Thursday, December 11, 2008


by Andrew Edwards | Wall Street Journal

DECEMBER 11, 2008, 3:50 P.M. ET

NEW YORK -- Extended bickering over the California budget led Standard & Poor's on Thursday to downgrade the state's recently sold $5 billion revenue bonds and put more than $50 billion of debt on watch for a downgrade.

On Wednesday, Governor Arnold Schwarzenegger had warned the Golden State could run out of cash by the end of February -- the second time California has rung such an alarm since October.

The state's legislature is in the midst of a bruising budget battle, with Mr. Schwarzenegger calling for lower spending and new taxes and with state Republicans blocking any new plan. Meanwhile, the state's projected deficit has widened to $14.8 billion. The issue isn't default, it's dysfunction, the ratings agency said.

"We believe California is pressured by recent sharp declines in revenue as the result of an economic slowdown," S&P credit analyst David Hitchcock said in a statement. "However, in our view, the state should have sufficient resources to solve its projected cash shortfalls if the legislature can reach the necessary two-thirds supermajority required for budget adjustments."

S&P noted that by February, the state will have a small cash position of just $314 million, or 0.3% of its yearly cash revenue, based on recent state cash-flow projections. In addition to lowering the revenue anticipation notes' rating to SP-2 from SP-1, the agency put $46.6 billion in general obligation bonds and $7.8 billion in general fund lease appropriations on watch for a possible downgrade.

If California doesn't have the cash, the state may have to refinance its RAN bonds when they come due in May and June, but it will likely be able to do so, investors said.

California sold the $5 billion of debt in October, helping to avert a cash shortfall that threatened to grip the state. Mr. Schwarzenegger had written to the U.S. Treasury earlier that month saying the state might need up to $7 billion in emergency short-term financing from the federal government.

Investor demand was so strong at the time that the state ended up selling more than it had expected.

"The good news is they can access the markets as long as they can straighten out this mess," said Dan Solender, municipal portfolio manager at Lord Abbett. "I think they should test the market before they make statements saying they can't access it."

The fact that the October debt has been downgraded just two months after hitting the market is likely to cause investors to demand even steeper risk premiums on future debt offerings. California paid between 3.75% and 4.25% on the $5 billion of debt.

More downgrades could lead to a wait-and-see attitude for investors, because the bonds' value is likely to decline if there are further downgrades.

"It doesn't mean you don't buy the bonds," said Bob MacIntosh, co-head of munis at Eaton Vance, but "with an issue like this you're better off waiting."

The state's financial officials feel that the market has worsened significantly since October, said California Treasury spokesman Tom Dressler.

"Asking investors to buy California bonds at this point is like asking investors to buy stock that they know is going to decline in value," Mr. Dressler said, adding that in State Treasurer Bill Lockyer's view "until we get a budget solution, no bonds."

Mr. Dressler cited a November issue of power revenue bonds that were rated higher than its general obligation bonds.

"We had to reduce it by two-thirds because institutional interest was virtually nil," he said.

—Agnes T. Crane and Michael Aneiro contributed to this report.

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