Fitting in perfectly with the previous article by Ron Paul suggesting the dissolution of the US welfare state, we now read that insolvent California is borrowing $40 million each day from the Federal government to pay for unemployment insurance. And while we won't comment on the ethics of all of America paying for one insolvent state's unemployment problems, what does need to be highlighted is that California, which already owes $8.6 billion to the government will have to cut a check for $362-million to Washington by the end of next September. As California, as pointed out earlier, is insolvent, it will never make this payment. Which means that we now have a timeline of when the Fed will start bailing out bankrupt states, and that QE3 will next focus monetizing on municipal debt.
With one in every eight workers unemployed and empty state coffers, California is borrowing billions of dollars from the federal government to pay unemployment insurance.
The Los Angeles Times reports that the state owes $8.6 billion already, and will have to come up with a $362-million payment to Washington by the end of next September.
The continued borrowing means federal unemployment insurance taxes are going to increase, upping the annual payroll costs $21 a year per worker.
California tops the list of 32 states that have borrowed a total of $41 billion to pay claims.
The state took out its first loan from the federal government early last year, to deal with rising payment of benefits and number of claims.
Conveniently, S&P today has released an update of their municipal view, with an emphasis on California. Not even S&P can be cheery when discussing the world's allegedly 7th largest economy. The text follows:
Since 1978, when Golden State voters amended their constitution to effectively shift the financing of portions of local government services and education from the state's property tax base to the more volatile income and sales tax base, California has run deficits in 58% of years, compared with deficits in 38% of years in the three decades leading up to the change. Clearly, economic factors also drive the state's fiscal performance. The dot-com implosion of the early 2000s had an outsize effect on jobs, personal incomes, and capital gains. As the decade progressed, the state's labor market mirrored the housing boom and bust, given California's large real estate finance and construction sectors.
We believe that the state's progressive personal income tax structure also exacerbates revenue volatility. Personal income taxes make up slightly more than half of budget proposal revenues for fiscal 2011, and the top 1% of earners pay 48% of personal income taxes – or 25% of general fund revenues. When total personal income declined 2.2%, to $1.57 trillion last year, general fund revenue fell almost 14%, to $84.2 billion in fiscal 2009.
California's struggles through the recent recession have drawn much media coverage – no surprise, we think, given that the state has run deficits in recent years that are larger than many peers' total budgets. When a state that represents 13% of the U.S. gross domestic product faces shortfalls of a combined more than $100 billion over the past three budget cycles, we believe that a certain amount of attention is a given. And we don't expect these long-term fiscal pressures to abate any time soon. Although the state's total debt burden is in our view moderate, it is increasing. Debt service supported by general funds represents 7.4% of the adopted budget for fiscal 2011 and we think could exceed 10% by 2015. Pension and OPEB funding for fiscal 2011 is $5.73 billion, of which $4.11 billion is a direct general fund expense. Taken together, debt service and funding for retirement benefits, not at actuarially recommended levels, represent an estimated 12.2% of general fund spending in fiscal 2011.
Unlike in many other states, California's constitution requires a two-thirds vote of the legislature to increase taxes. Until the Nov. 2, 2010 election budget adoption also required a supermajority vote of the legislature. Negotiation stalemates over both have led some observers to question whether a political standoff could bring about a default. Considering California's senior payments, and using audited 2009 data, we estimate that a 45% revenue loss (annualized) would place material pressure on the state's ability to fund its debt service. This level of revenue deterioration would be approximately 2.5 times the average among states during the Great Depression.
This stress scenario is useful as an analytic exercise, but we recognize that this is an abstraction designed to measure the state's ultimate fiscal capacity. Moreover, although the state has some payment obligations that hold a constitutional priority over those for debt service, they aren't true fixed costs. In recessionary conditions, and as it did for the fiscal 2011 budget, the legislature may suspend a major spending mandate for education. In doing so the state is able to reduce payments for education in sympathy with falling general fund revenues. We believe such legislative adjustment could increase the state's fiscal capacity to fund its debt service. We also observe that for its fiscal 2010 budget, the state implemented $31 billion in spending reductions versus its previous spending trajectory. This illustrates the state's capability to make budget adjustments when faced with extreme conditions.
This track record notwithstanding, we believe budget politics present a meaningful risk to the state's credit due to the cash flow implications they introduce. Whenever the state is without an adopted budget, it is precluded from borrowing in the public debt markets for intra-year cash flow purposes, which helps to smooth the state's cash position during low tax collection months. And yet, even when budget adoption is unusually late, the state controller has cash management tools at his disposal, including payment deferrals and IOUs. Other options include higher interest cross-year cash flow warrants. We believe these extraordinary cash management measures protect the state's bondholders, even if at the expense of vendors and other entities receiving delayed payments.
In our view, an inability to adopt a timely budget has made the state's credit profile dependent on the state's administration and cash management procedures. Although these factors have thus somewhat preserved the state's credit strength during cash crises – and reduced the likelihood of critical liquidity deficiencies – we don't see them as a panacea in the longer term.
Overall, we believe California has less fiscal cushion to absorb additional shortfalls than other states. However, through a combination of the cushion it does retain and the various cash management options it can employ, we believe the state is capable of withstanding further economic weakness while still meeting its debt payments in a timely fashion.
S&P points out the obvious: that without governmente assistance, most states will be toast sooner or later. But yes, aside from that, everything in the economy is peachy.
Government Response Is Key
The recent recession revealed the common challenges faced by many state and municipal governments, and we believe such governments will be facing the lagging effects for at least the next couple of years. This may delay or reduce their ability to address long-term challenges associated with an aging workforce and the benefits they are owed. At the same time, all of the aforementioned governments have statutory or other provisions that strengthen bondholders' claims. In addition, these governments have strong powers of adjustment, which in our view means they have an ability to withstand what we consider to be extreme stress scenarios that could lead to default. Some of the aforementioned borrowers suffer some of these conditions, but we see only Littlefield as having a reasonable risk of default, assuming the status quo continues. While Detroit might need to rely further on state oversight to weather another recession of similar magnitude to the recent one, we think that other governments appear well-positioned to do so.
How governments react to fiscal imbalances in coming years may change our view. Deferring payments in lieu of making structural adjustments – in the hopes of better future revenues – in our view further limits governments' ability to address rising costs. Ignoring OPEB costs could lead to a spike in pay-as-you-go requirements as Baby Boomers retire, unless governments are willing to change benefits. Although we don't expect government actions (or the lack thereof) in any one year to change the default scenarios, the compounding effect of incremental delays and deferrals could become meaningful. In our view, this is why governments' credit quality suffers less often when fiscal stresses appear and more often when officials postpone or overlook issues of structural balance.
The table below, in addition to providing other data, illustrates our assessment of the amount of financial cushion that remained in fiscal 2009 after each government funded its required priority payments (if any) and its debt service. For each case, we relied on information from fiscal 2009 audited financial statements, the most recent available. We recognize that analyzing audited and inherently historic data ignores budgetary and intra-year spending adjustments that would be available to financial managers and policy makers. This analytic exercise uses a consistent source of information and applies a conceptually similar stress test to show what we believe is the degree of fiscal capacity a government would retain if it reduced its expenditures in response to a severe deterioration in revenue.
Because tax-supported debt structures vary by government, we allowed the source of revenue for debt repayment to guide the scope of funds we considered in each case. Where a government pays its tax-supported debt service from a variety of special funds, we considered total governmental funds. Alternatively, we focused on the general fund where it serves as a government's primary source of repayment for tax-supported debts.
Just one thing to note on the chart above: in California all senior status payment + debt service payment are more than half (55%) of all revenues. In other words, California can withstand a 45% drop in revenue before these payments are jeopardized. It can't happen you say? In 2009 it dropped by 14%. This year will be worse. This is a perfect harbinger of what will happen to the US government itself in a few years.