State of California Update

California, the most populous state in the nation and representing roughly 13% of US gross domestic product (GDP), captured its fair share of headlines in 2012. While much of the news flow was not favorable, the state is entering the second quarter of its fiscal year headline-free and with operating performance reasonably on track. For the first time in recent memory, monthly revenue reports from the state controller's office are not sounding warning signals of impending crisis as a slow and somewhat steady economic recovery continues to grind forward. In the following pages, we review the state of affairs in California, address the year's major headlines and discuss the implications for the broader municipal market.

The Making of a Balanced Budget

Governor Jerry Brown signed the 2012-13 Budget Act four days before the start of the fiscal year (FY), closing a $15.7 billion gap and establishing a $1 billion rainyday reserve. This marked the second consecutive year of budget success. The 2012-13 budget required deep spending cuts of $8.1 billion (49% of solutions) and assumed temporary taxes and other revenues would generate a total of $6 billion (36%). Special fund transfers, interfund loan rollovers and other fee revenues totaling $2.5 billion (15%) rounded out the package (see pie chart on next page). Expenditure savings targeted major health and human service programs such as Medi-Cal, CalWorks, Cal Grants and childcare. The final budget fix had to overcome an expanding shortfall during the first half of calendar year 2012, driven by weak revenue performance from personal income tax receipts and higher guarantee requirements for education. Notably, the latest revenue forecasts reflect tempered optimism for modest economic growth in 2013, with projections for personal income gains of 3.4%, California unemployment of 10.4% (the rate stood at 10.2% in September) and US real GDP of 2.4%.

A cornerstone of the FY 2012-13 budget was the presumed passage of the governor's Proposition 30 tax initiative. The budget relied on temporary tax measures—up to a 3% increase in income taxes for seven years on those earning over $250,000 and a supplemental 0.25% sales tax for four years—to generate $8.5 billion in gross revenue. Fortunately, voters approved Prop 30 on November 6, avoiding the contingency trigger of $6 billion in automatic spending cuts (mainly targeted at K-12 education) and an immediate mid-year budget gap of $2.5 billion.

Forecasts and Frustrations

California's annual revenues have fallen short of expenses for more than a decade, and the 2012-13 budget could see other forecasting challenges. The larger budget items we believe are at risk, at least to some degree, relate to savings and one-time cash transfers tied to the dissolution of the redevelopment agencies ($2.4 billion), personal income taxes related to the Facebook IPO ($1.2 billion), restructuring cost savings at Medi-Cal and CalWorks ($1.9 billion) and new revenues tied to carbon cap-and-trade auctions ($500 million).

Moreover, the unpredictable outcomes of federal fiscal policy—related to the across-the-board cuts that would come with sequestration and the so-called fiscal cliff—are assumed to be resolved by year-end 2012. Nevertheless, federal spending represents more than one-third of total state spending and the threat of federal cost cutting looms ominously over California's fiscal health. A report from the State Budget Crisis Task Force highlighted the potential implications, noting that federal procurement and salaries represent 4% of state GDP. The report estimated that a 10% reduction in federal grants to California would cost the state $6.7 billion, eating primarily into health and human services. Although global macro uncertainties related to the fiscal cliff in the US, a slowdown in China and the financial crisis in Europe could not be specifically addressed in the 2012-13 budget, they will certainly shape the economic assumptions for the governor's 2013-14 budget proposal in January and revised in May.

The Power of the Vote

The state's accelerated progressive tax strategy, which concentrates on the highest earners (the estimated wealthiest 1% of taxpayers would pay more than three-quarters of Prop 30), achieved the necessary majority backing of its electorate on Election Day. The downside of this narrow revenue solution is that it adds more volatility to a revenue structure that has already proved to be more volatile than its peers. Interestingly, voters in San Jose and San Diego overwhelmingly passed local pension reform measures this past June, and in September the legislature responded with some of its own statewide pensionreform measures. The notable cost-savers included raising the retirement age for new employees and increasing employee contributions to at least 50% for both new and current workers. The state's preliminary analysis of its portion of the savings was estimated in the range of $10 billion-$13 billion over the next 30 years. Although voters may have noticed lawmakers' newfound interest in addressing generous pension and benefit packages as a cost problem, Prop 30 was successfully pitched as a panacea for financially stressed school districts. Still, more practically, it appears the trend of escalating fiscal distress among California cities may be starting to capture the attention of Sacramento.

Bankruptcy Filings and Lessons Learned

Following Vallejo's emergence from Chapter 9 bankruptcy in 2011, 2012 brought three more notable headlines with the bankruptcy filings of Stockton, Mammoth Lakes and San Bernardino. Investors question whether this trifecta signals the next wave of distress within a traditionally safe asset class. We do not believe it does, and would point out several factors that differentiate these cases, and California in general, from many other areas of the country.

In the case of Mammoth Lakes, the Chapter 9 filing was eventdriven—an extraordinary legal judgment amounting to more than two times the city's general fund spending. The "automatic stay" benefits afforded under Chapter 9 give Mammoth Lakes the time to negotiate a right-sizing of its liabilities to ensure the financial capacity to provide basic municipal services to its citizens. Mammoth Lakes and the plantiff real estate developer have reached a settlement and the town is formulating the details of its restructuring plan. A monetary default in such a catastrophic budget circumstance is not without precedent and should not come as a surprise. Cities, unlike corporate entities under Chapter 11, cannot be liquidated and, theoretically, exist in perpetuity.

The Stockton and San Bernardino distress stories share some fiscal and economic commonalities that other issuers and bondholders should heed. These cities suffered from various ills: 1) revenue shocks related to sharply depressed home prices and a weak recovery from the Great Recession; 2) high fixed costs associated with burdensome employee pay and benefits packages; 3) general fund interdependence related to a dissolving redevelopment district; and 4) reactive fiscal management that did not make the difficult, but necessary, decisions to maintain structural balance. Stockton's aggressive civic redevelopment efforts undoubtedly added significant debt leverage that exacerbated its challenges. San Bernardino, meanwhile, had financial management problems that included late audits and potential accounting irregularities with unauthorized special fund transfers. Their distress hardly came as a surprise.

Notably, California locals also are more vulnerable to fiscal pressure due to limited revenue flexibility and restrictions imposed by the state constitution under Proposition 13, which caps the property tax rate at 1% of the assessed value of a home and holds annual tax increases to no more than 2%. While overall assessed valuations in California turned positive in 2012 (after declining in 2010 and 2011), certain locales still face negative growth, pressuring revenues. Notably, California locals are highly dependent on voters' support for any additional taxes to maintain service levels to residents when large traditional sources (such as state aid and property taxes) have and continue to come under pressure. City managers must be proactive when deciding to use the new revenue option from their fiscal toolkit because of the mechanics of getting the tax proposal on a ballot. The League of Cities has reported that local revenue ballots have enjoyed positive support from constituents.

As a more drastic alternative, some California cities have resorted to declarations of "fiscal emergencies" as a tactic to get tax revenue measures quickly scheduled on the next available ballot. While clearly a warning signal, declarations of fiscal emergency need to be carefully evaluated to gauge management's financial strategy. From what we've seen, management intentions can be classified into one of four fiscal buckets: 1) a labor negotiation tactic; 2) shortening its tax ballot timeline; 3) red flag of fiscal stress; and/or 4) avoidance of new AB506 mediation requirements. Enacted late last year, AB506 is union-backed legislation intended to limit (or at least delay) local eligibility of bankruptcy protection under Chapter 9. Some observers have suggested AB506 has put the state in the awkward position of advancing a financial strategy to restructure or haircut bondholders.

The State of California does not provide any formal fiscal oversight for cities or counties in distress, with a noninterventionist approach that reflects its tradition of local "home rule." Of late, state officials appear to be revising their thinking. State Treasurer Bill Lockyer recently reported that California is exploring early-warning signals and fiscal tools that it could implement to help locals avoid bankruptcy. We believe headway in structuring an administrative oversight role by the state, with progressive involvement via an advisory and financial support network of state agencies, would be well received by the market. To date, the market has not exacted an extra risk premium for local California issuers, but market access could come at a higher cost without a better "parental" response. The cases of Stockton and San Bernardino could set landmark Chapter 9 precedent in terms of the treatment of a more robust creditor class that includes public pension systems. (Historically, pensions have been treated as a preferred creditor class. It is unclear whether this will remain so.) Bankruptcy plan negotiations that include CalPERS and result in a local no longer required to make full pension payments may force the state's hand to become more proactive managers of city and county fiscal affairs.

California Areas of Strength and Vulnerability

In our July 2012 commentary Local Government Bankruptcies: Cause for Alarm?, we identified potential areas of opportunity and vulnerability (at the county level) across the United States. Our assessment of relative economic health used foreclosure rates, unemployment numbers and various income measures as basic factors to create rankings. We applied a similar analysis within the State of California to identify local names vulnerable to fiscal distress (and potential bankruptcy/default). The areas of relative weakness include several Central Valley and Inland Empire counties. We also identified the top-ten distressed cities using some of the same socioeconomic factors applied to the counties and adding an education-level factor.

Not surprisingly, the cities of Stockton and San Bernardino were filtered in our analysis as "distressed" and indeed filed for bankruptcy. Other larger cities, such as Fresno, Madera, Merced, Porterville, Tulare and Hesperia, also were flagged. Several of the distressed cities identified—Perris, Hemet and Delano—do not have much, if any, general fund-backed debt outstanding. Even if each of the top-ten cities defaulted on its general fund-backed debt obligations, it would still represent a minor proportion of debt within the state and the overall municipal market. As such, we do not view the financial distress seen among California cities as a systematic threat. While defaults may increase in volume and frequency relative to historical experience, we expect such cases to be on the periphery rather than the core of the market.

Moody's View

Following a recent review of all their rated California cities, rating agency Moody's concluded that it will make wider rating distinctions between general obligation debt and general-fund-supported obligations to reflect the weaker willingness-to-pay characteristics of the latter. Ratings action is mainly focusing on lease and pension obligation security types, which do not benefit from having a tax rate dedicated to repayment. Moody's final determination was that it did not expect many cities to follow Stockton and San Bernardino into bankruptcy, but noted that as long as the economic recovery remained anemic, the risk that cities could make that choice is higher.

Conclusion

Following several years of fiscal stress that showcased dramatic mid-year deficits, California budgetary shortfalls have narrowed and longer-term structural balance may actually prove achievable. Voters considerably aided the state's move toward fiscal health by backing the first statewide tax increase in eight years on November 6. Ironically, that same day, voters also gave Democrats their first supermajority in both the Assembly and the Senate since 1883 — a development that likely would have meant legislative approval of Prop 30, negating the need for a public vote.

Notwithstanding the state's fiscal complexities, we continue to find value in California munis and remain vigilant in analyzing the risks and opportunities across issuers and credits.

 

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Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. A fund concentrating in a single state is subject to greater risk of adverse economic conditions and regulatory changes than a fund with broader geographic diversification.

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