Vendors May Get Burned in Budget Fight

With little evidence of progress toward a budget deal in Sacramento, California finance officials are bracing for the state treasury to run dry this summer and are making lists of whose checks will be cut off first.

The situation is sufficiently grim that the state controller already has begun to design IOUs that could be doled out in lieu of cash to vendors who do business with the state. Some contractors, including those who run nursing homes, worry about their ability to weather the crisis and about the effect it could have on the people they serve.

“This is the situation of last resort,” Controller Steve Westly said. “But if the pieces do not fall into shape, we will need to do this. We will be prepared to do it.”

Faced with dwindling options, the controller’s office has held meetings with the legislative caucuses to impress on Democrats and Republicans the stakes if they fail to resolve their differences on how to close an estimated $35-billion budget gap in the next 15 months.

So far, however, there are few signs that the warnings have jarred legislators into action. More than four months after Gov. Gray Davis first warned of a record shortfall, the Legislature has adopted about $3.3 billion in cuts and fund shifts, far less than the administration says will be needed to get through the current crisis. The Legislature has yet to adopt any tax hikes, despite Davis’ argument that more than $8 billion worth are needed.

As the Legislature returns this week from its spring break, Democrats continue to insist that the solution to the budget shortfall must include tax increases as well as service cuts. Some Democrats pledge to protect favorite programs from deep budget reductions. Republicans say tax hikes would deepen the state’s economic problems and vow to reject them. Neither side has budged from those positions.

The financial picture will get clearer in the coming weeks, after the state gauges recently filed income tax payments. New revenue projections for next year in Davis’ May budget revision will also be a factor. So far this year, however, revenues have been lower than projections.

Ted Gibson, former economist for the state Department of Finance, said the state’s budget problem is getting worse. When revised budget figures are released next month, Gibson predicted, the government will be in even more serious trouble.

Gibson said spending is running $3.5 billion to $4 billion higher than anticipated in the current budget. That means the state is depleting its cash faster than expected.

“The cash,” he added, “is your worst nightmare.”

Recent history does not give much room for optimism about an early resolution to the standoff. Last year, faced with a far smaller shortfall, legislators still failed to adopt a budget until early September, more than two months late.

“It is quite clear that a budget as late as last year is not going to work,” state Deputy Controller Mark Battey said. “We’ll be out of cash before then.”

Westly has assigned a team to work out legal and administrative details of what to do if that happens.

The plan, for the moment, is to borrow as much as $11 billion in June to meet current-year obligations and to pay expenses through much of the summer. If that money runs out before the state has a new budget, California could try to borrow more. But if the market isn’t willing to issue new bonds, Westly will have to begin delaying payments or issuing IOUs.

Who would be hit first would depend on a priority list that Westly and his staff are drafting to designate which obligations will be paid and in what order. Westly said state law gives education first claim to any available cash, followed by service of outstanding debts. After those, the choices become more delicate.

Westly’s chief of staff, Greg Larson, said the options have become “more problematic and difficult” in the decade since the state last faced a cash-flow crisis approaching this magnitude. In those days, the state paid its workers with IOUs, called registered warrants, which workers could then take to banks in exchange for cash under deals for repayment later. Since then, however, a federal court ruling has banned that practice; it requires that state workers receive their salaries on time and in negotiable checks, he said.

The state could still issue those warrants to contractors or vendors, but the IOUs may be worthless until the state has the money to cover them, because banks may refuse to honor them.

Since the crisis of 1992-93, the state’s two resident banks, Bank of America and Wells Fargo, have moved their headquarters elsewhere. Officials once appealed to them as California companies with a stake in the crisis, but those banks now are less interested in helping out, state officials say.

“In our initial conversation with banks, we don’t believe registered warrants will have the liquidity that they did in ‘92-’93,” Battey said. “It’s just a different world than it was 10 years ago.”

A Bank of America spokesman, Ken Preston, said that bank, which has more retail deposits than any other bank in California, would not discuss what it might do if the state issues registered warrants instead of regular checks this summer. “We would make an announcement at that time,” he said.

To meet its obligations, the state has been piling up debt since it dipped into the general fund to pay energy bills in 2001. A $12.5-billion package of short-term notes taken out last year comes due in June. Westly and state Treasurer Phil Angelides are now testing the financial markets for a new set of notes totaling $9 billion to $11 billion, the maximum allowed under a formula written into state law.

Westly and Angelides plan to go to Wall Street in the last week of May to firm up the loans.

Once the new fiscal year begins July 1, pressure will mount steadily on the state’s treasury until the Legislature adopts a new budget. That’s because revenue is typically lean in the summer, meaning that most expenses will have to be paid out of the money borrowed in June.

At the point the loans run out, expenses would exceed revenue, and the state would have to go on an emergency footing.

If it turns to Wall Street, the terms could be severe, said David Hitchcock, state and local rating director for Standard & Poor’s and a veteran of the 1992-93 crisis.

Investors refused to buy the bonds until the state agreed to make across-the-board cuts if it couldn’t pay on the due date, Hitchcock said of the budget trouble that year. Besides losing services, Californians had to pay higher interest costs, which could happen again. And this time, the cuts could run deeper.

To help paper over the cash shortage, the state could delay payments to contractors or issue them IOUs, but that course also has consequences.

Nursing home operators, for instance, already are being asked to accept a 10% reduction in Medi-Cal reimbursement under Davis’ proposed budget for the coming fiscal year. If their money is held back by a broke state government unable to make payments, the implications will grow even more severe, operators said.

Operators said they could handle a brief delay. But if it goes on for a month or more, patients would receive poorer service, said Charles Bruffey, manager of two homes in the Bay Area.

“Nursing homes typically don’t have big reserves,” Bruffey said. “I can’t stop paying the electric company. I can’t stop paying for food. The one thing I can do, I can trim hours.”

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Times staff writer Jeffrey L. Rabin contributed to this report.