California State General Obligation Bonds

Jan.11.10 | About: iShares California (CMF)
The offering statements for the State of California’s most recent bond issues remind me of New York City’s for the sale of general obligation bonds and notes in 1974.
Then, the City's short-term debt had no source of funding other than issuing new notes to retire the old. A few months later, the market refused to accept additional paper. That resulted in monetary default on $1.6 billion principal amount of NYC general obligation tax and revenue anticipation notes.
The City’s bonds did not default because bond principal and interest is funded one year in advance and held separate and apart from all other governmental funds. Those requirements and others like them are spelled out in the State’s Constitution, as it is in most of the other states.
The framers of California’s Constitution left the question of incurring state debt up to the voters, which is common among the states. But, voters also decide how to secure repayment and that is unique. Additionally, debt repayment is not among the Constitution’s listed priorities, education being first, having a payment priority ahead of debt service.
Payments of principal and interest on California State general obligation bonds are secured by a continuing appropriation from the State’s general fund. The exception being $14 billion in outstanding ER Bonds (Economic Recovery Bond Act) issued and approved by the voters as Proposition 57 in 2004.
ER is an apt label. Deficit funding is the purpose of these bonds - $11 billion were issued in 2004 and $3 billion in 2008. These are general obligations of the State but additionally secured by a first lien on the proceeds derived from the addition of .25% to the rate of the State’s sales tax. That is a first in the world of state general obligations. It says a lot when the State and its voters can take a part of its taxing capacity and pledge it selectively to just certain issues GO bonds.
California’s Constitution grants to the people the absolute right to propose, make, change, and ratify law by simple majority vote. There is no minimum voter turn out requirement. To qualify for voting, propositions to change statutes need signatures equal to at least 5% of the last gubernatorial turn out. To change the Constitution, the signature requirement is 8%.Interest groups and State legislators are in the process of considering a proposal to call for a constitutional convention. That could result in a rewrite of the entire document.
As of October, California had $68 billion in outstanding GO debt comprised of bonds, notes, and commercial paper. At that time, authorized but un-issued debt was $64 billion. The State has plans to issue $13 billion in additional GO debt by June 30, 2010.
Credit and liquidity lines drawn from two large consortiums of domestic and foreign banks totaled about $6 billion in November 2009. An unspecified amount of that debt has no source of repayment other than issuing new debt to retire old.
About $5.5 billion of GO variable rate demand bonds were outstanding this past October. The State reported, “On occasion, its variable rate obligations have not been remarketed resulting in draws on the applicable credit facilities”. About $1.5 billion had no liquidity support other than the State. In addition, $1.1 billion principal amount of general obligation commercial paper notes were outstanding.
In my opinion: The legal underpinning for the repayment of state general obligation bonds in California is sub-standard and voters could make it worse or better. One thing is certain; voters are not likely to surrender their right to make and change law.
Neither politicians nor voters will be willing to accept spending cuts and tax increases necessary to balance the 2010 budget. The State will need extraordinary Federal aid in the next 18 months.
For additional information about state and local government credit risk, please see Municipal Bonds: Time for a Closer Look from 3/26/09, or visit my web site: Municipal-Credit-Insights.Com.

Disclosure: No position in state general obligation bonds or notes.