We often hear from investors who fear the worst from California’s budget woes. Though we share many of their concerns, we continue to believe that California (along with the other 49 states), will continue to honor its debt repayment obligations despite its financial troubles. Here’s why.
Constitution: Debt service is a priority
First, the California state Constitution places only primary and secondary education funding ahead of debt service as a priority in the state’s annual budget. In Gov. Schwarzenegger’s recently released 2010-2011 General Fund proposed budget, Proposition 98 (education) funding accounts for $36 billion of expenditures out of a budget totaling $82.9 billion. In contrast, debt service is small at $6.2 billion. Accordingly, if education and debt service are paid as required, $40.2 billion would be left for other general fund purposes and would have to absorb a projected $19.9 billion deficit, absent any enacted budget cuts or revenue enhancements.
Clearly, we recognize the severity of California’s budget crisis, but believe the priority status accorded to debt service will ensure its payment.
Second, California, like many states, relies on the capital markets to provide funding for infrastructure projects and other long term governmental purposes. Failure to pay debt service when due would jeopardize California’s ability to re-enter the capital markets in the future and would drive the state’s cost of borrowing through the roof.
California has also traditionally relied on the short-term bond market for annual cash flow borrowings, known as Revenue Anticipation Notes (RANs), needed to smooth out a revenue cycle that sees revenues and expenditures peaking at different times during the fiscal year. California’s government would grind to a halt, absent annual RAN borrowings.
Officials publicly commit to paying bills
Third, state officials are committed to paying California’s bills. A recent joint statement signed by the state’s top three financial officials assured the public that “our three offices closely coordinated to ensure that California had adequate cash on hand so that the state’s priority payments – including debt service payments to bondholders – could be made on time and in full.”
Fourth, in a recently released report by Standard & Poor’s in which the state’s general obligation rating was lowered from “A” to “A-“, the rating agency expressed confidence in the state controller’s authority to direct the timing of cash disbursements, protecting the state’s ability to make priority payments. Such authority led S&P to note, “This quality of the state as a sovereign entity partially underscores our view of the state’s fundamental credit quality, which we generally view as strong even if strained.”
Finally, we are fully cognizant of the difficulty of closing a budget gap the size of California’s, and the likely short term cash flow squeeze it is predicted to experience in March and July. But, with proper financial management (which California has demonstrated in the past), and constitutional priority accorded to debt service, we believe bondholders will continue to receive their principal and interest payments in a timely manner.