Maybe it’s because their headquarters are on Montgomery Street in San Francisco instead of Wall Street in New York, but Charles Schwab Co. is telling investors that California is not about to go out of business.

In a rhetorical question-and-answer missive to investors, Schwab income planning director Rob Williams, says “California has severe financial problems, but we think it’s unlikely that the state will default on its general obligation (GO) bonds.”

Then he lists five reasons for reaching that conclusion, including constitutional guarantees; the fact the state can’t file for bankruptcy, and the fact that “states can’t just disappear.”

So does the firm see the state’s current travails as “a buying opportunity?” “No one can say for certain,” says Williams.

Here’s the document.  As Williams says, general obligation bonds are guaranteed by the state constitution, and only education is ahead of paying off these bonds.  Here’s a sample:

Many analysts point out that the state’s revenues are collapsing, its spending is out of control, and the structure of government prevents the state from ever being fiscally stable. Are these concerns valid?

All of these statements may be true, depending on your political view. But these troubles don’t inevitably translate into default on California GO bonds, for all of the reasons cited above.

However, they do translate into serious concerns for other parties interested in the state’s solvency-of which there are many. The politics of the situation can also be noisy, leading to steady reporting of the budget drama and ebbs and flows in market sentiment, likely adding to uncertainty and reducing confidence among investors. As confidence drops, the prices of outstanding bonds drop, and yields rise.

The situation has also resulted in changes to the state’s bond rating, including a downgrade by Fitch Ratings to BBB on July 6 and Moody’s to Baa1 on July 15. These ratings are two and three notches, respectively, from “junk” bond status. The rating is also on negative “Rating Watch,” meaning that the rating will remain on review for additional downgrades “if institutional gridlock” persists.

While ratings alone should not drive an individual investment decision, comments in Fitch’s rating report are worth quoting: “The BBB rating indicates that expectations of default risk remain low, although the rating is well below that of most other tax-supported issuers. GO debt in California has a constitutional prior claim on revenues, although after education.”

In other words, diving into Fitch’s rating report, they essentially admit that their rating is bullshit.  They are dropping the ratings because of perceptions of crisis that don’t match constitutional obligations.  This is gouging.  It’s almost the textbook definition of it.

And if you don’t think that goes on, check out this investigative report from last November:

Goldman, Sachs & Co. urged some of its big clients to place investment bets against California bonds this year despite having collected millions of dollars in fees to help the state sell some of those same bonds.

The giant investment firm did not inform the office of California Treasurer Bill Lockyer that it was proposing a way for investment clients to profit from California’s deepening financial misery. In Sacramento, officials said they were concerned that Goldman’s strategy could raise the interest rate the state would have to pay to borrow money, thus harming taxpayers.

“It could exaggerate people’s worries about our credit,” said Paul Rosenstiel, head of the public finance division of the treasurer’s office.

That’s exactly what’s happening.  The big banks are sparking irrational worry over California’s ability to repay bonds to increase their yields.  The federal government needs to step in with a backstop, not just to save the state money, but to prevent the commission of a crime.

Fitch, one of the main credit rating agencies, fresh off downgrading California bonds from A to A-minus a little over a week ago, just took them another step down today.

The downgrade to ‘BBB’ is based on the state’s continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis. Since no agreement was reached by the June 30, 2009 fiscal year (FY) end, the state’s controller has now begun issuing registered warrants (IOUs) for certain non-priority payments to preserve cash, and the budget gap to be addressed has increased to $26.3 billion from $24.3 billion. The use of IOUs for non-priority payments would offset cash shortfalls into September 2009 as now currently projected […]

With issuance of IOUs for non-priority payments, margins for meeting constitutional and court-required contractual commitments are narrowing. After September 2009, absent any proposed budget and payment adjustments, cash deficits will expand dramatically. Cash flow solutions, including the ability to access short-term borrowing, are inextricably tied to reaching timely agreement on effective and credible budget solutions.

The inability of the state to reach agreement has prompted the controller to begin issuing IOUs for non-priority payments, primarily disbursements to vendors, for certain social services, and for tax refunds, in order to ensure payment of priority payments, including General Obligation and lease debt service. The controller’s office estimates that $3 billion in IOUs will be issued during July 2009; priority payments of $10.8 billion will be made for education, debt service, Medicaid, payroll, pensions and other mandatory contractual obligations. Projections will be revised to reflect June revenue performance and other changes but as currently estimated, cumulative cash deficits of $3.7 billion are projected through August, offset by $4.5 billion in non-priority payments that could be covered with IOUS, excluding tax refunds. However, by the end of October, the projected cash deficit expands to $16.1 billion, well beyond non-priority spending of only $10.6 billion, excluding tax refunds.

It’s true that the IOUs work only until October.  But the credit rating is specifically tied to, in this case, long-term bonds.  And as I’ve laid out previously, as a matter of law debt service has pride of place in the state Constitution – only education must be funded before it.  It would take something like $50 billion dollars in program cuts before creditors must be paid, which is far less than current debt obligations.

In other words, this is a gouging effort by Wall Street, and the credit ratings agencies are downgrading California simply because they can.  The fact that every single creditor will get paid in full if California has to close every hospital and prison in order to do it is of little consequence.  This is all further reason why the federal government ought to provide loan guarantees to stop the gouging from Wall Street.

I’ve seen a bit of confusion in traditional media accounts of California’s budget situation, and whether or not the state should receive a federal bailout.  This seems to go toward the idea that without federal aid, California will default on its creditors and go bankrupt, and the federal government has a compelling interest in keeping that from happening.  You can argue whether or not it would actually make sense for the state to default – it certainly worked pretty well for Argentina, despite neoliberal fuming to the contrary.  And as noted by Peter Schrag in the above-linked entry, the Governor has never asked for any help of this kind, and given his status as a born-again Friedmanite, would probably reject it.  But Paul Kedrosky, who has read the relevant law, explains in a piece supporting default that California really cannot do so.

The root issue, of course, is that California is insolvent, and irritating people like S&P analysts keep noticing. The state — let’s call it Latvia by the Pacific — has a $24-billion budget gap that must be closed for it to continue operating (and I use that word advisedly). Without a clear sense of how that will happen rational creditors are going to be increasingly skittish about filling the hole. Now, does that mean California can’t sell enough bonds to backfill the gap this time? You bet it can, and it will. This is part Schwarzenegger/Lockyer Financial Theater, and partly a laughably transparent attempt to demonstrate budgetary semi-competency in hopes of a few basis-points of relief on the inevitable bond sale. That’s all.

Because California has $5.7-billion in debt servicing obligations. And while that will grow, debt occupies pride of place in California’s constitution — only education must be paid off before the next slug of cash goes to creditors. Get that? Healthcare, prisons, and other frivolities can all go to rack and ruin, but creditors must be paid, constitutionally speaking. That means, if you’re looking at this through the gimlet eyes of muni-bond ghouls, that California has something like $50-billion in budgetary space to make its $5.7-billion in payments. It’s pretty easy to calculate that California can make the payment nut, even if it has to close hospitals, release prisoners and stop patrolling the highways to do it.

Now, Kedrosky thinks this is theatrical and should not be rewarded.  I say it’s the perfect reason for California, and actually all states with this kind of constitutional arrangement, to receive those federal loan guarantees to stop gouging from Wall Street for short-term bonds.  Not only do Schwarzenegger and Lockyer know we have to pay back all out debt, so do the bondholders and the rating agencies.  It’s almost literally impossible for us to default on those bonds, short of the entire state’s residents spontaneously getting fired at once.  If those loans will obviously get paid back, the interest shouldn’t be set at payday-loan rates.  And the federal government could very easily remedy that situation, at no cost and probably at a profit, as they reaped from the loans to New York City in the 1970s.

Is it a problem that California operates at the mercy of its creditors?  In a sense.  Is there a remedy?  At the least, there’s a way to get some equitability into the process so that we aren’t blowing money on Wall Street firms who have been bailed out by those same Feds ten times over.  In addition, this kind of thing weakens the municipal bond market, and the federal government has an interest in keeping credit flowing through that.

…H/t to John Myers for tracking down the obviously dubious story about Washington rejecting California officials clamoring for a “bailout”.  Nobody was doing any such thing.  They were asking for loan guarantees, which they’ve been doing for months and months.  Horrible reporting from WaPo.  

I heard a bunch of California Republicans yesterday talking about the effort to get the US Treasury to backstop state borrowing as a “bailout,” and the media has fallen for it, using phrases like “California is too big to fail” and other snickering.

This is ridiculous.

Let me explain this fairly clearly.  California will need to borrow billions of dollars to cover their cash flow issues, the same way they do every year.  Traditionally, the money comes in at different times then the money goes out, necessitating short-term borrowing.  Because of the state’s miserable credit rating, the interest rates that investors charge for this borrowing are ridiculously high.  Usually, banks guarantee those loans, but this year they are balking because of the severity of the state’s fiscal picture.  So the state has asked the Treasury to step in and guarantee the loans instead.

This would cost the Treasury Department approximately $0.00 dollars to perform.  Providing loan guarantees simply means that you are insuring against default, which has never happened in the history of California.  Not through the Depression or at any other time.  What this would do is stop Wall Street from gouging the state with abnormally high interest rates, pure and simple.

Here are the words of an idiot:

Rep. Jerry Lewis (R-Redlands) predicted little sympathy for the Golden State on Capitol Hill. “I have the feeling that it’s going to be a long time before Washington decides that they’re going to ask Kansas or Wisconsin to help with California’s funding problem,” he said.

Nobody would be helping anybody.  The federal government would guarantee loans that California would pay back.  This is about lowering interest rates to make the price of short-term borrowing lower.

I understand that President Ford rejected these types of loan guarantees for New York City in the 1970s.  But later he approved them.  By the way, after that so-called “bailout,” every single dollar was repaid by the city of New York.  How on earth could this be characterized as a bailout?  

The Ford Administration, under the direction of Treasury Secretary William Simon, imposed certain conditions on the loan guarantees (which will actually delivered directly by Treasury, so this is somewhat different).  That could also happen here, and the Shock Doctrine possibilities are not pleasing.  Still and all, this savings (which would only represent about $1 billion dollars in all, 1/20 of the current deficit) would not cost the federal government one red cent and thus shouldn’t be used to cram down California in a punitive way.  The possibility exists, but it’s worth the risk.

UPDATE: Presumably because reporters still don’t understand this, Tim Geithner gave an answer today to a question no state was really asking which is being spun as the end of this option, when he plainly states its possibility.

Treasury Secretary Timothy Geithner said the U.S.’s $700 billion financial rescue package can’t be used to aid cities and states facing budget crises.

The law “does not appear to us to provide a viable way of responding to that challenge,” Geithner told a House Appropriations subcommittee in Washington today. Among the hurdles: Money from the Troubled Asset Relief Program is reserved for financial companies, he said.

The Treasury chief said he will work with Congress to help states such as California that have been battered by the credit crunch and are struggling to arrange backing for municipal bonds and short-term debt.

He added that cities and states need to “get deficits down” to aid their credit worthiness, but absolutely did not take the option off the table.

You can browse the Calitics live feed of the Governor’s May “this is not a revise” Revise, if you’re a glutton for punishment.  Basically, Arnold used a taxpayer-funded press conference to scare the public into voting for his ballot measures, vowing to fill a $21 billion dollar budget gap with a mess of cuts, some borrowing, and no new revenues, in taxes or fees, suggesting that the majority-vote fee increase idea would get a veto.  He’s including cuts that would spur the loss of stimulus funds, with the caveat that he would sweet-talk the Obama Administration to allow the funds to go through despite the cuts.  He’s floating a raid of state and local governments.  Essentially he’s lined up fully with the right wing of the Yacht Party to drown the state and make it impossible to climb out of this recession.  Calitics will have more coverage of this in the coming days.

So, with that, a bit of more promising news.  The state’s Congressional delegation will fight for a federal backstop for California’s bonds.  Well, at least the Democrats in the delegation.

“California faces a tremendous budget deficit and cash flow crisis, which requires immediate attention,” said Democratic Rep. Doris Matsui of Sacramento. “There is no panacea for addressing California’s budget issues at the federal level. However, it’s time for the federal government to step in and temporarily guarantee bonds until the economy improves.”

Matsui is working on a bill with Democratic Rep. Barney Frank of Massachusetts, the chairman of the House Financial Services Committee.

Proponents say they’re not asking Washington for a bailout, merely trying to lower the state’s borrowing costs by having the federal government back its loans.

Critics say it would be a drastic mistake that would jeopardize the federal government’s AAA credit rating, noting that California ranks as the worst credit risk among the 50 states.

“That’s never been dhttp://www.blogger.com/img/blank.gifone, and I think it’s never been done for good reason,” said Republican Rep. Dan Lungren of Gold River.

He said the federal government can’t afford to back bonds for every state, adding: “If California does it, other states are going to be standing in line, with New York right behind them.”

Does Dan Lungren have a functioning brain?  A federal backstop would cost the government $0.00 dollars.  The guarantee would lower borrowing rates.  The chances of the state defaulting on these loans is about 0.000001%.  California has never done so in its history, as much as the Yacht Party would like it to happen (then they’d get the REAL reform, is I believe how it goes).  Ultimately this would save the state $1 billion dollars in interest on these loans.  The federal government has spent $700 billion on the same financial firms trying to gouge the state on these bonds.  I think it’s a fair trade.

Not that $1 billion is more than a drop in the bucket in the overall picture of things, but I figure you need a little sugar with your rainstorm…

In this edition of “Did you know?” we take a look at Prop. 1C.  Sure, the ballot statement, the legislative analyst’s report, and every public utterance about Prop. 1C to date asserts that it would allow the state to borrow $5 billion dollars against future lottery revenues.  But did you know that, according to Darrell Steinberg, it would actually allow the state to borrow twice that?

Trailing badly in the polls, Proposition 1C would infuse the state budget with cash by borrowing against future California Lottery revenues. The February budget assumed that it would provide $5 billion for the 2009-10 budget. But Steinberg said he now believes the state could borrow $10 billion from the Lottery and use it all in 2009-10.

Consider it something of a “Hail Mary” argument for Proposition 1C.

“In my view we can triage our way through an $8 billion problem,” Steinberg said. “That doesn’t mean that there won’t be some difficult choices. But, you know, we have a $2 billion reserve. There may be other opportunities with federal economic stimulus … If 1C passes, you know, it’s actually a $10 billion one-time securitization. It was just contemplated as being spread across two fiscal years. You could bring the second $5 billion into the budget year.”

What fun things you learn when your proposition trails in the polls!

Let’s go to the summary of Prop. 1C, shall we?

Impact on 2009-10 State Budget: Allows $5 billion of borrowing from future lottery profits to help balance the 2009-10 state budget.

Hm, no mention of future state budgets there.  But yes, the Senate President Pro Tem is correct.  In the analysis by the Legislative Analyst, he mentions that “the state also could borrow more from lottery profits in future years.”  In fact, the $5 billion dollar figure appears nowhere in the text of Prop. 1C.  Here’s the relevant portion of the text:

(2) Notwithstanding any other provision of law or this Constitution to the contrary, the Legislature is hereby authorized to obtain moneys for the purposes of the California State Lottery through the sale of future revenues of the California State Lottery and rights to receive those revenues to an entity authorized by the Legislature to issue debt obligations for the purpose of funding that purchase.

Well, that would be interesting to know before voting, wouldn’t it?  That this proposition basically opens up a new state credit card for the potential purpose of endless borrowing?  Borrowing that would have to be paid back, with interest, for the next several decades?

California’s reliance on borrowing to cover the budget deficit has been part of the landscape for 30 years.  Debt service currently costs the state $5 billion a year.  If you think this is a good idea, I invite you to enable it by voting to allow basically limitless borrowing against the lottery.  Surely that won’t be abused.

…by the way, the depiction by Steinberg of $8 billion dollars as a niggling problem not to be trifled with, but $14 billion as simply insurmountable, is another new one.  Considering that Steinberg and the Senate passed a majority-vote fee increase of around $9 billion last year, more than the $6 billion allegedly at stake in the special election, and his description of how to fill the budget gap did not include this, forgive me for saying that his beliefs don’t hold up to scrutiny.

There’s a very pernicious habit in California of turning away from budget issues once a crisis is averted, in a show of relief that we will at least get a small reprieve from having to deal with the contentious battles for a period of time.  This false sense of security is bad enough in regular years, when the budget is cobbled together through borrowing against the future and no long-term solutions are implemented.  In this dynamic economic crisis, when rosy outlooks can darken in a matter of days, it’s downright foolhardy.

Greg Lucas at California’s Capitol has been one of the louder voices in insisting that the budget crisis is not at all over.  According to Controller John Chiang, revenue in February was $900 million dollars below estimates.  Now, if you extrapolate that out, we’ll be in a $10-$12 billion dollar budget hole by the end of the year just if things remain at the same level.  This is of course unlikely, as the February national job numbers showed.  So much of the tax increases passed in the February 19 budget solution are tied to employment – an increase in the income tax, and sales tax increases that of course rely on residents having purchasing power.  In addition, these lean economic times will push more people into needing state services, like unemployment and Medi-Cal.  Then there are the counter-cyclical increases and cuts that are working against what the economic recovery is attempting at the federal level.

In addition, many of the spending and taxation decisions made in the recent budget cancel out some of the benefits to California of the American Recovery and Reinvestment Act.

The federal package provides an estimated $13.1 billion in refundable income tax credits for middle to low-income Californians at the same time the state budget includes $12.2 billion in tax increases, only some of which are deductible. And only half of taxpayers deduct.

The federal bill includes a one-time $250 payment to the state’s aged, blind and disabled poor at the same time the state is reducing the maximum grant for an individual by $37 a month, $444 annually.

“California is roughly an eighth of the nation. The impact of this is sufficiently large that it could affect the prospects of recovery for the nation as a whole,” said Jean Ross, director of the California Budget Project, who has been examining how the state’s budget interacts with the federal stimulus package.

The biggest short-term issue is cash.  Lucas did an interview with John Chiang where he admitted that we will still need to borrow against the anticipation of future revenue as early as April, to the probable tune of $1.5 billion.  Because the budget deal was completed too late to include changes to the income tax code, those revenues will not come in until the following tax year.  The sales tax will go up April 1, but that will not be enough to cover expenses.

CC: Is February a big month for obligations?

JC: No. April is the real difficult month. If we don’t get that RAN, we’re $636 million in the red. But then the bigger issue is July. When we walk into the next fiscal year we will need a massive cash infusion.

CC: How come?

JC: We always borrow at the beginning of the year, 25 out of the last 26 anyway and then in April we make up the difference. But this year we walk in with weakness into the next fiscal year. There are less tools in the tool kit.  We’ll need a massive RAN or RAW (Revenue Anticipation Warrant).

Remember these last budgets borrow $16.5 billion from (state) special funds to backfill the general fund. So if we have any emergency in the state requiring aid from one of those special fund departments, the state is in trouble. Over 1,100 special funds in the state and we borrowed from over 650 of them. Part of this last budget solution gives us the ability to borrow another $2 billion more. The governor’s budget has us borrowing $11 billion from special funds over the next 18 months.

So we’re going to have to do some outside borrowing for the next fiscal year. Period.

And of course, there’s very little anticipation of the worsening economic picture in the budget, meaning that we’ll be in unquestionably worse shape by summer.  And the cash crisis, forcing short-term borrowing, really impacts selected projects that go out into the bond market, for example infrastructure like the high speed rail project, which will basically have to shut down if there isn’t a quick infusion of cash.  Keep in mind that California has the worst bond rating in the country and the credit markets are still not that friendly to the state.

Another pressing matter is the determination of how much money from the federal stimulus will be available to the state to fill budget holes.  There is a “trigger” in the state budget that would actually reduce some cuts – most of them the worst of the worst, particularly in health care for the needy – as well as reverse increases to the income tax, if at least $10 billion dollars in federal money hits the state budget.  It’s not just that money comes in, it’s that it has to go toward general fund relief in order to contribute to the trigger.  And Mike Genest, the Governor’s finance director, has a preliminary estimate up showing that the state will come up short.  This is insanity.  As the California Budget Project noted on a conference call today, there will be many billions above the trigger number available to the state, the legislature need only craft the receipt of that money in such a way to hit the trigger.  Otherwise, they are raising taxes and cutting services, and needlessly so.  One such bill would change Medi-Cal eligibility requirements to free up as much as $11.23 billion over 27 months.  That should happen ASAP.  Democrats are trying to write this as a special session bill and ensure that it requires only a majority vote.

The main point here is that we remain in crisis mode with the state budget, and will continue for years upon years until we stop putting off the fundamental, structural solutions the way we constantly do.  For example, the prison system remained virtually untouched during the budget crisis, despite being both crippling to the bottom line and unconstitutional in its overcrowding and inability to provide health care.  We desperately need structural changes with how the state budgets, and those will only be accomplished by demolishing the conservative veto over the process and repealing the 2/3 rule.

UPDATE: Here’s a link to the CBP study of the American Recovery and Reinvestment Act, identifying as much as $50 billion dollars available to the state in funding.  Surely the legislature can figure out how to capture 20% of that and set off the budget trigger.

While we push for this program or that program to be kept out or left in the final budget, the investor class has rendered their verdict on California, and you can hardly blame them.

The downgrade of $46 billion of California’s general obligation bonds by Standard and Poor’s on Tuesday sets the stage for similar actions by Moody’s Investors Service and Fitch Ratings as the state’s budget crisis persists, analysts said on Tuesday.

“It’s a red flag,” said Christopher Thornberg, an economist with Beacon Economics in Los Angeles. “What they’re responding to is the fact that the state is running out of cash.”

S&P cited the state’s weakening finances and slow talks between Gov. Arnold Schwarzenegger and lawmakers over closing a budget gap topping $40 billion through this fiscal year and the fiscal year beginning in July.

The agency cut its rating late on Monday on California’s GO debt, which is backed by the state’s general fund, to “A” with a stable outlook from “A+.”

The final straw was California’s cash shortage. “It just to us indicated another level of distress in the overall situation,” said S&P director Gabriel Petek.

What this means is that the value of outstanding bonds will be lowered, and more importantly, it will become incredibly steep for the state to borrow money.  If you weren’t aware, that’s how we finance the state.  It will not be possible to do so at usurious rates, which we brought completely upon ourselves, and so there is now no reasonable way out of the death spiral.  No matter what the budget solution.

Congratulations, Yacht Party.  You sunk California.  Have fun living in it.