California's Debt: Scenarios for the State in 2011

by: Carl Dincesen

On January 18, 2011, the original article asked, “Will the State deliver cash or warrants on its revenue anticipation notes maturing or issued in 2011? Benchmark Bond Ratings puts the probability of note default, or payment in other than cash, at 10%. That is a protection margin for investors we describe as 'Thin.' Current yields and the public rating companies suggest risk is much lower.”

March 31, The Bond Buyer reported: "California Notes in Question - Collapse of Budget Talks Hinders Plans." The report cites S&P as saying, “If the state is unable to enact a budget prior to the start of the fiscal year on July 1, we expect its cash-flow borrowing options to be complicated because it will be precluded from publicly issuing revenue anticipation notes,” Standard & Poor’s said.

“Extraordinary cash management actions such as certain payment deferrals or IOUs might in our view again prove critical to the state’s credit level if fiscal 2012 were to begin without a budget in place,” according to the rating agency.

We are reducing our protection margin rating on the notes to “Less Than Thin,” a 25% probability of monetary default up from 10% in January.

Since their issuance in December 2010, the public rating agencies have maintained top or second from top from short-term debt ratings on the California notes

Reprint of the original article follows with more detail on the notes.

Some might think short term lending is less risky than long. In the municipal market, for many issuers that is usually not the case, particularly today. When additional borrowing is necessary to redeem tax and revenue anticipation cash flow notes it is called a “rollover” - sell new notes to pay off the existing.

It works as long as the market for the issuer’s notes remains open. If it closes, current note holders are unlikely to be paid in full on the maturity date unless the issuer can sell bonds to redeem the notes.

California issued $10 billion of revenue anticipation notes this past December. They are due this May and June. Also, $8 billion were sold last year and $7 billion the year before that. Over that time, general fund tax revenues declined about 15%. The state’s ability to access the bond market could become an issue in the months ahead. More likely, if voters turn down an initiative to extend temporary tax rate increases worth $8 billion that are set to expire this June.

The state just announced a decision not to issue any general obligation bonds this year. Any concerns about market access will be hard to define and as a result, this is not good news for current note holders.

California can satisfy its revenue anticipation notes by delivering cash or warrants to note holders on the maturity date. That is because the notes constitute unsecured debt of the State, not general obligations. If warrants were issued, it would undoubtedly be viewed as a note default, although legally it is not.

The notes are expected to be paid from general fund revenues as they have in the past. Warrants could come into play if “un-appropriated” general fund revenues are insufficient.These warrants would pay interest at 5% until redeemed, according to the official statement for the sale of the notes.

California has three kinds of debt payable from the general fund. In the order of strength of legal claim, they are general obligation, annual lease appropriation, and unsecured obligations, which are, technically speaking, not debt. Consequently, not a “debt,” not a “default.”

Consideration in the form of interest bearing warrants in lieu of cash to satisfy the note obligation is not applicable to the other two kinds of California state debt. There the risk is much lower in large part simply because bond payments are known and planned. They do not come as a surprise.

Will the state deliver cash or warrants on its revenue anticipation notes maturing or issued in 2011? Benchmark Bond Ratings puts the probability of note default, or payment in other than cash, at 10%. That is a protection margin for investors we describe as “Thin.” Current yields and the public rating companies suggest risk is much lower.

Expiration of the Federal Build America Bond program came at a particularly inopportune time. For California and others, it shrinks the size of the market for its securities. There is nothing to prevent California from offering taxable bonds or notes without subsidy. The question is if investors will not buy notes, will they buy the state’s bonds?

When the City of New York was in a similar financial bind in the mid-1970s, the answer was "no." That led to a default by the City on general obligation cash flow notes and creation of the Municipal Assistance Corporation (MAC) for the City of New York. Holders of defaulted notes were offered MAC bonds in exchange for an equal principal amount of notes, extending the less than one-year note maturity several years.

City general obligation bonds, having pre-scheduled payments of principal and interest, were paid in full and on time. When an issuer loses access to the market, note holders usually bear most of the damage. New York State also created an emergency financial control board that largely ran the City’s budget process for many years.

What entity could play the same role for California? The problems are to a large degree political in nature with a bigger divide than currently exists in Washington, D.C. Add in voter initiative wild cards and it is understandable that a few of the country’s leading finance executives have nodded to the possibility of some fire in the municipal market, not just smoke.

Prior to the recession, California had large multi-year budget deficits. The state has little margin to raise income and sales tax rates because they are already among the highest in the country. In the last 10 years, per capita personal income growth has lagged that of the nation.

Disclosure: I am long MCO.