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California debt default 'increasingly likely,' Cal Lutheran economist says

December 16, 2009 |  5:09 pm

Bill Watkins, who runs the Center for Economic Research and Forecasting at California Lutheran University in Thousand Oaks, goes out on a limb today: He says the state should start discussing contingency plans with the Obama administration and the Federal Reserve for the day California defaults on its debt.

“In my opinion, California is now more likely to default than it is to not default,” Watkins wrote in an economic forecast excerpted on the newgeography.com blog. “It is not a certainty, but it is a possibility that is increasingly likely.”

Not surprisingly, his commentary quickly triggered sharp rebukes from California Treasurer Bill Lockyer and Mike Genest, the outgoing director of the state’s Department of Finance. More on that later.

Wall Street has for the last year harbored doubts about cash-strapped California’s willingness or ability to pay its creditors. The concerns are reflected in the state’s credit rating -- the lowest in the Union -- and in the above-average interest rates the state has had to pay to borrow.

Watkins But the fact that California still has been able to borrow tens of billions of dollars via short- and long-term muni bond debt in recent months shows that many investors don’t believe that default is a real possibility.

Watkins thinks muni investors are too sanguine. The state, he notes, resorted to a host of gimmicks to come up with a (temporarily) balanced budget last summer. Now Sacramento faces a $21-billion budget gap over the next two years.

"The Democrats have declared that they will not allow budget cuts,” Watkins wrote. “The Republicans will not allow tax increases.” The political leadership has “no idea where to go.”

In his blog post he takes a look at how a default might unfold:

What would a California default look like? In a sense, we’ve already seen California default, when the state issued vouchers. . . . Issuing vouchers didn’t trigger a California crisis because banks were willing to honor the vouchers. If banks refuse to honor the vouchers next time, employees and vendors won’t be paid, and state operations will come to a halt. This could happen if our legislature locks up and is unable to act on the current $21-billion problem.

Another possible California scenario is that the state will try to sell or roll over some debt, and no one buys it. Already, we’ve seen California officials surprised with the interest rates they have had to pay. What happens if no one buys California’s debt? We saw last September [2008] what happens when lenders refuse to lend to large creditors.

Lockyer’s spokesman, Tom Dresslar, said in a statement that Watkins’ commentary “was nothing more than irresponsible fear-mongering with no basis in reality, only roots in ignorance.”

Dresslar noted that the state Constitution mandates that tax revenue go first to pay education expenses and second for debt repayment. All other expenses come after debt service.

“After paying for education, the General Fund has tens of billions of dollars left to pay debt service,” Dresslar said. “Even at historically high levels, debt service does not come remotely close to needing all the funds left over after schools get paid.”

Genest, in a statement, echoed the constitutional safeguards, and also noted that “under state law debt service payments are a ‘continuous appropriation,’ meaning the payments are made even if the Legislature has not passed a state budget.”

“While our fiscal challenges remain substantial, to suggest or assert that the state will default is a scenario that has no grounding in either fact or history,” said Genest, who will be stepping down at year’s end.

I asked Watkins about the constitutional provisions for debt repayment. He isn’t impressed. “There is also a constitutional requirement to have a balanced budget by every June 30,” he said.

As for what he tells friends and relatives who own California muni bonds, he said: “I tell them to listen to what everybody has to say, and make up your own mind.”

-- Tom Petruno

Photo: Bill Watkins. Credit: Center for Economic Research and Forecasting

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