Buy Side

California a Crisis That's on the Brink

Mitchell Savader’s job is to stay one step ahead of the rating agencies.

He believes that staying ahead of the rating agencies right now means preparing for California’s credit rating, already the lowest of any state, to soon drop even lower.

Savader, chief executive officer of Savader Asset Advisors, sees California’s single-A credit rating from Standard & Poor’s and A2 from Moody’s Investors Service as inconsistent with the state’s credit profile. Savader’s firm provides credit advisory services on $2.1 billion in assets for investors.

With a $24 billion budget gap and what he describes as a dysfunctional political system, Savader believes that the Golden State is likely to sustain a drop in its ratings, perhaps to triple-B or Baa.

In May, California’s personal income tax receipts slipped 39%, corporate taxes tumbled 52%, and sales taxes dropped 7%.

Savader said these shortfalls reflect the weak economy, and he does not expect a turnaround any time soon.

However, his concerns about the state’s credit reach beyond a sickly economy.

“The problems of the economy and how they affect the state’s revenue base aren’t the core of the problem,” Savader said. “They’re really what’s magnifying the structural problem.”

Here is the structural problem as Savader describes it: the state Legislature requires a two-thirds majority to pass a budget, a process he believes consistently leads to gridlock; California voters can approve spending without approving the source of the money for the spending; and any measure designed to increase state revenues also requires the same two-thirds supermajority in each house of the Legislature.

These factors make it difficult to increase revenue or cut spending, Savader said.

“When times are good, there’s significant amounts of revenue generated by California’s huge economy and it’s easier to accommodate increases in spending,” he said. “When times are bad, they can get very bad .... It’s a dysfunctional political process that we see as really driving the potential for a downgrade. It’s a process that allows for increases in spending far more easily than increases in revenue to cover the spending.”

Savader does not contemplate default. The state’s bonds are what he calls “money-good,” meaning bondholders will be repaid 100 cents on the dollar.

What concerns him is the eroding buffer protecting bondholders, and its implications for the state’s rating.

“We’re not looking at the payment of debt service in terms of pass-fail, because we believe it’s a pass,” Savader said. “The margin by which it passes is getting narrower and narrower. It’s that narrowness that should be reflected in a bond rating.”

With the yields on California’s 10-year general obligation bonds up a percentage point in the past month, according to Municipal Market Data, Savader believes the bond market has already begun to anticipate a downgrade.

California general obligation bonds maturing in 2019 yield 5.1%, according to MMD, which is 178 basis points higher than triple-As at that point of the MMD yield curve scale.

By comparison, Maryland’s 10-years trade at 3.32%, Louisiana’s yield 4.29%, and Michigan’s trade at 4.42%.

The yield on Baa-rated 10-years, though, is still more than a percentage point higher than the yield on California’s 10-years.

Standard & Poor’s downgraded California’s GO credit in February and Moody’s followed suit in March. A triple-B rating for California would not be unprecedented: Standard & Poor’s assigned that rating to the state for more than a year beginning in July 2003.

California has pleaded for support from the federal government, and Savader thinks the state has a 50-50 chance to get it.

Whatever support the Obama administration offers, though, would likely come with strings attached, according to Savader.

In that case, bondholders should not assume making creditors whole would be the federal government’s first priority, he said.

He pointed out that bondholders in some companies bailed out by the government have not been too happy.

More likely, the federal government would emphasize essential services, and bondholders “would probably be pushed farther down the line,” Savader said.

The Obama administration is “looking out for the public good, as opposed to a strict interpretation of investors’ interests,” he said.

Following the implosion of the bond insurance industry, Savader said his firm is helping bond funds and wealth and asset managers that used to rely on this insurance assess the underlying credit profiles of their municipal assets.

Savader Asset Advisors is an affiliate of StoneCastle Partners LLC.


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