What Happens When California Defaults?

[Torie]

I am not sure where to put this, so I am going to put it here, since California doing a financial meltdown, may change a lot of electoral equations if it ensures. I post this article without comment by me, for the moment. It was sent to me by email from a source that I trust as to his knowledge of state and local finances.

What Happens When California Defaults?

Written by  Bill Watkins   
December 22, 2009
Bill Watkins is the Executive Director of the Center for Economic Research and Forecasting at California Lutheran University. For more, visit Fox & Hounds Daily.

The California Legislative Analyst’s Office recently reported that the State faces a $21 billion shortfall in the current as well as the next fiscal year. That’s a problem, a really big problem. My young son would say it was a ginormous problem. In fact, it may be an insurmountable problem.

Our governor and legislature used every trick in their books when they created the most recent budget. They even resorted to mandatory interest-free loans from the taxpayers. Now, they have no idea where to go. The Democrats have declared that they will not allow budget cuts. The Republicans will not allow tax increases.

They have probably run out of smoke and mirrors, although their ability to engage in budget gimmickry is enough to make an Enron accountant blush. No one is considering raising revenues by increasing economic activity.

In my opinion, California is now more likely to default than it is to not default. It is not a certainty, but it is a possibility that is increasingly likely.

Then what?

Ideally, we’d see a court-supervised, orderly bankruptcy similar to what we see when a company defaults. All creditors, including direct lenders, vendors, employees, pensioners, and more would share in the losses based on established precedent and law. Perhaps salaries would be reduced. Some programs could see significant changes. This is distressing, but it is better than other options.

Unfortunately, a formal bankruptcy is not the likely scenario. There is no provision for it in the law. Consequently, absent framework and rules of bankruptcy, the eventual default is likely to be very messy, contentious and political.

Other states have defaulted. Nine states defaulted on credit obligations in the 1840s. Most of those states eventually repaid all of their creditors (see William E. English "Understanding the Costs of Sovereign Default: U.S. State Debts in the 1840s," American Economic Review, vol. 86 (March 1996), pp. 259-75.) Unfortunately, the examples in the 1840s are not much help in anticipating the impacts of a modern default. Circumstances are different, and things have changed, a lot.

We’re left with the question: what happens when California defaults?

The worst case would be the mother of all financial crises. According to the California State Treasurer’s office, California has over $68 billion in public debt, but the Sacramento Bee’s Dan Walters has tried to count total California public debt, including that of local municipalities, and his total reaches $500 billion. Whatever the amount, the impact of default could be larger than the debt amount would imply. Other states – New York, Illinois, New Jersey, for example – are in almost as bad shape as California, and they could follow California’s example. The realization that a state could default would shock markets every bit as much as when Lehman Brothers failed. Given the precarious state of our economy and the financial sector, another fiscal crisis would be disastrous, with impacts far beyond California’s borders.

What would a California default look like? In a sense, we’ve already seen California default, when that state issued vouchers. If any company tried that, they would be in bankruptcy court in days. Issuing vouchers didn’t trigger a California crisis because banks were willing to honor the vouchers. If banks refuse to honor the vouchers next time, employees and vendors won’t be paid, and state operations will come to a halt. This could happen if our legislature locks up and is unable to act on the current $21 billion problem.

Another possible California scenario is that the State will try to sell or roll over some debt, and no one buys it. Already, we’ve seen California officials surprised with the interest rates they have had to pay. What happens if no one buys California’s debt? We saw last September what happens when lenders refuse to lend to large creditors.

If we continue on the current path, the worst case is also the more likely case. Bad news keeps dribbling out. One day we find we are paying 30-percent-higher-than-anticipated interest on a bond issue. A few days later, we find the budget shortfall is billions of dollars higher than projected just a short time ago. Every month brings new bad news. The risk that one of those news events triggers a crisis grows with every news event.

Given California’s recent history, it is difficult to believe that the people with the authority and responsibility for California’s finances can act responsibly, but that is what we need. Responsible action would be creating a gimmick-free budget that places California finances on a sustainable path, and provides an environment that allows for opportunity and job creation. But, sadly, Sacramento probably cannot draft an honest balanced budget, and will thus need to plan for California’s eventual default. They need to work with Federal Government and Federal Reserve Bank officials to insure a coordinated plan to limit damage to financial markets. That plan needs to be ready to release when markets go crazy, which is exactly what could happen when participants realize that default is possible. It could be needed sooner than they think.

This article originally appeared at NewGeography.com.

[Sam Spade]

For now the feds will bail them out, I suspect.  Arnold's already gone out with hat in hand a couple of days ago (need to find article).

But I haven't seen any evidence that their sales/income tax receipts are increasing, much less stabilizing.  In fact, recent numbers have continued to decline and, as far as I can tell, the curve is nowhere near turning (once again, will need to pull up data).

FWIW, a California default is an event that would probably cause greater problems than Lehman, given the impact California has on the world economy.

[Bo]

We apply for bankrupcy?

[MaxQue]

If I were the Fed, I would force them to repeal the budget amendments.

[Associate Justice PiT]

If I were the Fed, I would force them to repeal the budget amendments.

     The electorate would have to approve that, so it might end up not happening regardless of what anyone in a position of power does.

[Torie]

Suffice it to say, I exited from California state and local muni obligations a few months ago. I chose to pay the state income tax on muni obligations from elsewhere, or at least in a Muni fund, which  has a small percentage of California issues. I suspect a crisis will be needed to "solve" California's fiscal problems, and it won't be pretty. And it may change the political dynamics if it happens, in ways that we cannot at present really fathom.

[Sam Spade]

We apply for bankrupcy?

States cannot file bankruptcy.

[The Duke]

We apply for bankrupcy?

Can't.  Only municipalities can apply under Chapter 9.

[Sam Spade]

Suffice it to say, I exited from California state and local muni obligations a few months ago. I chose to pay the state income tax on muni obligations from elsewhere, or at least in a Muni fund, which  has a small percentage of California issues.

I would stay away from California munis, but also any munis in general where I cannot validate the solidness of their financial footing.  And, quite frankly, that's a lot of them out there.  Examine the tax receipts and you would agree.

And I say that recognizing their tax advantages if nothing goes wrong...

You must be logged in to read this quote.

We're closer than you might imagine - that's where the writer of the article is correct.  The thing is, the Feds will continue to bail them (and everyone else) out until they are no longer able to (or are unwilling - I consider that low probability given what's gone on so far).

[○∙◄☻¥tπ[╪AV┼cVê└]

We will keep sending our tax dollars to DC to help out Nebraska while our state crumbles.

Anyways, we're obviously not too big to fail.

[MaxQue]

If I were the Fed, I would force them to repeal the budget amendments.

     The electorate would have to approve that, so it might end up not happening regardless of what anyone in a position of power does.

We all know than a crisis will force people to change their mind...
They will complain if California cut a service than they use...

[Associate Justice PiT]

If I were the Fed, I would force them to repeal the budget amendments.

     The electorate would have to approve that, so it might end up not happening regardless of what anyone in a position of power does.

We all know than a crisis will force people to change their mind...
They will complain if California cut a service than they use...

     Lest we forget that the average American seems to have an irrational belief that they can have every government program ever conceived, cut taxes, & balance the budget at the same time. Maybe if the airwaves were blanketed with ads around the clock telling them that they needed to repeal these propositions or else all the state programs would disappear it would work, but I'm not sure otherwise.

[JohnnyLongtorso]

Maybe they could repossess Schwarzenegger.

[Beet]

It can't be allowed to happen. Period.

Btw, what happened to the California constitutional convention?

[Beet]

If I were the Fed, I would force them to repeal the budget amendments.

     The electorate would have to approve that, so it might end up not happening regardless of what anyone in a position of power does.

We all know than a crisis will force people to change their mind...
They will complain if California cut a service than they use...

     Lest we forget that the average American seems to have an irrational belief that they can have every government program ever conceived, cut taxes, & balance the budget at the same time. Maybe if the airwaves were blanketed with ads around the clock telling them that they needed to repeal these propositions or else all the state programs would disappear it would work, but I'm not sure otherwise.

Or, we could just install Sarah Palin as dictator.

[CARLHAYDEN]

First, investment in California government debt instruments will dry up.

Second, the question which has been lingering for nearly fifty years is whether the judiciary can order tax increases (there was an interesting case in Kansas City schools on that issue many years ago).

Third, can a judge and/or his representative order spending reductions?  The D.C. case may shed some light.

Fourth, the chances of the California government getting its act together (slim to none).

[muon2]

First, investment in California government debt instruments will dry up.

Second, the question which has been lingering for nearly fifty years is whether the judiciary can order tax increases (there was an interesting case in Kansas City schools on that issue many years ago).

Third, can a judge and/or his representative order spending reductions?  The D.C. case may shed some light.

Fourth, the chances of the California government getting its act together (slim to none).

The role of the judiciary will be interesting should events continue in their current direction. Generally, it would be up to the state supreme court, since it is a question of the action/inaction of the state legislature. In that case it may come down to the wording in the state constitution.

If a state fails to support a federal mandate, there may be a question that federal courts can take up. Medicaid services might fall in this category, since half the money come from the state for the federal program. Of course, the feds could step up and cover the cost of their mandates, rendering that issue moot.

[© tweed]

bong hits 4 state solvency.

[Lunar]

part of the reason I am fleeing the West Coast

[CARLHAYDEN]

part of the reason I am fleeing the West Coast

So, you destoyed California with your socialist nonsense.

Now you're looking to bring your disease to other states.

[Joe Republic]

Lunar:  Single-handedly wrecking the world's 9th largest economy with his ideology, according to some internet crackpot from Arizona.

[Lunar]

I don't particularly remember forming California's public policy or even being anything but a critic of it.  Maybe one of those drinking episodes resulting me talking to the state legislature and telling them they're doing a great job, but I just can't recall it.

[Torie]

I don't particularly remember forming California's public policy or even being anything but a critic of it.  Maybe one of those drinking episodes resulting me talking to the state legislature and telling them they're doing a great job, but I just can't recall it.

Lunar, even if it is all your fault, and we tar and feather you as a lagniappe to burning you at the stake in the middle of  Fashion Island in Newport Beach, so that all the well turned out nubile trophy wives can  get all hot and bothered watching the  Commie perp writhe in agony  up close and personal, that still leaves the small matter of how to undue all of your damage.

I suggest California take over Texas, and steal all of its oil money. Of course, we don't want its residents, just its money.

[Southern Senator North Carolina Yankee]

I don't particularly remember forming California's public policy or even being anything but a critic of it.  Maybe one of those drinking episodes resulting me talking to the state legislature and telling them they're doing a great job, but I just can't recall it.

Lunar, even if it is all your fault, and we tar and feather you as a lagniappe to burning you at the stake in the middle of  Fashion Island in Newport Beach, so that all the well turned out nubile trophy wives can  get all hot and bothered watching the  Commie perp writhe in agony  up close and personal, that still leaves the small matter of how to undue all of your damage.

I suggest California take over Texas, and steal all of its oil money. Of course, we don't want its residents, just its money.

Why? You got oil and Natural Gas. Pass and oil extraction tax, get the feds to adopt a revenue sharing program with the states for the money collect off OCS drilling, and then drill in the OCS. It would deliver for more money then legalising Pot would.

It can't be allowed to happen. Period.

Btw, what happened to the California constitutional convention?

CA really needs one of these desparately. The legislature is worthless. The people won't stop using that stupid intiative process to legislate themselves a free lunch, the special interests especially.

It took 40 years to take the greatest paradise and most desired spot in the US to live(when it was most promoted as such around the 60's) and turn it into something worse then New York state. Congratulations California. You deserve it.

[Хahar 🤔]

What, it's unpleasant to live here now? I hadn't noticed.