payments to ensure enough cash remains to meet bond payments and others given high priority under the constitution.

Rating Cuts

Faced with the impasse, Moody’s Investors Service lowered California’s credit rating two steps to Baa1 from A2 on July 14 and said the ranking may be reduced further unless legislators solve the cash crisis quickly. Fitch Ratings on July 6 lowered its evaluation of California’s general obligation bonds by two steps to BBB from A-, placing the debt two grades above so- called high-yield, high-risk junk status.

A California bond maturing in 2037 traded for as little as 89.5 cents on the dollar yesterday to yield 5.76 percent. The difference between a 10-year California bond and top-rated municipal bonds jumped as high as 1.71 percentage points on July 1 and has since slipped to 1.6 percentage points, according to data compiled by Bloomberg.

“Sophisticated buyers will still buy the state’s credit, but they just want to buy it as cheap as possible. I would like to see the bonds trade down in value so we can buy more,” said Ken Naehu, who oversees more than $2 billion as head of fixed income at Bel Air Investment Advisors in Los Angeles. “There’s a lot of market timers that are trying to buy California bonds when they hit the low point in terms of rating-agency press. They want to take advantage of the maximum headline risk.”

Schwarzenegger and Republicans have ruled out raising taxes, as was done in February in an unsuccessful attempt to eliminate the budget deficit.

Democrats, who control both chambers of the Legislature, have sought to limit cuts to state programs, including those that provide aid to the unemployed and health care to children. Democrats lack the votes to reach the two-thirds majority needed to enact any solution immediately.

To contact the reporters on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net; William Selway in San Francisco at wselway@bloomberg.net.
Last Updated: July 17, 2009 00:01 EDT

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