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.