California Dodges Bullet with Budget Deal–for Now

By Peter Henderson and Jim Christie

SAN FRANCISCO (Reuters) – California’s state budget deal is a bet its economy, the world’s eighth-largest, will rebound — but that’s not likely to happen soon.

Governor Arnold Schwarzenegger and top lawmakers agreed Monday to close a $26 billion budget gap, largely with $15 billion in spending cuts, with many pushed into future years.

“They are waiting for the economy to bail them out,” said Chris Ryon, a fund manager at Thornburg Investment who sees “a lot of risk” for investors in California debt.

The budget deal would let the state start traditional borrowing again, although state officials were waiting for the legislature to pass the deal before saying when they will tap the debt market.

Meanwhile, the state is still paying its way with IOUs and must contend with the financial effects of double-digit unemployment and foreclosures dominating its housing market.

“Unemployment, unfortunately, probably hasn’t peaked yet,” said Nuveen Investments fund manager Paul Brennan, who views the budget as a bet that better times are around the corner.

California’s revenues rely heavily on personal income taxes and tend to swing strongly. Google Inc’s initial public offering helped fuel a bumper year for taxes, so if the state economy recovers, revenue could grow quickly.

But economist Steve Levy says California’s economy likely will remain weak for some time and the state government’s main problem will persist — that its citizens and government can not agree on the level of public services to provide.

“We are a state in gridlock, in disagreement,” said Levy, director of the Center for the Continuing Study of the California Economy.

Lawsuits Ready

Around the state, uncertainty greeted the budget agreement. Its details were sparse while rank-and-file lawmakers reviewed the deal for potential votes in the state Assembly and Senate by Thursday.

But opposition formed quickly to some of the plan’s proposals, such as taking roughly $4 billion from cities and counties for state needs. The Los Angeles County Board of Supervisors, for instance, voted Tuesday to sue the state to stop proposed cuts to the county’s share of the state highway tax and community redevelopment funds.

The California State Association of Counties said it would mull a lawsuit as well and San Jose Mayor Chuck Reed told Reuters that his city, the 10th-largest in the nation, also is “committed to participating in a lawsuit” to keep the state from grabbing its money.

“They are probably in violation of the (state) Constitution in taking our redevelopment funds, in violation of the law in taking our highway users tax,” Reed said.

In addition to concerns about losing money to the state, county officials fear losing state aid for health and human service programs they must provide.

“Make no mistake, under this budget scenario counties cannot uniformly ensure the delivery of critical health, public safety and other vital local services,” said Paul McIntosh, executive director of the California State Association of Counties.

To Buy or Not

Once a budget is signed, state finance officials will decide on the kind of short-term debt the state will need to sell to raise money for cash-flow purposes.

Until then, plans for selling either revenue anticipation notes or revenue anticipation warrants are on hold, said State Treasurer Bill Lockyer.

Nevertheless, the budget deal came just in time, Lockyer told Reuters, and he sees lawmakers endorsing it. “Most of them understand we’re getting real close to the edge of the cliff here and we’d better wrap it up quickly.”

Standard & Poor’s analyst Gabriel Petek said the deal averted a certain downgrade next month by his rating agency, which has the state’s general obligation debt at A and CreditWatch with negative implications. “That was the trajectory it was on,” Petek said.

Investment analysts were split over the budget agreement and whether to buy California’s existing or new debt.

Dick Larkin, director of credit rating analysis at Herbert J. Sims Co Inc, said he suspects the agreement will end up deferring hard decisions about the state’s finances and a budget deficit will reemerge. “This is a pretty crappy budget to try to make the case to borrow billions of dollars over the next three months,” Larkin said.

Tom Tarabicos, a financial adviser at Wells Fargo Financial Advisors, said the deal failed to sway him from his dim view of California’s finances and their effect on the state’s bonds.

“This appears to me to be just a short-term reprieve,” Tarabicos said. “We’re going to maintain our distance.”

By contrast, Ken Naehu, head of fixed income at Bel Air Investment Advisors in Los Angeles, said the agreement should end speculation over whether California would not make payments on its debt service to bondholders.

Naehu said debt service payments were never in doubt as they are the state’s No. 2 payment priority as required by law and because the state’s revenues, albeit weak compared with a year earlier, were strong enough to support them.

“Why in the world would you cut your arm off and not make debt service payment when it’s such a small part of the budget?” Naehu said.

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