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
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
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
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
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
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
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
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,
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
Yet some investors said that still isn't enough to entice them into California's
"I wouldn't touch [state general obligation bonds] at these levels," said
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.