Brown Debt Gimmicks 'Balance' Budget

JUNE 14, 2011

By WAYNE LUSVARDI

Most knowledgeable people realize that California’s debt emperor has no clothes. Even if the mainstream newspaper media continue to clothe the emperor in the robes of an all-wise Buddhist monk who has taken a vow of poverty.

The good news is that California is “drying out” from its addiction to Federal Stimulus monies, which end this month. However, the state’s addiction to bonds, one-time capital gains taxes and underfunded retiree health benefits continues despite Gov. Jerry Brown’s insistence that he would not sign a state budget balanced with gimmicks (one-time revenues and non-taxes).

Did you know that the California government is operating on $11 billion of authorized but unspent general obligation bonds? Jerry Brown didn’t tell you that when he announced his May Revise Budget with $6.6 billion of supposedly unexpected new tax revenues, mainly from a one-time burst of capital gains taxes from April income tax filings by investors selling stocks and real estate.

State Assemblywoman Diane Harkey (R-Dana Point) has blown the whistle that California has “pre-funded” $11 billion in bonded debt issued but not spent, for which we are paying hundreds of millions annually. In other words, if it were not for plugging $11 billion of the state budget with pre-funded bonds, there would still be a $20.6 billion budget deficit instead of the $9.6 deficit being advertised after the Governor’s May Revise Budget. Brown is still trying to mend a patchwork budget.

The term “pre-funded” is a euphemism for “arbitraging” or taking out a low interest loan to pay for state operations. Arbitraging tax-exempt bonds — by investing bond proceeds in higher yielding taxable investments resulting in a profit — is illegal, except with a small percentage of bond funds under very strict rules.

Pre-funding typically involves issuing a general obligation or revenue bond and putting the bond proceeds into an escrow fund invested in U.S. government Treasury Bills to pay the bondholders, while using the excess for government operations. This is a dangerous practice that private corporations do everything they can to avoid; it means making payroll and operating expenses from long-term debt.

This would be analogous to you taking out a low-interest home equity loan to pay for household operations such as groceries and gasoline expenses. But if you can’t pay for food and gas, how are you going to pay back a home loan?

Where the Bond Money Goes

Where is the state spending that $11 billion? According to Assemblywoman Harkey it is being spent on:

Housing and Emergency Shelter claims $1.1 billion, education $1 billion-plus, more than $3 billion for water (mostly studies I’d have to guess based on our recurrent droughts), $2.7 billion for traffic reduction and highways, and more for clean air and prison construction…high-speed rail has $205 million reserved, and the governor plans to peddle an additional $1.53 billion in bonds next fall and another $2.37 billion next spring.

Some of the above budget items would be hard to qualify as essential. California is still addicted to spending on luxury services and programs to favored political constituencies, while its naked governor continues to create an image of austerity and budget cuts.

Why any private investor would buy California tax-exempt bonds, on which the state is apparently making a profit, or could earn the same interest rate in T-Bills is an unanswered question. This is perhaps why California is using older, pre-authorized bonds and currently has elected to avoid issuing new bonds in the money markets.

Investors are balking at buying more California bonds even at higher interest rates. According to Harkey, State Treasurer Bill Lockyer plans to remedy this situation by issuing “mini-bonds” in denominations of $25 to apparently unknowledgeable California investors in the future. One can imagine that entrepreneurs might print fake “California Great Depression Bonds” showing Gov. Brown on their face, sans clothes, as a souvenir.

$1.895 Billion Balloon Bond Payment Owed in 2013

Under ABX4 14 and 15, enacted by Gov. Schwarzenegger and the Legislature as part of the fiscal year 2009-10 State budget packages, the local government protection provisions of Proposition 1A of 2004 were suspended. Prop 1A was originally enacted to protect state raids of local government property taxes.

The relaxation of Prop. 1A allows local governments to “loan” an 8 percent portion of their property taxes to the state, which must be returned with interest in no longer than three years. These bond monies went to fund public schools.

Under the 2009 loan arrangement of ABX4 14 and 15, California must pay back $1.895 billion in revenue bonds by 2013; and pay three years of interest at 4.8 percent, reflecting $90.9 million of interest per year. The Statewide Community Development Authority, a statewide redevelopment agency, issued these bonds and is administering bond interest payments. How a naked governor wrapped in the robes of a Buddhist monk plans to repay $1.895 billion in bond principal by 2013 remains uncertain.

Revenue Bonds Threatened by “State Arbitrage” or Flight

Investment analyst Meredith Whitney, who warned of the Bank Panic of 2008 before it occurred, has predicted a large number of municipal bond defaults, especially in California. Whitney has recently clarified that what she meant was not defaults of government general obligation bonds, but revenue bonds that are used for self-sustaining projects such as redevelopment, tollways, conference centers and stadiums.

What Whitney apparently hasn’t recognized is that her prognostication of bond defaults has already occurred. In an online paper by Daniel Bergstresser and Randolph Cohen of the Harvard Business School titled, “Why Fears about Municipal Credit are Overblown,” they point out that in 2009, municipalities in the United States defaulted on 178 bond issues with an aggregate value of $3.5 billion. In 2010, there were 75 more bond defaults totaling $1.7 billion.

In a $2.5 trillion overall municipal credit market, this reflects a default rate of about one-fifth of a percent (0.2 percent). Whitney’s prediction of hundreds of muni-bond defaults has already occurred, but the amount of losses has been small relative to the whole market.

The doomsday default prediction has reportedly already been embedded into the interest rate of bonds and prices of bond insurance as reflected in what is called the MCDX 5-year index spread. The MCDX is an index of 50 municipal bond credit default swaps, or insurance, on municipal debt. That index is up over 100 percent since November 2009.

The MCDX Index assumes a 7 percent annual bond default rate and market interest rates spreads expecting 30 percent of municipal bond issuers going into default through 2014. If Meredith Whitney is right, most of the future bond defaults will occur in revenue bonds. No wonder Gov. Brown wants to shut redevelopment agencies down.

According to Meredith Whitney, the specter of future revenue bond defaults could be hastened if “state arbitrage” occurs on a larger scale than it is already happening in California. Whitney defines “state arbitrage” as where businesses and workers flee fiscally stressed states for business-friendly, lower-tax states such as Texas. State arbitrage, or middle-class flight, would undermine retail sales in shopping centers financed with redevelopment bonds.

That would result in fewer travelers on bond-financed toll roads, and fewer fans at sporting events in stadiums backed by redevelopment or Build America Bonds (BABS). The trend that is emerging at Dodger Stadium in Los Angeles — gang crime inflicted on middle-class victims and a resulting decline in attendance — might be a portent of the future.

An OPEB is Like a MOPED — Underpowered

A MOPED (motor velociped) is a low-powered motorcycle or scooter that can be driven by pedaling and/or a small motor. OPEB is a bureaucratic acronym for “Other Post Employment Benefits.” OPEB refers to health benefits for government retirees, which are often off budget and underfunded, like a MOPED is underpowered. In other words, retiree health benefits are not shown on state budgets and are funded out of cash (“pay as you go”). OPEB’s weren’t required to be reported until 2008.

The State Legislative Analyst reports that, prior to 2008, retiree heath benefits were not funded at all in California. They were uncovered, naked. State Controller John Chiang reported a $51.8 billion unfunded liability for health and dental benefits for CalPERS and CalSTRS retirees for whom California didn’t create a retiree health benefit trust until 2007. The California Employees Retirement Benefit Trust earned 13.4 percent in 2010 in what must be highly risky investments, given that private investors cannot realize those kinds of returns except on junk bonds with a high risk of default.

Budget Clothes Make the Man

Gov. Brown’s May Revised Budget plan to retire $29 billion in debt by 2015 thus far looks like an empty suit. Instead of putting $5 billion in tax extensions on the upcoming ballot, Brown could have put to the voters whether they still want to continue funding duplicative stem cell research ($3.5 billion), high speed rail ($9.95 billion) and the unspent funds from five water bonds that mainly went for open space land acquisitions and water studies ($4.1 billion) — at the same time California’s Unemployment Fund is broke and the deficit will balloon to $20 billion by the end of 2011 if nothing is done.

Mark Twain, who often dressed in fancy white suits, famously said: “clothes make the man.” And in California, how the politically unclothed governor dresses up the public debt is a reflection of how much reality we can deal with. California’s debt picture is still highly problematic. But Gov. Jerry Brown and Treasurer Bill Lockyer continue to look for a suit to dress it up in. They know that a stylish appearance is a lever to power. Continuing to dress up California’s debt in a business suit seems to have taken a lesson out of that book.