California's Crisis Deepens... Part 1

California's financial situation is so complex it could fill up a book.  So, I'll begin with the way things stand NOW and, in Parts 2 and 3, I'll tackle other aspects, such as the ramifications to the state.


There has  been no shortage of talk regarding the worsening financial condition of the Golden State.  Increasingly, people are speculating that California will default on its debts.  Recently, Governor Arnold Schwarzenegger has stepped up the rhetoric by repeatedly warning of a default.  He has even contacted former Treasury Secretary Hank Paulson to ask for assistance in arranging an emergency Federal loan of $7 billion.  This was reported in the LA Times last week when a copy of the email correspondence was obtained.


John Chiang, the State Controller, publishes official records at his website (http://www.sco.ca.org/.). According to the most recent report, Chiang notes that the year-to-date deficit is already up to $794 million and he provides breakdowns of which sources of revenue are up and down. Since California's fiscal year starts July 1, a deficit that large so soon is quite troubling.  He notes some positive items, though.  For example, sales taxes were UP last month and even UP year-over-year.  He also acknowledges the positive impact of "Cash For Clunkers", but that program was temporary. What Chiang does NOT acknowledge in the latest report, is that only one month earlier, he warned the Governor and other lawmakers quite starkly of the emergency conditions that were prevailing.

California recently enacted a significant increase in withholding taxes and, it is believed, that state finance officials intend to issue "IOUs" to anyone receiving a  tax refund.  This would be at least the fourth time "IOUs" have been used.  The problem  is that an "IOU" is a form of currency which, in California's case,  carries a yield of 3.75%. Given the state's problems, they may ultimately prove to be worth FAR LESS than face value.  At the moment, a small trading market has evolved, but apparently, a few banks are still honoring them. So for now, no sizable discounts that I know of exist. However, there are numerous reports of opportunistic buyers bidding as little as 85% of face value on places like Craigslist.

There is historical precedent to what the true market worth of "IOUs" might become, albeit from the 1840's.  The states of Indiana and Michigan and the city of Chicago all issued some form of scrip, or "IOUs", only to have them ultimately drop to 40% of their original value.

If you listen to independent sources, the budget situation is far, far worse than Chiang implies. Very recently, The LA Times reported that a study by a man named Marc Taylor, who is described as a "non-partisan Legislative Analyst", estimated that over the next 18 months, ANOTHER $21 billion in budget deficits would be realized. The reality is that no one really knows how bad the deficit will actually become because of all of the constantly moving pieces. It is even conceivable that the deficit could go LOWER.

Finally, I want to re-iterate that  Fitch, a respected rating agency, has given California a BBB rating, shared only with Louisiana.  A rating of BBB is barely above junk bond status. Only one month ago, California tried to sell $4.5 billion worth of bonds to help finance its deficit.  The issue size had to be scaled back by nearly 10% despite a hike in yields.

I hope this gives you a small glimpse into just how tragic the state's financial situation has become.  Next Monday, in Part 2 of this series,  I  intend to cover the likelihood of  California's potential descent into bankruptcy. As for tomorrow, my topic will be "Taxes On Taxes".  Meanwhile, I hope you keep coming back and review some of the other topics we've covered.  Your feedback, pro or con, is always welcome.

Marko's Take