State Has No Way to Avoid Loans

California will face borrowing billions of dollars this year, no matter what voters decide on Gov. Arnold Schwarzenegger’s March 2 ballot initiative to reduce the state’s budget shortfall with a $15-billion bond sale, administration officials say.

“The choice isn’t borrow or don’t borrow,” said Finance Director Donna Arduin, explaining that there is no way to cope with defeat at the ballot except with more financing. Even with massive cuts and tax hikes, she said, the state still wouldn’t be able to generate enough money to pay all of its bills come June.

“The scenarios we’ve run through -- all of them -- include borrowing,” Arduin said. “The backup plan is borrowing.”

Financial analysts agree that it would be extremely difficult to avoid borrowing at this point. But they warn that most backup scenarios would be risky and could lead California further down a path similar to that taken by New York City in its 1970s-era financial crisis.

The governor so far has framed his initiative as a choice between selling bonds or making severe cuts and raising taxes. Now the administration is warning Californians that rejecting the bond sale would not put an end to borrowing; it simply would make it more financially perilous.

Even so, Schwarzenegger has pitched the bond measure as a move to empower the public rather than to allow politicians to choose the state’s course.

“I don’t trust the politicians in Sacramento,” he said at a town hall meeting Thursday in Irwindale. “I have to be honest with you. I don’t want them to decide what happens in the state. You should decide what happens in the state.”

Should voters reject the plan, Schwarzenegger would be in the awkward position of trying to move ahead with an alternative bond sale without voters’ consent.

Bond analysts agree that the governor’s choices are limited and that the required cuts might be too painful to pull off.

“I don’t think you can cut the budget enough to compensate for it and allow a reasonable operating level to be maintained,” said John Hallacy, managing director of municipal research at Merrill Lynch. “In many respects, it is not really feasible.”

In warning that the state will have to borrow, regardless of what the voters decide, the governor blames overspending by the last administration. But he also has contributed to the shortfall by fulfilling a campaign promise to kill last year’s vehicle license fee increase.

“Yes, we are stuck with it because it is inherited debt,” Schwarzenegger said at a news conference last week in response to questions about the inevitability of borrowing. “It’s a problem that I inherited over when I got into this office. And this is the only way to get out of the problem.”

On the March 2 ballot, the bond issue will appear as Proposition 57. Also on that ballot will be Proposition 58 -- the governor’s “never again” constitutional amendment -- which would restrict the state’s ability to sell deficit bonds in the future. Both measures must pass by majority vote to take effect.

Should the bond package fail, administration officials say, the resulting shortfall of nearly $30 billion through June 2005 would force them to pursue other loans immediately.

State Controller Steve Westly, a Democrat who is co-chairman of the campaign for the bond measure, said that if voters reject the governor’s ballot measure, “we would, in effect, be handing control of the state of California’s checkbook over to Wall Street.” The state would immediately need to come up with a plan for paying off billions of dollars in short-term loans that come due in June.

Administration officials said they would try to bridge that gap with $10.7 billion in deficit bonds approved last year, but which the governor abandoned in favor of his ballot measure. The legality of that borrowing remains in doubt, however, and Schwarzenegger referred to that bond issue last week as “magic” that the state shouldn’t count on.

The Pacific Legal Foundation filed a lawsuit to have it blocked, alleging that it violates a constitutional provision that prohibits borrowing to close deficits without voters’ approval.

“I think the odds are relatively high that it will be struck down in court,” Westly said.

Concerns that the court might kill the backup bond measure have some in the administration discussing alternatives. Among the options is putting together another bond sale and trying to hold a special election for voters to approve it, one advisor said.

Should all of that fail, state officials would have to try to work out a plan with the banks scheduled to collect from the state in June to refinance $14 billion in loans, extending their repayment for another year.

Rolling over the loans in such a way would cost taxpayers hundreds of millions in additional borrowing costs, financial analysts say.

Arduin has suggested that it also could require the state to make $12 billion in additional cuts immediately. “That’s the only way we could show them we could actually repay them,” she said.

State Sen. Tom McClintock (R-Thousand Oaks), an opponent of the governor’s bond plan, suggests that the administration is overstating the cost. He wants to roll over the loans, and make a 13.4% across-the-board cut in government services that he says would make the state deficit-free by mid-2005.

“We will have to rely on the good judgment and good sense of the people not to become the first generation in this state to pass on their day-to-day expenses onto the next generation,” McClintock said.

Financial analysts say a proposal like McClintock’s is fine with them, but they doubt that there is the political will for it. And though they acknowledge that the banks might be somewhat flexible in crafting a payback plan, they warn that the state is relying on them for a huge amount of money, and that there is a point where those banks won’t be able to keep giving.

“Ultimately, everyone wants to be taken out and made whole,” said Hallacy of Merrill Lynch, adding that California risks repeating the mistake New York City made in the 1970s when it kept relying on banks to roll over its loans. When they finally refused and the city lost access to the markets, it triggered a cash crisis.

“The banks kept lending money short-term and it seemed like the budget wasn’t getting resolved,” he said.

“That memory still lingers over the market here, almost 30 years later. For people in the industry who have studied credit over the years, it is a pretty fresh memory.”