California’s Controller Speaks: Will State Default On Its Debt Obligations? NO

(Excerpted from the March 2010 print edition)

In last month’s edition, and in several issues last year, the Bond Advisor explained why investors are making a serious mistake if they let catchy and/or scary headlines deceive them about the true status of protection afforded the State of California’s general obligation bonds. Rather than revisit this issue every month in 2010, we are going to let someone else do the talking in this edition and then drop the topic and move on to other things. This “someone else” is worth listening to because it happens to be California Controller John Chiang, and the controller knows better than anyone how the state’s “priority” allocations of available money get made.

Chiang’s comments are particularly timely to review in this edition because California will be selling $2 billion of tax-exempt general obligation bonds on March 11, with a two-day “retail” order period March 9 and 10. As we noted last month, income-oriented investors would be foolish to ignore the yield premium offered on California’s bonds in light of the actual default risk. Yes, we know the state’s credit rating is crummy, but if your goal is to generate as much tax-free income as possible it is difficult to ignore  California G.O. bonds.  If you can’t stomach buying a lower-rated credit, or aren’t allowed to for fiduciary reasons, there are plenty of muni bond alternatives. Go for those instead.

Let us set the stage before we get to some fascinating observations made recently by Mr. Chiang. These observations were especially fascinating to us because the “mainstream” press ignored them, even though they are the strongest comments yet regarding the treatment of state bond payments during rough times. Over the next few months, just as you saw in 2009, there might be another spate of headlines talking about the state “running out of cash,” going “broke,” etc. As we explained many times last year, California wasn’t running out of cash or for that matter even “short” on cash. The state’s problem, year in and year out, is that it refuses to make the tough decisions that will align spending with actual revenue. No matter where you want to place the blame—federal mandates, overly-generous benefits for public unions, a revenue system too dependent on volatile income tax collections—many state leaders still want the budget  to be all things to all people, regardless of the actual revenue coming in the door.

But our main concern, this year as last year, is to explain very clearly that the state is not “running out of cash” or “short of cash” when it comes to the funds available for debt service. The constitutionally-mandated financial cushion that carves out top priorities for education and debt service lets investors sleep at night, even if the “headline risk” would suggest otherwise. Understanding this “cushion” is especially important at a time when the state’s credit ratings are at triple-B levels. Some “conservative” investors, if they go by credit ratings alone, will avoid purchasing California’s bonds. That decision carries with it a major trade-off for an income-oriented investor. You are leaving money on the table because the state’s G.O. bonds are paying a hefty premium over what you will receive on higher-rated municipal debt.

Okay. Enough on that. We have made that point ad nauseam in recent months.

The only reason we are revisiting this topic once more is so that our readers can hear directly from the state official who understands this topic better than anyone. State Controller Chiang has been a hero of sorts to us during California’s recent distress because he did just what he was supposed to do to protect bondholders. Many investors and the media alike didn’t get the “positive” angle last year when California turned to IOUs to survive during the summer. What many of them didn’t understand is that this strategy was a “positive” step for bondholders because Mr. Chiang was conserving cash flow to make sure California could cover top-priority funding requirements such as education and debt service. The state is taking steps to lessen such bad “IOU” publicity this year, thanks to new cash-management legislation passed last week that gives bond investors even more comfort. More on that legislation later in this essay.

Early in February, in a monthly summary of trends for California’s general fund revenue and spending, Controller Chiang wrote an excellent essay talking about the protection afforded the state’s debt. The headline for this essay also was catchy, but didn’t show up in the media: “Will California Default on its Debt Obligations? NO.”

Controller Chiang then explained why. While he acknowledges that the state faces another tough year trying to close a budget deficit, Chiang writes that “a reality check is needed” for anyone suggesting California is going to default on its bonds. “In the discussion of the crisis many forget the actual practice of fiscal management,” Chiang explains. “My job as California’s Controller is to make sure the State meets its financial obligations. The State’s constitution ensures bondholders that money will be set aside for service of debt, and failing to do so may be an impairment of contract. The constitution mandates that the first obligation is payments to education, and second is payment of the State’s debt service.”

The Bond Advisor wants to interject something here. Some of our readers might say, “hey, this guy is a state official, isn’t he going to put the best construction on this mess?” Our answer boils down to this. Don’t confuse the state controller and the state treasurer. California Treasurer Bill Lockyer is the one who has to “sell” the state’s bonds. While he, too, acknowledges the state’s fiscal problems, Lockyer also has to market California’s debt. In contrast, the controller basically has to take the resources the state has available and make the best of them. He isn’t out marketing California G.O. bonds. Having said that, he is entitled to explain the process of how this debt is protected in a way that offsets irresponsible “headline risk” in the media.

Chiang then goes on to explain the “state’s available resources.” This is where the all-important financial cushion the Bond Advisor stressed in 2009 comes into play. Chiang writes that California expects to receive $83 billion in general fund revenue in fiscal 2011, which begins on July 1. “Under the Governor’s budget proposal, we will spend about $47.8 billion on education,” Chiang writes. “Debt service is the very first priority to be paid from the remaining $35.2 billion. The State’s total debt service for this year is about $5 billion, and some of that will be paid from secondary funds. There is plenty of cash available to meet our debt service obligations.”

(The Bond Advisor isn’t sure if “this year” in the controller’s comments means this calendar year or a fiscal year, but either way Chiang’s point is made. There is about $35 billion of general fund money available to cover a few billion dollars of debt payments. In addition, because public universities and colleges get “priority” money, and they then first carve out a chunk of this dough to pay things such as California State Public Works Board lease-revenue bonds, that “secondary” debt also has a high level of protection. Of course, it is still a step below a general obligation.)

Controller Chiang goes on to explain that a late budget, no matter how tardy, isn’t going to stop his office from making bond payments. “Some worry that a late budget could delay scheduled debt service payments. Not so. Debt service is ‘continuously appropriated’ and does not rely on the passage of a budget.”

Finally, some people worry that higher-than-planned spending or lower-than-expected revenue could lead California to “run out of cash” during a fiscal year. 

“This is where good cash management becomes paramount,” Chiang wrote. “My office will continue to monitor daily cash flows and adjust its cash scenarios accordingly for what will likely occur in the upcoming 18 months. Furthermore, major assumptions regarding future revenues (for example lawsuits and federal stimulus funds) also are taken into account as part of this ‘stress-test.’ As a practical matter, there are a number of fail safes I can use to ensure that money is available for primary obligations. They include payment deferrals for other expenditure items, special fund or short term borrowing and, of course, the use of IOUs bearing maturity dates. Unfortunately, a number of these options were adopted in 2009 in response to the Legislature’s delayed passage of the current budget.”

Since some of these measures—even if they protected bond payments—still tended to scare investors, and gave the state an even bigger black eye in the process, state legislators last week passed a bill numbered as ABX8 (5). Among other things, this bill lets the state temporarily delay certain general fund payments for some education and local government purposes. These delays, sometimes of 30– or 60-days, are meant to avoid certain cash-flow crunches through fiscal 2011 and in the process provide even more of a cushion for priority payments. No doubt the legislation also will assure holders of the state’s short-term revenue anticipation notes. Treasurer Lockyer was so insistent on having this tool in place, he delayed the state’s G.O. sale until it passed.

Returning to Chiang’s essay, he concludes this way: “As we saw over the last few years, there is not a situation where there is not enough money to honor the top two payment priorities of the State—education and debt service. While default is not impossible, it has never happened in California history, and I will use every cash management tool available to my office to ensure that record continues.”

The Bond Advisor has always cautioned that a multi-pronged nuclear attack on the U.S., or other doomsday scenarios that led to a complete breakdown of our society as we know it, certainly could lead to a default on many municipal bonds. Under such scenarios that might be the least of our readers’ concerns. In the last couple years, however, no matter how scary the “credit crisis” has been, no matter how disappointing it was to see the once-proud triple-A bond insurers implode, no matter how distressing it has been to see “scary” headlines over government finance crunches, the fact remains: the State of California has maintained an ample cushion several times over to cover its debt payments.

This notion floating around among certain wacky commentaries that local and state governments are going to walk away from their debt en masse makes great headlines. In reality, however, even some of the poorest-governed issuers aren’t that stupid. Be grateful that elected officials such as Controller Chiang are diligent about making the best of a terrible situation, including overcoming the failings of our other elected officials.

The Bond Advisor is finished making this point for 2010. Recall this essay when the state sells new bonds in coming months, no matter what the “headlines” are saying.