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California Is More Likely to Default than Iceland or Iraq

George Washington's picture




 

Washington’s
Blog

The Federal
Reserve
isn't the only one who owns credit default swaps betting
that California will default.

As Ed Harrison points
out
, credit default traders have now ranked California in the list
of top 10 governments most
likely to default, with a 20% default probability:

Most recent numbers: 11 May 2010

highest-default-probailities-2010-05-05

California has pushed
ahead of Iceland and Iraq, which were on the top 10 list last week:

Last Week’s Numbers: 06 May 2010

highest-default-probailities-2010-05-05

Central banks and other
savvy players now look to credit default swaps as the primary
economic indicator
for judging an entity's health (and see this
and this).

And
in February, Jamie Dimon - chairman of JP Morgan Chase - warned
that American investors should be more worried about the risk of
default of the state of California than of Greece's current debt
woes.

On the other hand, Dow Jones pointed
out
in March:

Greece and California face
similar challenges: each needs to cut spending and raise taxes to cover
a hefty budget shortfall even as their economies are struggling to
recover from the sharp global downturn.

 

But there are
significant differences that make California a safer bet for U.S.
investors--the key being that California must balance its budget, can't
declare municipal bankruptcy and would likely receive support from the
federal government as a last resort.

 

***

 

"California is a
deficit problem, Greece is a debt problem," said Matt Fabian, senior
municipal analyst at Municipal?Market?Advisors. "Greece needs current
market access in order not to default on their debt. In California, all
the debt is fully funded and debt service is well below 10% of the
state's expenses."

Similarly, Michael Connor argues
today that California is very different from countries like Greece:

California
is so not Greece.

That's the broadly held view in the $2.8
trillion U.S. municipal bond market ....
"It's
wacky," said municipal debt analyst Jeffrey Cleveland at Payden &
Rygel. "Just look at the ratio of debt to state gross domestic product.
It's 10 percent for California and somewhere between 104 percent and 150
percent for Greece."
California's economy, at
$1.845 trillion, dwarfs Greece's and on a stand-alone basis and would be
the world's eighth-largest. It is the biggest borrower in the U.S.
municipal market, which states and local governments use to fund roads,
sewers and other infrastructure.
Most muni debt
comes with tax-free interest and is often bought by rich Americans
looking for tax savings.

***

Munis, whose
total returns have smartly outperformed U.S. Treasuries in the last half
year, have also become increasingly attractive to foreign institutional
investors since 2009's roll-out of Build America Bonds and their fatter
taxable yields.
State governments in the
United States, from tiny Rhode Island to huge California, do face
daunting yearly budget crises and long-term pension and health care
obligations that may require $1 trillion or more to fund over time.

***

But institutional investors, analysts, ratings
agencies and finance officials say a Greek-style collapse of a state
government in the United States is immensely remote, despite some
parallels in exploding pension obligations and aging populations.
"California is not Greece," said Tom Dresslar, a spokesman for
California's state treasurer. "Greece's budget deficit in 2009 was 13.6
percent of its GDP. Our budget deficit, at $20 billion, was 1.1 percent
of our GDP."
LAST STATE DEBT DEFAULT DURING GREAT
DEPRESSION
No state, including California, with $83
billion of general obligation, lease-based revenue and other long-term
debt, has defaulted on interest payments or principal of municipal debt
since Arkansas did during the 1930s, according to Payden & Rygel's
Cleveland.
Overall default rates by U.S. municipal
issuers between 1970 and 2009 totaled just 0.06 percent, according to a
study by Moody's Investors Service, the same agency that rattled global
markets last week with a report saying some European banks would be
weakened by the Greek debt crisis.
That 0.06 percent
10-year cumulative default rate included no state general obligation
stumbles, versus a 2.50 percent default rate over the same four decades
among issuers of investment-grade corporate debt.
Then,
too, many of the commonly taken routes to relief from debt commitments
are barred to state governments. With the exception of Vermont, they
cannot legally run deficits like the U.S. federal government and are
prohibited from filing for Chapter 9 bankruptcy petition, a rarely used
U.S. legal tactic open to some municipal issuers.
"It is
not possible for the plight of one state to take down the rest," Peter
Hayes, a managing director at BlackRock Inc, said in a newsletter. "We
would also argue that the current fiscal crisis is not a debt problem."
Debt service, such as interest payments among the 50 U.S.
state governments, typically runs at just 3 percent of each state's
annual expenditures, according to the U.S. Bureau of Economic Analysis.
"California debt is different from Greek debt," said Kenneth
Naehu, a managing director at Bel Air Investment Advisors in Los
Angeles. "Our debt service is so small a part of our budget that it is
minuscule, and it gets a top priority. For California, restructuring
debt is not possible, but for Greece it may be the best thing."

In
any event, Governor Schwarzenegger is enacting "terrible"
budget cuts
to try to close the budget gap.

But forming a
public bank would be the best way for California to be able to dig its
way out of the hole. See this,
this
and this.

 

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Thu, 05/13/2010 - 15:58 | 349942 Mercury
Mercury's picture

California defaults (or comes close enough), fall into the arms of the federal government and forever has less control over it's own affairs.  What's not to love from Obama's perspective? He's probably pushing with both hands.

Thu, 05/13/2010 - 16:23 | 350021 The Professor
The Professor's picture

I think that's exactly right. I have never bought the argument that "states can't print money, therefore they must default, and any fed intervention creates too many states spending whatever they want, knowing they will be bailed out." Greece was bailed out by those with a printing press, just as California will be.

I think the feds can step in and bail out California under the radar. I can see a nationalized prison system funded by a printing press happening much faster than California furloughing half the prison population or drastically curtailing welfare. Plus, more control!

Thu, 05/13/2010 - 17:46 | 350251 baserunr
baserunr's picture

Professor--

I think Cali is more likely to default than Greece.  The state's budget is heading for a brick wall at 90MPH.  But not to worry, the legislature and Gov have agreed to take their collective foot off of the gas pedal.  However, if you touch the brake, the unions will scream.  I see little appetite for the rest of the States to bankroll Cali's fiscal insanity.  In theory, Cali is a soverign state.  they can tell bondholders to pound sand.  Obama did w/Chrysler.  Then it's not a problem until the state needs to borrow again.

 

Like next year!

Thu, 05/13/2010 - 15:36 | 349861 SWRichmond
SWRichmond's picture

Forgive me for wandering OT a bit, but I couldn't help but notice that Argentina is yet again deemed likely to default.  Dare I suggest that the rampant corruption that overtook the country after the recent default has hastened the next one?  Did Argentina elect demagogues after the earlier default?  Lessons not learned?  Can WE learn from this?

Thu, 05/13/2010 - 06:32 | 348599 Tic tock
Tic tock's picture

So, pork, more pork, pornos and computers.

Thu, 05/13/2010 - 10:32 | 349004 Postal
Postal's picture

Need less pork, and more porn... ;-)

Thu, 05/13/2010 - 09:45 | 348874 Hephasteus
Hephasteus's picture

Oranges, happy cows and pissed off movie makers who only make 16 million on a movie that costs 15 million to make but gets a shit ton of 'awards' goes on sue rampage against pirates.

The Butthurt Locker.

Thu, 05/13/2010 - 00:03 | 348384 Cheeky Bastard
Cheeky Bastard's picture

Nice, balanced, well reasoned article.

+1000

Thu, 05/13/2010 - 03:00 | 348518 Burnbright
Burnbright's picture

I have to agree, but I still don't get how california has a 1.8 Trillion economy. What on God's green earth do we produce in this state that creates that much economic activity, it can't all be house flipping and pot growing.

Thu, 05/13/2010 - 15:08 | 349768 Steaming_Wookie_Doo
Steaming_Wookie_Doo's picture

As a Californian and Latvian, you can only imagine the ecstasy of financial excess I can (at least tangentially) experience. The only thing better than this would be being Icelandic.

As for the size of California's economy, please recall all of the wine, dairy, fruit, nuts, etc we produce for your eating pleasure. High tech, biotech, military (at least in SoCal) and the movie industry. Of course, at least one of my friends is praying fervently for pot to be really legalized, not just in Berkeley and SF...that alone will double the GDP.

Thu, 05/13/2010 - 16:25 | 350031 Burnbright
Burnbright's picture

I live in northern california and as far as I can see there is no real industry. My point was that their isnt any textile or manufacturing jobs. Most jobs in california are either producing drugs like pot, alcohol, or pharm or its in software design/electronics.

Humboldt county for example has had its timber industry basically wiped out. All most all the money comming into Arcata and Eureka is soley do to student loans, pot, or the fishing industry. And yet the cost of living here is increasing not decreasing. A house in this area is 250k to 500k that isn't a mobile home and the average pay around here is 10hr. Nothing adds up.

Thu, 05/13/2010 - 03:25 | 348532 Oh regional Indian
Oh regional Indian's picture

Agriculture, defense and then Silicon valley, in that order I think.

But it is so concentrated (Pasadena and environs for defense) and San Joaquin Valley area for bulk of the ag.

The rest, well, you just need to look around you and count the for sale signs.

At least last I was there in 06, doubt much has changed, especially from what I read/hear.

Wed, 05/12/2010 - 22:43 | 348250 barnvette
barnvette's picture

Saying states won't default, is like saying the housing market will never decline.  Of coarse, Big Ben would likely step in to save the day.

Thu, 05/13/2010 - 06:19 | 348594 Real Wealth
Real Wealth's picture

Caution: when going down a hill in a wheelchair, don't roll into a crocodile's mouth.

Wed, 05/12/2010 - 21:33 | 348133 carbonmutant
carbonmutant's picture

Do not underestimate the spectactular November election payoffs for Ms. Pelosi's efforts regarding health care...

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