Measured Reaction to Governor’s Bond Plan

Gov. Arnold Schwarzenegger pledged during the recall election campaign to put California’s finances in order. So Tuesday, in his first move on that score, he proposed that the state borrow $15 billion, like some credit card junkie trying to consolidate his debts.

Off to a lousy start?

Not judging by the reaction from the municipal bond market, the mechanism through which California will borrow the money if voters approve the debt issue in March.

After the governor announced his proposal, no frenzied trading in California securities ensued -- even though the bond issue would be the largest borrowing ever undertaken by a state or private corporation, surpassing General Motors Corp.’s recent $13-billion deal. No howls of protest rose up from managers of municipal bond funds.

Rather, traders seemed intent on giving the new governor a pass -- a reasonably accepting, if muted, welcome to office.

One big reason for this reception was that Schwarzenegger coupled his bond proposal -- which effectively replaces a $13-billion borrowing plan offered up by Gov. Gray Davis to cover the state’s looming deficit -- with a spending cap on future state budgets.

“A spending cap,” says Joe Deane, a manager of Smith Barney’s California Municipal Fund, “is sorely needed.”

Actually, Sacramento has a spending cap on the books now. But it’s effectively a dead letter. What the market seems to be hoping for is that Schwarzenegger’s political muscle will match the set he developed at the gym, giving him the ability to wring real budget cuts out of the Legislature.

“The market wants to see a plan for controlling spending” -- not just a cap without any specifics attached to it, says Robin Rappaport, senior municipal credit analyst for Payden & Rygel, a Los Angeles investment firm.

An inability to get a handle on the budget already has cost the state dearly. Investors in California general obligation bonds have driven Sacramento’s borrowing costs to the highest level of any major state.

Not everyone is convinced that Schwarzenegger has the stuff to turn the situation around. California Treasurer Phil Angelides, who is positioning himself to take on Schwarzenegger in the 2006 gubernatorial race, blasted the bond proposal Tuesday.

“A balanced budget should be the first step to California’s fiscal recovery, and borrowing $15 billion is not the way to go,” Angelides told reporters. As to the proposed spending cap, the Democrat called it “the illusion” of fiscal restraint.

“If you are in debt,” Angelides said, “and you say, ‘Well, we’ll just spend at this level but not add to it,’ you are not moving toward a balanced budget.”

Marilyn Cohen, president and chief executive of Envision Capital Management Inc., a Los Angeles investment firm, agrees that the added borrowing is simply putting off the kinds of hard choices that need to be made.

“When the rubber band snaps,” she says, “it could be painful.”

Some in Schwarzenegger’s camp appear to be counting on the recovering economy to swell the state’s tax receipts and ease the budget crunch. Researchers at Chapman University -- whose president, James Doti, is an advisor to Schwarzenegger -- predict that the deficit for 2004-05 could come in at $2 billion or less.

But others, including some of the governor’s closest aides, are far less sanguine.

Finance Director Donna Arduin, for one, has predicted that next year’s deficit could reach $14 billion.

Details of the Schwarzenegger spending cap were not announced Tuesday, but people familiar with the plan said it would limit future growth in spending to the rate of California’s population increases or the rate of general inflation.

Still, the question remains: How exactly will the pols get there?

The bottom line is that the governor and lawmakers on both sides of the aisle have myriad reductions in spending to spell out. A cap is fine. But the devil remains in the details.

“If the markets sense that a limit on spending will bring stability to California’s finances, they will support the borrowing,” says John Fitzgerald, head of a Los Angeles-based underwriting firm that helps California towns and cities issue bonds.

If not, expect a much louder -- and harsher -- response from the markets before too long.

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James Flanigan can be reached at jim.flanigan@latimes.com