The State of California is defaulting.
In lieu of cash, it is issuing i.o.u.’s to meet obligations to vendors and citizens, postponing payments on its current liabilities.
But current liabilities are defined as short-term obligations, or debts. Ergo, based on this standard accepted definition, California is already defaulting on debts.
It’s not the same as defaulting on its bonds. But for reasons I’ll explain in a moment, I believe that, too, is coming.
If California’s creditors had a say in the issuance of i.o.u.’s, Sacramento officials might be able to deny they’re in default by implying some sort of mutual consent. But that’s far from the facts. The creditors had nothing to do with this decision. It was unilateral, a telltale signature of debt defaults.
If the i.o.u.’s were as good as cash, Sacramento might also deny the D-word. But the sad reality is that, if you’re among those stuck with California i.o.u.’s, you have only two choices: Either hold them while you sweat and cross your fingers or sell them at a steep discount; either wait for your money or accept an immediate loss — exactly the same choices facing creditors in a default.
If all major financial institutions accepted California i.o.u.’s, that might also help Sacramento justify a continued denial of default. But the reality is that most banks are not accepting the i.o.u.’s, and no one could argue their reasoning is financially unsound. Why accept a piece of paper at face value when it’s worth significantly less than face value on the open market? The nation’s largest banks already have enough troubles with toxic mortgages, toxic credit cards and toxic loans on commercial real estate. They’re not exactly anxious to pile on toxic California paper.
If, as in past episodes, California’s budget mess was mostly due to a political snafu, it could be argued that the i.o.u.’s are merely a temporary stop-gap. But that’s clearly not the case either. The crisis is rooted in an unprecedented economic depression with 11.5 percent unemployment and the greatest concentration of mortgage delinquencies in the nation. Even if the i.o.u.’s are ultimately paid in full, California’s debt troubles are not going away. (For my earlier comments on the California economy, see www.moneyandmarkets.com/california-collapsing-34271.)
Defaults on Bonds Next
Although defaulting on short-term debts to vendors is different, bond investors must be asking: If California can stiff other creditors, will they do the same to us?
On June 22, in “California Collapsing,” we answered this question before it was asked: Yes.
Short of a 11th-hour rescue from Washington — where political resistance to bailouts has grown dramatically in the wake of recent federal rescues — it will be almost impossible for California to avoid a default on its bonds.
The exit doors are shutting. I see no way out of this crisis without a default.
The fundamental reason: A vicious cycle of budget tightening and falling state revenues. The state cannot balance its books without inadvertently making the California economy — and its deficit — even worse.
When it cuts spending, it merely creates more unemployment and forces consumers to slash their own spending or default on their own obligations, driving the economy into a still deeper depression. When it raises taxes, it has a similar impact. Either way, the end result is lower revenues flowing into the state’s coffers.
The immediate problem: California has over $28 billion in bonds coming due between now and October. How will it come up with the cash is a great mystery to me. Bond holders are certainly not going to be among those grudgingly accepting i.o.u.’s.
Wall Street Rating
Agencies Also in Denial
Moody’s has publicly warned that, if California did not resolve its budget crisis, it would face a massive downgrade. Now, California has not resolved its budget crisis. But as of this writing, we have not yet heard from Moody’s.
Meanwhile, despite everything that’s happened this week, Standard & Poor’s has reaffirmed its single-A rating, and Fitch has done nothing more than slide its California grade from A to A-.
Maybe we’ll hear more from these rating agencies today. Or maybe their analysts are too busy preparing for the 4th of July weekend. No matter what, their firms have already lost any semblance of credibility. Their conflicts of interest are endemic, and their zeal to protect their clients at the expense of investors borders on fraud.
After multiple investigations, the SEC, Congress and the Obama Administration are proposing some solutions. But to date, the business model of the big three Wall Street agencies — ratings bought and paid for by the rated companies — stands unchanged.
Despite the conflicts and delays, however, the truth cannot be bottled up forever. Here’s what I see coming next:
1. Downgrade massacre: A series of multi-notch downgrades by Fitch, Moody’s and S&P, making it extremely difficult — if not impossible — for California to roll over maturing debts at any cost.
2. Worsening deficit: Surging interest costs and greater than-expected declines in cash inflows, bloating California’s deficit even further.
3. Washington snub: A last-ditch effort to persuade Treasury Secretary Geithner and President Obama to reverse their earlier decision not to bail out state and local governments.
But Washington’s arguments against a California bailout are relatively firm: They’re already giving California billions through the stimulus package. If they bail out California, what will they say to the dozens of other states that line up on the White House lawn asking for the same?
In contrast, arguments supporting a federal bailout sound like a hollow rerun of last year’s “TARP-or-meltdown” ultimatum by Treasury Secretary Paulson to Congress. It’s a long-ago discredited approach to financial emergencies.
4. Default on California bonds: Despite Sacramento’s official mantra that a default is impossible and unthinkable, it happens.
5. Cascade of defaults: If giant California can default, the new assumption will be that virtually any issuer of tax-exempt securities can do the same. A cascade of downgrades and defaults by other states and municipalities ensues.
Bottom line:
If you’re an investor, better to be safe than sorry. Unload your tax-exempt bonds and mutual funds. With few exceptions, the purported benefits do not justify the rapidly growing risk.
If you’re a U.S. citizen or resident — whether in California or not — don’t count on borrowing money. Prepare yourself for a return of last fall’s environment in which consumer credit was either too expensive or unavailable. Pinch pennies. Sell off unneeded assets and possessions. And raise as much cash as you can — for emergencies and for your family’s future.
