California Faces Issuing IOUs Again

California, and its largest city, Los Angeles, continue to be embroiled in a political deadlock. Yesterday, Governor Arnold Schwarzenegger released a new executive order requiring state workers to take 3 unpaid days off per month starting in August.  State workers were furloughed a total of 46 days when Schwarzenegger issued a similar order in February 2009, which translated to a pay cut of about 14%.

California faces a $19 billion deficit for the fiscal year that began July 1, and Schwarzenegger is demanding pension, tax and spending reforms in the new budget.  He said that if the Legislature doesn't give him a budget that meets his expectations, he won't sign it.

It's unclear how long the latest round of furloughs could last, as Schwarzenegger and lawmakers enter the 5th week of the new fiscal year without a balanced budget.  Earlier this week, the governor hinted that he might not sign a budget before he leaves office next January unless it includes pension, tax and spending reforms.

State Controller John Chiang has warned that he will start issuing IOUs in August or September if the budget stalemate drags on in the Legislature.  Chiang said the cash-saving measure is necessary because the state is projected to run out of cash in October.  While thus far IOUs have been honored at face value, it is increasingly likely that recipients may ultimately have to take a substantial discount, if the budget crisis isn't resolved.  In the 19th century, when several states had to issues notes, holders lost about half face.

Los Angeles, like many other cities, is struggling with a budget crisis of its own.  The situation is so grave that city officials have been involved in tense negotiations with the Department of Water and Power (DWP) over the transfer of funds into the city treasury.

On Tuesday, executives with the DWP issued a sharply worded defense of their decision to withhold $73.5 million from city coffers in the middle of a recent fight over electricity rates, saying they did so to protect the utility's credit rating and its customers.

After a lengthy standoff between the council and DWP over proposed rate increases, City Controller Wendy Greuel reviewed the utility's records and concluded that, contrary to its claim, the utility could have made the promised transfer to the cash-strapped city budget without first being granted the increase.  Official with the DWP, in turn, accused Greuel of making misleading statements.

Unlike investor-owned power companies that pay regular dividends to stockholders, the DWP transfers more than $200 million each year to the city's general fund, which pays for police, fire and other basic services. This year, that transfer was broken into two installments — $147 million followed later by $73.5 million.

With so many states, cities and counties in financial trouble, it would seem inevitable that some will be forced to default.  It's highly unlikely that California, which has the 8th largest economy in the world, on a stand-alone basis, would be allowed to go under.  However, cities have fewer options to plug their budget gaps.  If even one major city becomes unable to meet their debt obligations, the spillover into the investor community will be most severe. 

And, if cities begin to default with police and fire support becoming extremely understaffed, can civil disobedience be far behind?

Marko's Take

Los Angeles Fiscal Crisis Intensifies

Los Angeles has endured a devastating decrease in tax and fee revenues as the result of the global economic downturn.  In addition, the entire state of California is struggling with it's own budget crisis, putting the State's bonds in jeopardy of being downgraded to junk status.

Compounding the situation was the collapse in investment revenues for the city employees' pension funds because of the Wall Street implosion that contributed to the recession.  Thus, the identical factors that have caused City Hall to spend dramatically more, have also contributed to taking in substantiall less.

The budget gap for the city of Los Angeles has grown to $222.4 million this fiscal year, prompting plans to transfer money from the Department of Water and Power (DWP) to close the shortfall.  Relations between the city and DWP have become very strained over the proposal.

The only bright note has been a small increase in property tax fees.  City Administrative Officer Ray Ciranna said the city has collected $26 million more than expected in property tax revenues.

The massive budget gap means the city will have to dig deeply into its reserves to balance its books to end the fiscal year on June 30 in the black.  City Council President Eric Garcetti and Councilman Bernard C. Parks, chairman of the budget committee, stressed that the better than expected revenue collections did not mean the city’s budget crisis has been solved.

DWP executives refuse to send the city a promised $73.5 million because council members refuse to approve a sweeping electricity rate increase.  Meanwhile, other budget-balancing moves, in combination with the increased revenue, had reduced the midyear deficit from $212 million to $148.9 million.

Ciranna said he believed that the city’s reserve fund, which is about $207 million, would drop to about $39 million at the end of the fiscal year, far below what bond rating agencies consider to be a healthy threshold.

The budget stalement has led to a downgrade of the city's credit rating.  Rating agency Moody’s announced last Wednesday that it had downgraded the credit rating for the City of Los Angeles from Aa2 to Aa3.  This affects approximately $3.2 billion in debt.

Moody’s expressed concern about the DWP’s transfer of $147 million instead of the previously budgeted $220 million.  The rating agency noted that the reduction in the transfer of funds posed a challenge for the city’s general reserve funds.

Expressing fear that the City would run out of cash in less than a month, Mayor Villaraigosa proposed a two-day-a-week shutdown for all General-funded city services except for public safety and revenue-generating positions beginning the week of April 12.

The City of Angels is beset by devils.  As the global financial crisis intensifies, problems are being felt from the Euro-Zone to individual cities.  The question is how many entities can suffer major problems before the fabric of the entire global financial community unravels.

Marko's Take

Our new YouTube video on the Legality of the Personal Income Tax is now posted at
(http://www.youtube.com/markostaketv#p/u/0/1TInKnCIikg).