LL: California is required by its state Constitution to pass a balanced budget. Given its current fiscal problems, is this just a joke? When will reality truly be reflected?
GP: This requirement forces the legislators and governor to grapple with the budget shortfall on an almost ongoing basis. However, what you are alluding to, that a budget is a political and legal document, and may not always equal fiscal reality, is true.
In recent years, we saw the state enact budgets with overly optimistic assumptions, particularly regarding the receipt of increased federal reimbursement for certain programs.
Over time, we believe that the requirement to enact a balanced budget is one reason the state's debt burden is relatively low, compared to a Greece, for example. If the state were legally allowed to fold all of its deficits into bonded debt, suffice to say that its overall debt burden could easily be much larger than it is.
LL: Does their constitution protect bondholders?
GP: Absolutely. As I mentioned, the state constitution enumerates the top fund priorities of the state. Education and general obligation bond debt service, in that order, hold the top claims on cash in the state's general fund. We have seen the state controller's actions in recent years, including implementing payment deferrals and IOUs as respecting this priority payment structure. This has been supportive of the state's credit quality in our opinion.
LL: California has been painted in the press as the "next Greece". Is it?
GP: We don't think so. California's economy produces more than enough tax revenue to service its debt as it comes due—even without new or increased economic growth. This is not so in Greece. Now, in California, the economy may not generate enough tax revenue for the state to fund its debt service and all of its desired programs at levels that satisfy demands on services. This is where the tension lies.
Policy makers are currently grappling to either trim spending levels or increase the tax rates (or maintain temporarily increased tax rates) to help fund the programs. The gap between existing revenue and the cost of the government's suite of programs represents the budget deficit. But it's incorrect to interpret this gap as a threat to debt service. The state constitution mandates that debt service is one of the top priorities of the state.
LL: The debt load of California and the imbalance of the amount of money coming in versus coming out as well as double digit unemployment is behind this fear. Given all these headwinds, are you confident California can right the fiscal strain it is feeling?
GP: This is one of the misconceptions we have observed. California's debt burden is growing. In 1990 debt service was just under 2 percent of general fund expenditures. In 2011, debt service consumes 6% of general fund expenditures. So, while we agree that it's growing, we don’t view the state's debt burden as excessive at its current level.
The money coming in to the state—measured by cash collections—is both ahead of what was assumed in the state budget proposal as well as ahead of collections from last year. Preliminary reports from the legislative analyst's office suggest that the key tax revenue collections are running as much as $2.5 billion ahead of what the governor's proposed budget assumed. The problem is, even with this improvement, the underlying level of state expenditures are scheduled to exceed tax revenues by approximately $15 billion between now and the end of next fiscal year.
LL: Real Estate prices are still on the way down in California, how much is the real estate market in your outlook?
GP: The taxable (assessed) values lag current real estate market prices. The softness we see in the real estate market confirms our view that the current economic recovery is likely to be gradual and uneven. Weakness in property or assessed values will more directly affect local governments than the state. Schools and cities rely more on property taxes than the state—which is more income and sales tax dependent.
However, the state is not immune to weakness in the real estate market, which translates to softness in the economy overall. Moreover, when property taxes are down, the state is required to provide a relatively greater portion of the overall funding for education in the state. All of this being said, the S&P Case Shiller Index shows that the three metro areas in California covered by the index (San Diego, Los Angeles, and San Francisco) are among the nations better performing areas—and better than the 10-and-20-city index averages.
LL: What will change your view on the state's credit quality?
GP: An inability to reach a budget agreement for an extended period of time (August-September-October, like last year) makes it so the state cannot conduct its regular cash flow borrowing. Since most of the state's disbursements are scheduled to occur in the first half of the year (60%) and the state collects most of its revenue later in the year (40 percent in the final three months), the state smooths this out with a revenue anticipation note—even in normal years. But without a budget, it legally cannot do this borrowing. This really strains the state's cash flow.
The state controller must engage in the more extraordinary cash management measures to help conserve cash (including payment deferrals and—more extreme—issuance of IOUs). We believe any additional deterioration of the state's rating is likely to be linked to problems with its financial liquidity.
On the other hand, if the state could enact a budget with a preponderance of "structural" solutions (defined as ongoing cuts or revenues), the rating could stabilize or even improve. The governor's budget proposal was comprised of 70 percent ongoing budget solutions and was a step in this direction. He just doesn't have the requisite political support to enact the plan--at present.
LL: Revenues are dwindling across the country. The cash flow spiket if you will, is not flowly freely. Investors are concerned. How worried are you and will this problem just continue as the pace of this economic recovery?
GP: According to U.S. Census Bureau data, state and local government revenues are in a recovery mode and have growth in recent quarters. The problem is that the revenue is insufficient to fund all of the demands on state and local governments—which of course move inversely to the economy. The demands for services tend to increase when the economy—and tax revenues—are down. We believe the state and local governments' fiscal positions remain under pressure, but the vast majority will manage through.
Keep in mind, more 90 percent of our rated universe are 'A' or higher, implying a 'strong' or 'very strong' capacity to pay their debt obligations. That said, we expect there will be some instances of genuine credit distress. The recession and given its duration tends to be an environment that reveals weakness.
I would note that so far in 2011 there have been zero defaults among obligors rated by S&P. Even though there have been more rating downgrades, none have defaulted; this is consistent with the forecast we published in January.
A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."
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