California to issue IOUs after missing budget deadline; muni bond rating at risk

Beginning tomorrow, California will issue IOUs to elderly, disabled and welfare recipients who are due checks because the governor and the legislature failed to agree on a spending plan before the state's budget year begins today.

Treasurer Bill Lockyer said California won't default on any bonds, which have claims second only to schools. Schwarzenegger's administration forecasts that the state will spend $4.5 billion on debt service this year, but only $16 million is due in July.

Bond rating agencies could act as early as today to lower California's bond ratings, as they've warned in the past few weeks. Both Moody's and S&P have threatened multistep downgrades if California doesn't work out its budget problems, which could mean the state's bonds would be near junk level. California currently has the lowest bond rating of any state in the U.S.

Negotiations between Governor Arnold Schwarzenegger, fellow Republicans and Democrats broke down last night and they missed the midnight budget deadline. If bond ratings drop to near or below junk status California's debt service payments will go even higher for any debt it may need. Bloomberg reports the value of its bonds maturing in 2037 traded for as little as 83.35 cents on the dollar yesterday to yield 6.27 percent. In May the bond sold for 97.25 cents.

Politicians failed to reach a deal because Republicans want to eliminate welfare programs and deny government health insurance to 1 million low-income children. Democrats want fewer reductions and suggest some tax increase instead to make up for the more than $20 billion shortfall caused primarily by the recession. The recession has reduced state revenue by 20 percent.

Many blame California's current dilemma on Proposition 13 passed back in the 1970s. "We've chosen mediocre public service and more private money. We've decided not to tax ourselves as much. We've basically turned our back on schools. It's a choice we made within our state," John Mockler, former Executive Director of the California State Board of Education, contends in an interview with the Merrow Report.

Proposition 13 is not the only tax-cutting measure that impacted the state's budget. Republicans have steadily cut taxes, while Democrats have tried to minimize cuts to the social and education programs in the state. Instead of reaching a compromise on the matter, the state has funded its shortfall by issuing bonds.

Now that the bond agencies have said enough is enough, California politicians have some hard choices to make. Unfortunately for the rest of us, if California munis are ranked at junk status, it will put the rest of the municipal bond market in panic. Many institutional bond holders will need to reassess the safety of municipal bonds and the entire market may take a hit. Add to this pressure the fact that other states are facing significant shortfalls in income because of the recession and we have a muni bond storm in the making. Investors holding municipal bonds may want to think twice about the safety of that segment of their investment portfolio.

Lita Epstein has written more than 25 books including The Complete Idiot's Guide to Value Investing.

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