State’s Credit Rating Slashed

California’s credit standing was lowered three grades Thursday, and two hours later Senate leaders announced that a state budget agreement had been reached and would be passed by their members on Sunday.

If the leaders can deliver the votes of other lawmakers as expected, the deal would signal the end of a months-long stalemate over how to resolve a $38-billion shortfall that has threatened to cut off services to millions of Californians.

The credit downgrade had an immediate political impact in the Capitol, where lawmakers worried about being blamed for the state’s financial slide.

For the last several months, officials of Davis the administration have been using the fear of Wall Street as a goad to push reluctant legislators toward a deal.

Legislative leaders spent Thursday morning denying that an agreement was close. But soon after the rating news, Senate President Pro Tem John Burton (D-San Francisco) and Republican leader Jim Brulte of Rancho Cucamonga confirmed the deal. They insisted that the downgrade did not compel their announcement.

The change in credit status “is unprecedented bad news that will send shock waves throughout the nation,” said Controller Steve Westly. “It is a very sad day for California. This damages California’s financial reputation and can take years to dig out from.”

Bond analysts were more temperate, however.

“It is a bit of an alarm,” said Lauren Post, head of municipal bond research at Stone & Youngberg in San Francisco, one of the state’s largest bond underwriters.

“We are going to urge our investors not to panic,” Post said. “These bonds are backed by the full faith and credit of the state, which has an obligation to tax as needed to pay off these securities.”

In a move that will cost investors and state taxpayers hundreds of millions of dollars in additional interest and fees, Standard & Poor’s dropped its measure of California securities from an A rating -- already the lowest of any state in the nation -- to BBB, the last point at which offerings are considered “investment grade.” California’s state-backed obligations have never been so poorly regarded.

Standard & Poor’s officials made clear that any move to effectively paper over the shortfall by borrowing huge sums -- as the Senate compromise proposes -- would leave a structural imbalance between what the state spends and what it collects in revenue.

The rating downgrade was a resounding vote of no confidence in the Legislature and Gov. Gray Davis over their failure to resolve a fiscal crisis that has steadily worsened during the last three years. Under the spending plan worked out in the Senate, officials said, a $7.9-billion shortfall would emerge next year.

“Just bonding your present deficit and not doing anything to close the hole where you are leaking red ink is not progress,” said Steven Zimmermann, managing director of S&P;’s western region. “We want to see movement toward closing the structural imbalance.”

Burton said the rating action did not force the budget deal.

“I don’t care about Standard & Poor’s, and I don’t care about Wall Street,” Burton said. “I care about 27 and 54 and a signature.”

He was referring to the supermajority of votes necessary for the Senate and Assembly to pass the bill and send it to Davis for signing. The Senate budget proposal calls for obtaining billions of dollars in loans, primarily $10.7 billion in borrowing to roll over part of the deficit into the next five years.

Burton said he is unconcerned about getting those loans or repaying them. “The money will be there to pay off the bond,” he said. “It is that simple.”

State Finance Director Steve Peace said that although the money may be there, borrowing it could cost California hundreds of millions of dollars more.

The credit downgrade, he said, will have the immediate impact of adding $34 million to the cost of an $11-billion bridge loan the state has outstanding.

That borrowing, completed last month, was necessary to pay off earlier loans and provide enough cash to keep the state afloat through August because the budget debate extended into the new fiscal year.

Any further drop in the credit rating would result in additional payments to a syndicate of banks that guaranteed the state’s borrowing.

S&P;’s action also could drive up costs for other bonds that the state is preparing to sell.

“There’s no reason for [institutional investors] to go to California when they can put the money elsewhere with less risk,” Peace said. “So they’ll demand as a condition of continuing to invest in California a higher interest rate, a higher price.”

Peace said that also will result in cities and counties having to pay more to borrow.

“There’s a psychology in the market that influences the whole package of California paper,” or debt, he said.

The BBB level is “an extremely low rating for a state,” said S&P;’s Zimmerman.

Since the peak of the stock market in 2000, California’s credit rating has dropped sharply as income tax revenue from capital gains on stocks and stock options went into a free fall.

“It is going to be very difficult for us to borrow more money at all,” Westly said. “Very few people are going to have an appetite for California paper.”

The drop to BBB is not unprecedented. Louisiana and Massachusetts also have been at that level, although they are higher now.

Securities traders said they didn’t want to speculate on how much yields on California’s general obligation bonds would rise as a result of the downgrade -- something they will find out today when the bond market opens for trading. California was already paying more interest than higher-rated states.

The budget deal to be voted on Sunday in the Senate includes no additional cuts to kindergarten through 12th-grade schools, but makes significant reductions in some health-care programs and a $1.2-billion cut in aid to local governments, officials said.

The proposal also includes a tax swap between state and local governments that would provide $2.3 billion annually to pay for the deficit loans.

The state would take a half cent of sales tax revenue from cities and counties, and local governments would be reimbursed with an equal amount of new property tax revenue that has been going to the state.

Democrats had long resisted the swap, pushing instead for a sales tax increase that would create a new revenue stream to finance the deficit. But Republicans refused to approve any new taxes. The swap compromise would result in a net loss for the state, and that forced Democrats to accept more cuts.

Yet Burton said that despite more trims in Medi-Cal and other programs, Democrats were able to limit the pain to the poor. He said his GOP counterpart, Brulte is “happy with the ‘no tax’ thing and I’m happy with the protection of the aged, blind and disabled.”

As for the $7.9-billion budget hole that would occur next year under the plan, Brulte said it is a major improvement over where the state is now.

“No matter how much I would like to, I do not know how to eliminate that deficit that took three years to create in one year,” he said.

“And if at the end of the day, we come back here next May or June with a $7-billion or $8-billion problem, instead of a $38-billion problem, I consider that a huge step forward.... I’m absolutely convinced the [financial] markets will consider it a huge step forward.” Davis praised Brulte and Burton for striking a deal and called the rating action “our latest and loudest wake-up call,” adding that “it’s imperative that the Legislature pass a budget and pass it quickly.”

A spokesperson for the governor noted that the agreement reflects much of what was in the budget Davis proposed in May.

Times staff writers Carl Ingram and Debora Vrana contributed to this report.