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Schwarzenegger Discipline Shattered by Subprime Slump

Oct. 24 (Bloomberg) — Four years after Arnold Schwarzenegger was elected governor of California, vowing to “tear up the state’s credit card,” the actor and former body- builder is about to charge $7 billion to taxpayers’ accounts.

California is selling notes tomorrow due in eight months to help pay its bills until tax revenue comes in, the largest short-term loan since Schwarzenegger took office and almost five times more than last year. Debt is increasing after cash receipts fell $777 million below the state’s projections during the first three months of the fiscal year that started July 1.

Schwarzenegger is losing the revenue cushion he used to plug budget deficits as home foreclosure rates increase at a faster pace than the rest of the country. The rise in IOUs is an early sign that finances are deteriorating after four years of revenue growth won credit-rating upgrades and spurred gains of more than 20 percent on California bonds.

“A California budget crisis is beginning to recur, and the big increase in short-term seasonal borrowing is the classic leading indicator,” said Richard Larkin, a municipal bond analyst at J.B. Hanauer & Co., a Parsippany, New Jersey-based money manager that oversees $10 billion.

Schwarzenegger, 60, may have to cut spending, said H.D. Palmer, his budget spokesman. The state needs to borrow to shore up its reserves after ending last year with about $6 billion less in cash than fiscal 2006, Palmer said.

`Difficult Decisions’

“The continuing slump in the housing market has been a drag on the economy and that has a spillover effect on state revenue,” Palmer said. “It’s very likely going to involve some very difficult decisions on the spending side.”

The note offering marks the first increase in so-called revenue anticipation securities since 2003, when California sold a record $14 billion. Those bonds closed a hole during a budget crisis that helped force the recall of then-Governor Gray Davis and led to credit-rating downgrades. Short-term borrowings have decreased since then as revenue climbed.

California sold $6 billion of revenue anticipation notes in fiscal 2005, followed by $3 billion the next year and $1.5 billion in 2007, according to state figures. It has borrowed $4.7 billion annually on average in the short-term market since 1990.

“This is a pretty big jump,” said John Cummings, who manages $14 billion of municipal debt at Newport Beach, California-based Pacific Investment Management Co., which oversees the world’s largest bond fund. “It was more than I thought it would be.”

Biggest Sale

The yields on the new notes will be set tomorrow, according to state officials. The sale, managed by Charlotte, North Carolina-based Bank of America Corp., will be the largest short- term offering in the municipal market since a $7.4 billion issue by Texas in 2003, according to data compiled by Bloomberg. The debt will mature June 30.

At last year’s $1.5 billion sale, California offered yields of 3.35 percent, or 14 basis points below the Bond Buyer 1-Year Note Index, a benchmark for short-term municipal borrowing. A basis point is 0.01 percentage point.

The new securities may yield 3.35 percent to 3.40 percent, said Tom Dresslar, spokesman for California Treasurer Bill Lockyer. That equates to a spread range of 4 basis points below the index’s current level of 3.39 percent, to 1 basis point above it.

California is offering the notes to individual investors in a three-day period ending today before selling them to institutions tomorrow. It collected $1.17 billion in orders during the first two days, Dresslar said.

Revenue Gap

In the three months ended Sept. 30, the state has spent $10.2 billion more than it received in taxes and fees, according to Controller John Chiang. Officials project a $6.1 billion budget gap in fiscal 2009 between mandated expenditures and projected revenue, up from $1.5 billion in the current year.

Budget officials said they don’t yet have an estimate for how much the blazes raging in Southern California will cost the state. The current budget includes $82 million in emergency funds for fighting fires. That’s in addition to the $861 million allocated to the California Department of Forestry, whose main task is to combat and protect against wildfires in the state.

“Our first thought isn’t to get the accountants together, our first thought is to lay on enough manpower and equipment to knock down these fires, stabilize the situation and then begin the process of recovery,” Palmer said today.

The federal disaster declaration by the Bush administration will allow California to get reimbursed for most of the fire- fighting costs, Palmer said.

Upgrades

Fitch Ratings and Moody’s Investors Service increased California’s credit rating three times during Schwarzenegger’s tenure, while Standard & Poor’s lifted it twice. The state, the biggest borrower in the municipal market, is rated A1 by Moody’s and A+ by S&P and Fitch, each the fifth-highest of 10 investment grades.

While Moody’s and Fitch have “stable” outlooks on California’s debt, and S&P has it at “positive,” all cite the risk to revenue from the housing slump and projections for future budget gaps for leaving the rating the second-lowest in the U.S. after Louisiana.

“People recognize that while there’s a little bit of stress, it’s still a very manageable level and doesn’t appear to have any short-term threat to the state’s credit,” said Paul Brennan, who manages $12 billion of municipal bonds at Nuveen Investments Inc. in Chicago. “It’s in the long term we have to watch.”

No `Upside’

Investors require an extra quarter of a percentage point in yield to own California debt instead of top-rated municipal bonds, down from a high of 63 basis points in July 2003, according to data on 20-year bonds compiled by Bloomberg. That was during the height of the budget crisis under Davis.

The bonds have gained 20.8 percent since Schwarzenegger took office in November 2003, compared with 19.9 percent for the broader municipal market, according to indexes compiled by New York-based Merrill Lynch & Co.

“There doesn’t appear to be much upside potential,” Brennan said.

Foreclosure Rate

The state had the third-highest foreclosure rate in September, or one for every 253 households, according to RealtyTrac Inc., an Irvine, California-based company that has a database of more than 1 million properties from 2,500 U.S. counties. Only Nevada and Florida had higher foreclosure rates.

Home sales have declined 23 percent this year, the California Association of Realtors said Oct. 10. The trade group estimates a decline of 9 percent in 2008.

As many as half of the 450,000 subprime borrowers nationwide whose mortgages reset at new rates through December may lose their homes because they can’t afford the higher payments, according to data complied by UBS AG and Credit Suisse Group. Subprime loans are made to people with poor or risky credit histories.

“If you look at what’s going on in the state in terms of the budget and the revenue projections and the revenue collections over the last few months, things are tighter than they have been in the last few years,” said Emily Raimes, who analyzes California for Moody’s in New York.

Past Patterns

From 1991 to 1994, when an economic slowdown curbed revenue, short-term borrowing rose to $9.5 billion from $5.6 billion. The rating fell to A1 at Moody’s and A at S&P from AAA, the highest possible. Republican Pete Wilson was governor then.

Short-term borrowing climbed again earlier this decade, reaching a record $14 billion in 2003 from zero in 2000 as revenue fell amid a slowdown in the national economy and a slide in Internet shares. The rating plummeted to Baa1 from Aa2 at Moody’s and to BBB from AA at S&P.

“Today’s short-term borrowing is the tip of the iceberg,” J.B. Hanauer’s Larkin said. “This stress will probably play out for two years or more.”

Schwarzenegger campaigned on a promise to rein in spending without raising taxes. “We tore up the credit card,” he told lawmakers during his first State of the State speech in January 2004. “Never again will government be allowed to spend money it doesn’t have. Never again will the state be allowed to borrow money to pay for its operating expenses.”

One-Time Items

While revenue growth helped Schwarzenegger meet that goal during his first four budgets, one-time items were used each year to balance the books.

Schwarzenegger proposed in April that the state sell its student loan guarantee portfolio to generate as much as $980 million for the current fiscal year. He included the revenue in his spending plan though no sale has taken place and Democratic lawmakers who control the Legislature have said it is unlikely a sale will happen soon.

“They made tremendous progress, at least through last fiscal year, in terms of cleaning up a lot of the fiscal crisis that was left over from the previous years,” Douglas Offerman, a credit analyst at Fitch in New York, said in an interview. “But that’s easy to do when year over year you see revenue grow faster than you project. We don’t see that happening any more.”

Unlike in 2003, California isn’t running out of money, said Raimes at Moody’s. The firm said in a report last week that states’ revenue growth is “losing momentum” as the housing slump threatens growing reserves that helped governments win credit-rating increases.

“That’s probably the next big story in the municipal market, not specifically for California,” said Joe Darcy, who manages $3 billion of municipal bonds at Dreyfus Corp., a unit of New York-based Bank of New York Mellon Corp. “I don’t think we’re there yet.”

To contact the reporter on this story: Michael B. Marois in Sacramento at [email protected] .