Banks Put on the Spot

After Gov. Gray Davis huddled with Wall Street bankers last week as the Legislature scurried to cut the state budget, he announced that every major investment firm had told him that California can borrow to resolve its $35-billion financial crisis only if it raises taxes.

Sources with knowledge of the meeting and the firms, however, say nothing so clear-cut was said.

“I don’t know the group was necessarily presenting it in that manner,” said one banker who was at the meeting but would speak only if not identified. While Wall Street executives told Davis there must be a dedicated revenue stream to support repayment of the $10 billion or so that California is expected to seek, the banker said, “it doesn’t necessarily have to be in the form of a new tax.”

Whether or not Davis misspoke -- an aide insisted last week that he did not -- the governor has good reason to imply that Wall Street is laying down the law. As budget negotiations move into their most difficult stage and lawmakers are faced with either making crippling cuts in government services or raising at least some new taxes, many are positioning themselves behind the pinstriped suits from New York for political leverage -- and cover.

Democrats haven’t been able to get Republicans to budge from their fundamental anti-tax stand, so they are hoping Wall Street can do the pushing for them. The argument goes like this: Without new taxes, there will be no way to finance the debt, and without doing that, the state steadily goes broke. So Republicans would be left with no choice but to fold -- if Wall Street is really saying what Davis has relayed.

A bonus for the governor, who faces political problems of his own amid an effort to recall him, is that he can argue it was Wall Street that forced a sure-to-be unpopular sales tax increase and not he.

Assemblyman Joe Canciamilla (D-Pittsburg), a moderate Democrat who has been working on bipartisan budget solutions, warned in a speech several weeks ago that this was coming.

“There are many of my colleagues on both sides that love the prospect of jackbooted investment bankers marching in from the East Coast, telling us what we are going to do to balance the budget,” he said. “And then, guess what? We can say it wasn’t our fault. We didn’t do this; they told us we had to do this. The ever popular and infamous ‘they.’ ”

So it follows that, if there are Republicans who believe that any reasonable solution to the budget crisis should include a new tax, arguing that Wall Street forced them to support it gives them the cover to vote their consciences without committing political suicide. In years past, several Republican legislators who voted for tax increases went on to lose primary elections to more conservative anti-tax candidates.

So far, no Republicans have acknowledged publicly supporting a tax hike. But several say they are eager to hear from Wall Street.

Today, representatives from bond rating agencies and other financial firms will make a presentation before the bipartisan group of 18 lawmakers working on budget solutions that Canciamilla leads with Assemblyman Keith Richman (R-Northridge).

Also this week, the Department of Finance and the controller’s office are hoping to bring bankers from several major investment firms before the Democratic and Republican caucuses in the Legislature to answer questions about conditions that could be placed on borrowing to make it acceptable.

Many members of the bipartisan group support a plan to pay off $10 billion of the state shortfall with bonds that would be financed over the next five years. Richman said a key question will be whether new taxes will be required to do that.

“It’s important we hear from the financial community whether or not we need a dedicated revenue stream that is a new source,” he said, though the answer his group receives will probably be that it’s up to them.

Which revenues should be used to back up the bonds “really is a legislative issue,” and is not something that Wall Street will dictate, said the investment banker who attended the Davis meeting.

Steven Zimmerman, a bond rater at Standard and Poor’s who did not attend the Davis meeting, said his firm’s concern is only that the state gets to a point where it is not spending more money than it brings in. How that happens is not its concern, he said, as long as the numbers work out.

“We don’t have a position over how revenues and expenditures should be balanced,” Zimmerman said. “We just want to see that they are, and it is not smoke and mirrors.”

Pressed on the details of the meeting, Davis and the administration finance director, Steve Peace, each said there was “no dissension” among the bankers they met with -- including representatives from Merrill Lynch, Bank of America, Goldman Sachs and Lehman Brothers -- that any borrowing to cover part of the shortfall would have to be financed by a new tax. Davis said the tax could be temporary, but the bankers said it needed to be a new revenue source.

An aide who attended the meeting said Davis asked the bankers at one point if everyone agreed that a new tax would be necessary to support the borrowing, and all the bankers nodded. However, three people who were at the meeting said that, although there was consensus that new taxes are the best way to go, Davis didn’t press the bankers on whether loans could be secured without them.

State Treasurer Phil Angelides, also a proponent of new taxes, picked up on Davis’ theme Friday and told reporters in a conference call that he was getting every indication from Wall Street that new taxes were needed.

“This does fall in the category of nonstarters in terms of our knowledge of financial markets,” Angelides, a Democrat, said of the Republican plan to finance the proposed $10-billion borrowing with existing sales tax revenue.

Controller Steve Westly was more measured. He has been getting clear messages from Wall Street, Westly said, but a warning that taxes must be raised has not been among them.

Though Westly has urged lawmakers to reach a budget solution that includes a balance of spending cuts and new taxes, he said attorneys in his office have concluded that the debt could be paid back over time without a new tax. However, Westly and others say that doing so would devastate government services.

Some Democrats, meanwhile, caution the governor not to overplay the Wall Street hand. They warn that it could backfire among veteran Republicans who vow that New York bankers are not going to tell them how government should be run.

Senate Republican Leader Jim Brulte of Rancho Cucamonga is one of them. Asked how he would proceed if Wall Street approaches him with the message that taxes must be raised to get loans, Brulte’s response was unequivocal: “Then we won’t do any borrowing.”

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Times staff writer Gregg Jones contributed to this report.