Moody’s sees possible ‘multi-notch’ cut in state debt rating

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Credit-rating firms blew their reputations in the last few years by giving top grades to mortgage-backed bonds that later crashed and burned.

Given that backdrop, the firms aren’t about to give cash-strapped California the benefit of the doubt.

So today, we have more drama than usual in Moody’s Investors Service’s warning that it may cut California’s bond grade, already the lowest of the 50 states.

If the budget mess isn’t fixed to its satisfaction, Moody’s said, the state could face a ‘multi-notch downgrade’ in its rating, which currently is ‘A2’ from Moody’s for nearly $60 billion in general obligation bonds.

Normally, ratings firms just say a downgrade is possible, and if it happens it’s typically one notch.

Moody’s threat follows Standard & Poor’s announcement Tuesday that it had placed the state on watch for a possible downgrade. S&P, too, sounded more alarmist than usual, warning that ‘insufficient or untimely adoption of budget reforms serve to increase the risk of missed [debt] payments.’

As I’ve written many times, most recently here, debt repayment is mandated by the state Constitution, so by law Sacramento has no choice but to pay bondholders what they’re owed, even if that means slashing essential services.

S&P and Moody’s both say they don’t really expect the state to miss debt payments.

But Emily Raimes, who wrote the Moody’s report, said the warning about a multi-notch downgrade was an attempt to convey the firm’s concern about the ‘worst-case scenario’ if the Legislature and Gov. Arnold Schwarzenegger can’t agree on a plan to patch the $24-billion budget hole.

That worst-case scenario, she notes, is that the state would delay making certain ‘priority payments,’ which may not include debt service but could include payments to pension plans, Medi-Cal and other programs.

Investors already know the jam the state is in, and have pushed market yields on California general obligation bonds sharply higher in the last few weeks to reflect rising risk. The tax-free yield on five-year California bonds is nearly 4% today, up from 3% in mid-May, according to Bloomberg News data.

The state still has what are considered investment-grade bond ratings. To fall into the ‘junk’ category, California’s rating from Moody’s would have to slide from ‘A2’ to ‘Ba.’ In between those ratings are ‘A3,’ ‘Baa1,’ ‘Baa2’ and ‘Baa3.’

The state’s lowest rating ever from Moody’s was ‘Baa1’ from December 2003 to May 2004, amid the budget crunch following the special election that booted Gray Davis from the governor’s mansion and replaced him with Schwarzenegger.

-- Tom Petruno