CA’s Bond Rating Equals F-Minus Grade

APRIL 21, 2011


Why is there such a large discrepancy between California State Treasurer Bill Lockyer’s assurances that the state is not broke and has plenty of money to pay off its bonds and the state’s effective bond rating of F-minus?

Lockyer says California isn’t broke and has never defaulted on its bonds even during the Great Depression of the 1930’s.  Lockyer adds that after meeting mandated funding for K-12 schools of $36 billion, that leaves $53.4 billion general-fund money available to pay its $6.6 billion annual payment on the state’s debt.  That reflects a debt coverage ratio of eight times the annual debt payments.

However, Standard and Poor’s ranks California’s bonds 50th of all the states.  If we converted Standard and Poor’s ranks into grades, it would look like the chart below, where California would get a F-minus grade.  That’s two notches below Louisiana after Katrina and the BP Oil Spill devastated it.

A key factor is what interest rates will be charged, based on the policy of the U.S. Federal Reserve Board. One pessimistic financial market watcher, Martin Hutchinson, just predicted that, to fight rapidly increasing inflation, the Fed will enact a policy that will:

involve a federal funds rate that is far above the rapidly accelerating level of inflation — say 50 percent — and long-term bond rates also above the inflation rate, at about 25 percent or so.

But no one really knows what future interest rate the bond market is going to demand to finance California debt.

The Coming Great Squeeze

Of course, higher bond interest rates would only affect any new added debt, not the existing $6.6 billion in bonded debt.  So what California and its bond raters have to mainly worry about is any added future debt such as:

* The looming pension Tsunami for state and local government workers;

* The cumulative debt burden of any new large capital projects such as the proposed Delta Water Bond, Peripheral Canal, High-Speed Rail, and added debt for stem cell research, etc.;

* The planned spike in electricity rates to pay for Green Power starting in 2012.

Nonetheless, if California’s bond rate goes from roughly 5 percent today to anywhere near 25 percent, the state’s $6.6 billion yearly debt payments would more than double, due to looming pension obligations, even if no more new debt was added.

If California were to add new debt, such as the $11.1 billion Mega Water Bond and a $13 billion Peripheral Canal Bond proposed for the 2012 ballot, the state’s debt situation could escalate into a crisis quickly.

The real tab for the two proposed water bonds is $29.1 billion when matching fund requirements are added.  Below is how much annual interest those two water bonds would entail at varying interest rates:

Added Interest from Water Bonds:

5% 10% 15% 20% 25%
$1.5 billion $2.9 billion $4.4 billion $5.8 billion $7.3 billion


In other words, if tax-exempt interest rates were about 5 percent, the two water projects, combined, would add about $1.5 billion in expenditures to the $89.4 billion general-fund budget for 2011.  In a declining or stagnant economy, that means that $1.5 billion has to be cut from some other programs, such as education, Medi-Cal or CalWORKS, to fund water bonds; or taxes would have to be increased to pay for it.

But if interest rates were to spike to, say, 25 percent, the amount of added debt service in the budget would more than double to $7.3 billion a year.

Another reason for concern is California’s Green Power Law that begins in 2012.  According to Mark Landsbaum of the Orange County Register, California’s electricity ratepayers will face 15 percent to 26 percent higher electricity bills by 2020 due to the Green Power Law.

That breaks down to an extra $5.69 billion to $9.09 billion extracted from the private economy and households per year to pay for higher electricity rates for Green Power.

Put that in the context of Gov. Jerry Brown’s current attempt to plug about a $25 billion hole in the state budget. Among other tax increases, he wants to continue a “temporary” increase in sales taxes and vehicle license fees. Add that to a $5.69 to $9.09 billion electricity rate hike.  With monetary inflation starting to show up in gas and food prices, Californians will be facing a big squeeze in 2012 and thereafter.

All totaled, Californians are facing a $10.59 to $14.09 billion hit beginning in 2012 if taxes are raised as Gov. Brown proposes and the Green Power Law is not suspended by the governor.

All the above tax hikes and utility rate increases would do nothing to plug the huge pension Tsunami that will hit state and local governments in 2014 and thereafter. California may be headed for one of its proverbial Perfect Storms of tax and utility rate increases, unaddressed pension obligations and monetary inflation.  Hence the slogan, “Shelve 2012.”

Programs mandated by the State Constitution (Proposition 98 for K-12 schools and the obligation to pay off bonds) would continue to be funded, resulting in no bond defaults or school closings. But everything else in the state budget would have to face deep cuts or decimation.

Bonds Wouldn’t Default But Markets Would Panic

This Perfect Storm is what has bond underwriters and rating agencies worried.  Not that existing bonds would go unpaid, but that the bond markets would stop buying any more California debt or would raise bond interest rates to such levels that the state would not want to issue the bonds.  Even if the voters passed California’s water bond package, the state might be unable to find any buyers for the bonds.  This is what happened during the Great Depression of the 1930’s when the federal government had to intervene and complete water projects in California.

Bond markets work on the Principle of Anticipation.  They panic way before the actual crisis shows up.  This is what happened with the National Financial Panic of 2008.

California Congressman Tom McCllintock may see his plan for Auburn Dam yet arise along with federal takeover of the Peripheral Canal project.

So State Treasurer Bill Lockyer can issue all the reassurances that California won’t default on its bonded debts.   Big deal.  It’s only a half-truth.  Politicians don’t lie, they just filter the truth.  California didn’t default on its bonds during the Great Depression either.  But the federal government had to rescue it.

What’s important is whether California can continue to attract investors to buy its bonds at rates that make infrastructure projects feasible.   Another worry is that California might try to issue bonds to cover its huge pension Tsunami. This is what the City of New York did in the early 1970’s, when Mayor John Lindsay financed social services, which do not produce a revenue stream, with bonds. After he left office in 1973, in the mid-1970s the city nearly went bankrupt.

Pension Fund Gamble

California’s pension funds are currently playing a high stakes game of gambling with its investments in the hope of bailing out the state from its unfunded pension obligations.  CalPERS continues to boast of annual returns of around 13 percent.  This is about a seven times greater return than you can get today from an inflation-protected security investment.

An investment returning about 12 percent per year has an implied risk of default, and wipeout, of part of or all of your investment every eight years.  So CalPERS and CalSTRS and local pension government pension funds may eventually catch up and plug the unfunded gap in its funds, only to suffer a wipeout of their investments somewhere down the road, just as they did in 2008.

In an ominous move that portends the future, the University of Texas Endowment Fund bought $1 billion in gold bars on April 16 to protect from future inflationary wipeout of their invested funds.

Taking all of the above into consideration, you now know why California’s bond rating is F-minus.

Here are the Standard and Poor’s Bond Ratings for the states. The “Proxy Rating” grade at the right translates those ratings into standard, A to F, school grades.

Standard and Poor’s Bond Ratings

State Credit Rating Rank Proxy Grade
Delaware AAA 1 A
Florida AAA 1 A
Georgia AAA 1 A
Indiana AAA 1 A
Iowa AAA 1 A
Maryland AAA 1 A
Minnesota AAA 1 A
Missouri AAA 1 A
North Carolina AAA 1 A
Utah AAA 1 A
Virginia AAA 1 A
Alaska AA+ 12 B
Kansas AA+ 12 B
Nebraska AA+ 12 B
Nevada AA+ 12 B
New Mexico AA+ 12 B
North Dakota AA+ 12 B
Ohio AA+ 12 B
Oklahoma AA+ 12 B
South Carolina AA+ 12 B
Tennessee AA+ 12 B
Texas AA+ 12 B
Vermont AA+ 12 B
Washington AA+ 12 B
Wyoming AA+ 12 B
Alabama AA 26 C
Arkansas AA 26 C
Colorado AA 26 C
Connecticut AA 26 C
Hawaii AA 26 C
Idaho AA 26 C
Maine AA 26 C
Massachusetts AA 26 C
Mississippi AA 26 C
Montana AA 26 C
New Hampshire AA 26 C
New Jersey AA 26 C
New York AA 26 C
Oregon AA 26 C
Pennsylvania AA 26 C
Rhode Island AA 26 C
South Dakota AA 26 C
West Virginia AA 26 C
Wisconsin AA 26 C
Arizona AA- 45 D
Kentucky AA- 45 D
Louisiana AA- 45 D
Michigan AA- 45 D
Illinois AA+ 49 F
California A- 50 F-Minus
Source: Standard and Poor’s Media Relations Department

Wall Street Journal, Oct. 4, 2010




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