Fitch Drops California General Obligations To BBB

SAN FRANCISCO - Fitch Ratings downgraded California's general obligation bonds two notches to BBB from A-minus yesterday, pushing the state's lease-backed debt to the lowest investment grade, BBB-minus.

Fitch kept the state's bonds on rating watch negative, suggesting the lease-backed debt may fall to junk bond status if a solution to California's budget impasse is not found soon. The agency downgraded the state to A-minus from A on June 25.

"The downgrade to BBB is based on the state's continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis," the agency said in a release. "The rating watch negative reflects the short-term risk, in Fitch's view, that institutional gridlock could persist, further aggravating the state's already severe economic, revenue and liquidity challenges and weighing on the state's credit."

California, which has the lowest state credit rating in the nation from all three rating agencies, last week began making payments with registered warrants, or IOUs, because lawmakers could not agree on a plan to close a $26.3 billion budget gap in time for the new fiscal year.

Controller John Chiang plans to make $3 billion of "non-priority" payments with the IOUs this month, conserving cash for $10.8 billion owed for educational aid, debt service, and other priority payments.

But Fitch said IOUs will only keep the state afloat until October, when its cash-flow deficit is projected to rise to $16.1 billion and the amount of obligations eligible to be paid by IOUs shrinks to $10.6 billion. At that point, the state would have to begin to pare back priority payments.

"Margins for meeting constitutional and court-required contractual commitments are narrowing," Fitch said in a release. "After September 2009, absent any proposed budget and payment adjustments, cash deficits will expand dramatically."

California's economy has been hard hit by the recession. Its unemployment rate rose to 11.2% in May, having more than doubled in the past two years. State revenues, which are particularly volatile because of the state's dependence on capital gains taxes, fell by almost 19% in fiscal 2009 through May, according to the controller.

While lawmakers have spent much of the past eight months working on fixes to the budget, each budget deal has been followed by further deterioration in the economy, forcing increasingly painful cuts on the state.

Gov. Arnold Schwarzenegger last month proposed eliminating the state's welfare program, closing most state parks, and dropping the health coverage for 900,000 low-income children to close the deficit.

Democrats, who control both houses of the Legislature, refuse to close the entire budget gap with cuts to the social safety net, while Republicans, including the governor, refuse to approve new tax increases, arguing that taxpayers can't afford to pay more during the deepest recession in decades.

Fitch's action pushes its California rating to the lowest among the rating agencies. Standard & Poor's last week affirmed its A rating for California's GOs, keeping them on CreditWatch with negative implications. The agency said issuing warrants should allow the state to maintain positive cash flow through August.

Moody's Investors Service last month put the state's A2 GO rating on watch for a possible downgrade.

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