Wall Street Takes Dim View of Budget's Reliance on Borrowing

By Jeffrey L. Rabin, Tom Petruno and Thomas S. Mulligan
Times Staff Writers

July 31, 2003

Wall Street's reaction to California's budget deal ranged from suspicion to disdain Wednesday, a response that makes it likely the state will continue to pay well-above-average interest rates to borrow.

Analysts at credit-rating firm Standard & Poor's in New York warned that the new budget passed by the Legislature and awaiting action by Gov. Gray Davis fails to bring spending into line with revenue and sets the stage for another financial crisis next year.

Among big investors who are potential buyers of California's general-obligation bonds — long-term debt critical for financing school construction, roads, prisons and a host of other major projects — many said the state's image isn't helped by the new budget, which calls for heavy new borrowing.

"I'm not recommending California bonds today, because I think they're going to be cheaper tomorrow," said James Lebenthal, chairman emeritus of New York investment firm Lebenthal & Co., which specializes in municipal bonds.

David Hitchcock, director of state and local government ratings at Standard & Poor's, criticized the near $100-billion spending plan passed by lawmakers for its reliance on "massive borrowing" and one-shot financial fixes that do not address the fundamental problem that the state continues to spend much more than it takes in.

Hitchcock told Wall Street investment firms and reporters in a lengthy conference call Wednesday that the new budget "seems to be going in the wrong direction."

Until California makes progress toward closing the persistent gap in its finances, Hitchcock said, S&P will maintain the state's credit rating at just two steps above junk, or non-investment-grade, status.

S&P cut the rating last week to BBB, the lowest of any state.

The cornerstone of the budget package is a plan to borrow $10.7 billion, via bonds, to pay off the deficit from the fiscal year that ended June 30. The bonds would be repaid over five years.

To make the bonds more appealing to investors, Sacramento would back them with sales tax revenue from a swap deal with local governments: Cities and counties would turn over at least $2.3 billion in sales tax revenue to the state each year, in exchange for a share of property taxes that now pay for schools.

The state would then be on the hook to make up any school-funding shortfall.

Under the budget plan, the state also would issue $1.9 billion in bonds to pay this year's contribution to the pension funds of state workers. That borrowing would be repaid over five years.

In addition, the budget anticipates borrowing $1.5 billion using bonds backed by payments the state is expected to receive over the next two decades from the 1998 settlement of litigation with tobacco companies.

All told, the $14.1 billion in longer-term borrowing under the budget plan would prolong and aggravate California's fiscal crisis, many analysts say. The state also expects to borrow an additional $3 billion on a short-term basis in September to address its cash-flow problem caused by deficit spending in the last three years.

Credit-rating firms and investors view the use of debt to pay for ongoing operating expenses as a sign of structural weakness in the state's finances.

California already pays interest each year on $27 billion in outstanding general obligation bonds, and an additional $24.1 billion in such bonds have been authorized by voters for issuance in the next few years.

What's more, state Treasurer Phil Angelides last year chose to temporarily ease pressure on the cash-strapped general fund by refinancing and restructuring a portion of the state's long-term bond debt. The bonds' contracts allowed Angelides to defer principal payments, but the result is that they will increase rapidly beginning in June 2005.

S&P's Hitchcock said California's overall debt burden isn't onerous at the moment. Principal and interest costs for the debt eat up about 6% of the general-fund budget each year, a "moderate" level compared with other states, he said.

But the debt burden has been rising rapidly in recent years, Hitchcock said.

And as more debt is piled on, the fixed costs to service it will rise and will take precedence over funding for education, health, welfare, transportation and environmental programs, for example.

Many institutional bond investors, such as mutual funds, said they agreed with S&P's assessment of the budget.

The agreement solved the immediate cash shortage, ensuring that the lights would stay on and current bills would be paid, said Reid Smith, who manages two California-bond mutual funds for Vanguard Group in Valley Forge, Pa.

But the longer-term problem remains, he said: how to match spending with tax revenue that may take years to return to its levels of the late 1990s, when it was swollen by capital-gains tax receipts from Silicon Valley tech-stock millionaires.

Until a credible plan emerges, he said, more cautious investors may shy away from the state's bonds.

That would not be because investors fear that the state might renege on its debts. The lower credit ratings are less a reflection of repayment risk than a commentary on the general financial health of California compared with other municipal borrowers.

The state's general obligation bonds, which pay interest that is exempt from federal and state income tax, compete for buyers with similar bonds of other states and with debt issued by California counties, cities, school districts and other entities.

"When you look at a general-obligation bond, you look at the ability to pay, and you also look at the willingness to pay," said Joe Deane, who manages more than $7 billion in bond investments for Citigroup Asset Management in New York.

In California, he said, the ability to pay "seems quite strong, but the willingness seeks weak," based on the budget plan.

Even so, Wall Street doesn't consider actual default even a remote possibility.

"Nobody believes that the state of California is going to default," Vanguard's Smith said.

Instead, for many big investors the key issue is whether the supply of new state debt could essentially overwhelm potential buyers. The state would always be able to issue bonds — the question is simply what price investors would demand in terms of the interest rate.

Also, a heavy supply of new bonds could drive down prices of older securities issued at lower fixed rates. That might leave many investors reluctant to hold existing state bonds for fear that their securities would be devalued.

That concern has helped to depress California bond prices in the last month, traders say, leading to losses on the securities, at least on paper. A general rise in market interest rates also has hurt the state and its securities, analysts say.

On Wednesday, the price levels of outstanding 10-year California general obligation bonds indicated that the state would pay an interest rate of about 4.6% if it issued new bonds of that term. That yield is 0.70 of a percentage point above what highly rated states are paying on such bonds, bond traders said.

Yet some investors said that still isn't enough to entice them into California's securities.

"I wouldn't touch [state general obligation bonds] at these levels," said Citigroup's Deane.

Given the sheer supply of state bonds in the pipeline, he said, California will probably have to pay more to borrow in coming months, so he sees little reason to rush in.