S&P Puts California on Negative CreditWatch

I was sent this article from a contact at Bear Stearns, but I think its worth posting the whole thing--

Action Comes as Budget Crisis Drags On

Bond Buyer Wednesday, June 17, 2009
By Rich Saskal

SAN FRANCISCO — As lawmakers in Sacramento this week showed increased signs of coming to an impasse over California’s severely unbalanced budget, Standard & Poor’s placed the state’s A-rated general obligation bonds on negative CreditWatch.

In its late Monday analysis, Standard & Poor’s, while stating its belief that California “retains a fundamental capacity to meet its debt service,” also raised the specter of an increased risk of missed debt-service payments should the state fail to adopt the budget actions needed to avoid a liquidity crisis.

A spokesman for state Treasurer Bill Lockyer castigated the rating agency for those comments.
“Once again, Standard & Poor’s has understated California’s ability to meet its debt service obligations and overstated the risk that we won’t,” said Tom Dresslar, Lockyer’s spokesman. “This commentary raises undue alarm over what they call the potential for missed payment.”

The Standard & Poor’s action affects approximately $59 billion of GO debt as well as $8.1 billion of A-minus rated appropriation debt. It’s the second such rating action since the end of May, when Fitch Ratings revised its outlook on California’s A rating to negative. Moody’s Investors Service retains an A2 rating and stable outlook.

The action comes as state lawmakers this week, through a special conference committee, attempt to formalize their response to Gov. Arnold Schwarzenegger’s plan for $24 billion in budget solutions, including some $16 billion in program cuts.

While that committee, over the past two weeks, has voted on aspects of the budget on a piecemeal basis, it hasn’t yet put all those actions into a spreadsheet that delivers final totals, according to a spokesman for the committee’s chair, Assemblywoman Noreen Evans, D-Santa Rosa.

The votes it has taken, however, have diverged from the governor’s proposals in a number of significant ways — mostly ways that widen the budget gap.

Lawmakers voted to preserve programs the governor proposed eliminating, and also rejected his plan to borrow $2 billion from local governments.

H.D. Palmer, finance spokesman for Schwarzenegger, said the Standard & Poor’s action underlines the severity of the state’s predicament and the need for action.

“It is independent confirmation of what we’ve been saying for some time: that the failure to adopt a solution to close this $24.3 billion budget gap in a very short period of time is going to have very dramatic consequences for the people of California,” he said.

Lockyer, a Democrat, has told lawmakers that they need to adopt budget revisions equal to the governor’s proposals, including a significant reserve in order to avoid a cash crunch by the end of July. He said those actions are needed to persuade investors to loan California up to $10 billion to manage the state’s cash flow over the course of fiscal 2010, which begins July 1.

But Dresslar said Lockyer strongly disagrees with Standard & Poor’s even hinting that the state’s liquidity crisis would have any impact on its ability to service its bond debt.

“There is zero risk that California will fail to pay its bond investors on time and in full,” Dresslar said.

California’s constitution gives debt service payment priority just under education. Standard & Poor’s, in its analysis, said the state, after meeting its education obligations, should have more than $50 billion in resources available in fiscal 2010 to pay its approximately $5.74 billion in debt service obligations.

If the state is unable to adopt a budget solution that allows it to borrow to meet its immediate cash needs, the result is likely to be that the government begins deferring payments, or issuing registered warrants, a form of IOU, to lower-priority obligations, including those to vendors, for student aid, and for tax refunds, according to Standard & Poor’s .

“A failure to address the structural budget gap leading to significant use of registered warrants, payment delays, and more acute liquidity strain could cause the rating to fall below the 'A’ category,” its analysis said.

Credit analyst Dick Larkin, a senior vice president at Herbert J. Sims & Co., said California is likely to face downgrades to triple-B levels.

“I think that the rating agencies haven’t acted sooner because they have been under pressure to recalibrate ratings higher under the 'global rating’ concept,” Larkin said in an e-mail yesterday. “As a result, I don’t think that the raters would consider ratings below investment grade. The last time a state came close to a non-investment grade rating was Massachusetts in September 1990.”

A California default is unlikely, in Larkin’s view, but not impossible.

“Could there be a situation where California tries to pay maturing short-term debt with Raws (basically IOUs)? I think so,” he wrote. “But if the crisis came to a missed payment, I believe that the state would cure it very quickly, because it cannot afford to be locked out of credit markets.”

Being on CreditWatch doesn’t mean a rating change is inevitable, according to Standard & Poor’s, but reflects short-term trends that require special surveillance from its analysts.

Standard & Poor’s last put California on negative CreditWatch in December, citing concerns about cash shortfalls. It removed it from watch in February in conjunction with a downgrade to A from A-plus.