California could be canary in the coal mine for municipal bonds

Bond rating company Moody's (MCO) has downgraded the State of California's general obligation (known as "GO") bonds to Baa1, from a level of A2. The new rating is three notches above "junk" status. Moody's expressed concern that the ongoing political gridlock stemming from a $26 billion budget deficit will continue, and could eventually lead to certain debt service payments being put at-risk. California also remains on the watchlist for potential further downgrades; as a borrower's credit rating falls, it becomes more difficult and expensive to obtain additional financing.

The cash crisis in the state, which has been hit hard by the collapse of the housing market, has led to certain groups receiving "IOUs" in lieu of actual payments. Several major banks temporarily accepted such IOUs, but their originally annouced deadline windows have since passed. Speculation about California's creditworthiness, both as it relates to GO bonds and IOUs, has created some market interest at trying to buy notes at a discount.

Giant asset management firm BlackRock said, "While it's too early to speculate as to whether we've seen the bottom, the assumption of a resolution and our belief in the state's long-term viability could translate into an opportunity to buy California munis at attractive levels," according to a client note obtained by Bloomberg News. Are California bonds, or muni bonds in general, really attractive to investors? And what does the situation say about the fiscal and political landscape as a whole?

The cash flow situation at the municipal level is similar to that of the federal government (quite negative), but with one important difference as it relates to the existing balance sheet: the federal government controls its own currency, whereas states cannot print money. This gives states extremely limited flexibility if the markets refuse to go along with the borrow-and-recklessly-spend charade, and President Barack Obama yesterday said that 48 states face fiscal deficits this year. The muni market stands ready to get a flood of supply this year, and likely next year as well, because state income tax receipts will not recover overnight. This supply could easily push prices down and force states to pay even more to borrow.

Overall, the first part of BlackRock's comments are more appropriate, in your author's opinion -- California is the first state to really run into a borrowing wall, and have to face up to their fiscal irresponsibility. Debt problems tend to be like cockroaches; the first one you see is rarely the last, and those who rush in often find better bargains come along later in the cycle. This should make investors wary that problems will be confined to California's bonds, and voters everywhere more concerned about how their state and local governments are handling budgets.

James Cullen also edits and writes at

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