The state of California – the lowest-rated state in the union – has embarked on a program of issuing IOUs to vendors who are owed money by the state. This is a result of the budget stalemate in the California legislature and their inability to agree with the governor on the course of action to fix the state’s finances. State workers, by law, cannot be paid in IOUs, but essentially anyone else owed money by the state will be paid with them. There is no question that this financially hurts vendors.
California had their long-term general-obligation debt rating cut by Fitch Rating Services to “A-” from “A” on June 25th. The Moody’s rating is at A2 and the Standard and Poor’s rating is A. Both the Moody’s and the S&P ratings are on negative credit watch.
There is a precedent for this action. In 1992, lawmakers were also deadlocked on getting a budget passed under then-governor Pete Wilson. Result: the state issued IOUs. The question is how to view today’s circumstances from an investment standpoint. The IOUs are just one part of the large effort being made to solve California’s $24-billion budget deficit. Furloughs for state employees, closing certain state offices, and delaying tax refunds are all part of the ammunition that is being used by the governor to save cash until the budget impasse is resolved. The IOUs carry an interest rate of 3.75% and cannot be cashed until October 1, 2009. Banks have said they will accept the IOUs until July 10th. We expect other financial institutions to be trading in these IOUs.
While it is clear that there is a huge financial problem to be solved, this is, at its heart, a political problem. The governor and state lawmakers will need to come together on the cuts in spending and increases in revenues that are needed to solve the budget problems.
While likely to be downgraded, the state’s general-obligation rating was actually lower in the 2001-02 crisis, when it was lowered to BBB by the rating agencies. There are many resources available to a state to raise revenues and clear avenues to cut spending. The key is the legislature working to solve the problem. The ratings agencies review the economy, debt, finances, and overall management of the state in assigning ratings. An A rating is considered by the rating agencies as representing a strong ability to pay debts. Long-maturity California general-obligation debt is trading at approximately 6.0-6.10%. If bonds were to trade down closer to 6.5% they would represent excellent value, in our opinion. Ten-year bonds significantly cheaper than 5% would also represent value.
California is by no means the only state facing budget woes but the nature of its legislature makes it tougher to come to agreement. Illinois, Connecticut, New York, Ohio, and Mississippi are among other states that are also facing severe current fiscal problems.
We have no reason to believe that states – including California – won’t do all they can to avoid missing any debt-service payments. There is no question that this is the toughest economic environment the states (as well as other municipal entities) have faced in a long time. They will adapt to the leaner world because they will have to.
One endnote: the late and great Will Rogers said “during the Depression half the population of Oklahoma moved to California and the intelligence level in both states went up.” What Rogers forgot to note is that all the migrants are now in the legislature.