California’s a fiscal mess, but debt isn’t the problem

Market Beat

California took a record 100 days into the new fiscal year to nail down a budget, and that plan already is sporting a gaping hole.

Now, the state will go to investors to borrow $14 billion in the next two weeks.

If you don’t read much beyond those headlines, it’s easy to send the outrage meter spinning well into the red zone. How can California, with such horrendous financial problems, dare to dig itself into a deeper debt chasm?

And why would investors be willing to fork over their money to a state that looks more fiscally dysfunctional than ever?


Yet the dots don’t quite connect the way the outrage-prone might prefer. The borrowing spree that Treasurer Bill Lockyer is about to launch isn’t about trying to paper over short-term budget troubles with long-term debt.

Rather, about $10 billion of the borrowing is a short-term loan the state typically takes out at this time of year to tide it over, awaiting the bulk of tax revenue to arrive in winter and spring. That loan, though larger than usual this year because of the late budget, still must be repaid by next June 30, before the current fiscal year ends.

The rest of the debt will be long-term bonds to fund construction that voters have mandated in recent years by approving ballot propositions for schools, roads, water facilities and other big-ticket infrastructure projects.

To put it another way, this borrowing wave isn’t going to fix the $25.4-billion budget deficit expected to accumulate by mid-2012, as estimated this week by the state’s chief fiscal analyst.

While some investors understandably prefer to steer clear of lending money to California under the circumstances, others continue to see opportunity in the state’s woes. A financially struggling borrower, after all, has to pay higher interest rates for money than one whose credit is gilt-edged.

California’s entrenched budget problem now is infamous, and it’s the primary reason the state has the lowest overall credit rating in the Union.

But odd as it may sound, what the state doesn’t have, so far, is a debt problem. “That’s not one of the negative drags on the rating,” said Gabriel Petek, the primary analyst tracking California for ratings firm Standard & Poor’s.

The state can keep borrowing because its long-term bond debt load of $90 billion still is judged to be reasonable by Wall Street, given the size of the economy. By key measures, the debt is less than the burden carried by such states as New York, Delaware and Hawaii — though far above the levels carried by low-debt states such as Texas, Iowa and Nebraska.


The state’s debt works out to $2,362 for every Californian, according to Moody’s Investors Service. That ranks seventh among the states, well below the burdens of No. 1 Connecticut, at $4,859 per capita, and No. 3 Hawaii, at $3,996, for example.

In measuring debt relative to the state’s total economic output, California ranks eighth highest at 4.7%, compared with No. 1 Massachusetts at 8.3% and No. 5 New York at 5.4%.

Another good gauge is debt as a percentage of a state’s total personal income, because income is the source of taxes that cover debt payments. By that measure, California ranks seventh highest, at 5.6%, according to Moody’s latest data. That’s more than double the state median of 2.5%, but so are the ratios of Kentucky and Washington, two states you might think would be more fiscally conservative.

The point here is that, while California ranks in the top 10 of state debtors, its borrowing hasn’t been worrisome as judged by the ratings firms. For the biggest state, California’s debt is “still moderate,” said Emily Raimes, who analyzes the state for Moody’s.


But Lockyer says he worries about the trajectory of the debt burden.

California’s debt as a percentage of personal income has more than doubled from 2.4% in 2000 as voters have been generous in approving big bond packages for water projects, stem-cell research and education facilities, among other things.

And the state has a backlog of $53 billion in bonds yet to sell to fund other projects voters have authorized over the years.

Of course, the point of infrastructure spending is to enhance the state’s economy in the long run. “It’s an investment,” Raimes notes. It also creates jobs.


Even so, every dollar that goes to repay debt is one less dollar available to fund the state’s current operating expenses.

In his annual debt-affordability report, issued in October, Lockyer noted that bond interest and principal payments ate up 6.7% of the state’s general-fund revenue in the last fiscal year, a figure set to rise to 7.2% in the current year.

The state “needs to pay serious attention to its growing debt service,” he said.

California and many other states also face heavy future liabilities that aren’t reflected in official debt figures — unfunded pension costs for public employees, for example.


Still, there should be plenty of buyers showing up, as usual, when Lockyer sells new debt in the next two weeks. Most probably won’t be thinking about the state’s debt load math. More likely, they just won’t be able to resist the tax-free interest rates on the bonds at a time when decent yields are hard to find.

Compared with the highest-rated municipal bonds, the penalty California pays to borrow can exceed 1 percentage point on longer-term securities.

California also pays far more than what investors can earn on U.S. Treasury bonds. The market yield on 10-year California bonds is now about 3.7%; the Treasury pays about 2.7% on its 10-year T-note.

Even on the $10 billion in short-term notes the state will sell early next week, it will have to pay more compared with other short-term interest rates. Muni bond dealers expect the notes to pay annualized tax-free yields of 1% to 1.5%. That’s a lucrative return these days for investors who have idle cash that they don’t want to risk in stocks, bonds or other longer-term assets.


California’s awful history of budget tricks includes stealing (er, borrowing) money from internal funds and local governments, putting off certain employee-pension funding and delaying payments to vendors and others with whom the state does business.

But most of these tricks have one central goal: making sure that bondholders are paid on time and in full, as mandated by the state Constitution.

The state’s image is one of a hopeless deadbeat, but its bond investors have come to know better.