California to lead us into Abyss

California Leads Nation to Bond Default Abyss: Kevin Hassett
Commentary by Kevin Hassett

June 1 (Bloomberg) -- There is an old joke that a borrower dies if everyone stops believing in him. A look at the history of financial crises suggests there is a kernel of truth in this.

That's why the California budget crisis may well lead to a second financial calamity that would be far worse than anything experienced over the past 18 months.

California is, of course, facing a debacle. Voters rejected a series of ballot initiatives designed to restore some sense of sanity to the state's budget. As a result, California is more than $21 billion in the hole.

Governor Arnold Schwarzenegger is struggling to find enough spending reductions to close the gap, but investors are skeptical. According to Fitch Ratings, which in March downgraded California's general obligation bond rating, California has the worst rating of any state.

Even amid economic calamity, the people of California are relatively wealthy, and the state's economy is an impressive engine. If California were a country, it would have the eighth- largest economy on Earth. Given those advantages, the notion that California might default on its government debt might seem farfetched. After all, the reasoning goes, they can always raise taxes to pay off debt. Even a gridlocked legislature might act if California gets too close to the edge.

The problem with that line of thinking is that California's politicians might get little notice that desperate times are at hand. For some borrowers, the first sign of problem is their inability to make an interest payment. For others -- and here lies the nightmare scenario -- the problem first becomes visible when all the lenders disappear.

My reaction: As Kevin Hassett writes, “The California budget crisis may well lead to a second financial calamity that would be far worse than anything experienced over the past 18 months.”

1) California is more than $24.3 billion in the hole.

2) On Monday, California Gov. Arnold Schwarzenegger ordered a halt to funding for state contracts on everything from pencils to office space.

3) California's state controller has warned about the state running out of cash in two weeks (this warning happened last week).

4) The likely scenario (also the nightmare scenario) is that all California’s lenders disappear, and the state is unable to roll over its debt.

5) If the unofficial eighth-largest economy fails on its debt, it will cast doubt on all government debt, especially treasuries.

6) The US government's fiscal situation is in worse shape than California's.


Conclusion: The ‘bad’ phase of the financial crisis is on the verge of beginning. It involves the dollar’s collapse, soaring commodities, and skyrocketing interest rates.

The time frame for everything to really start falling apart is the next two or three months. California budget crisis is one of many factors which sets this time frame (default is likely within three months). A default by California would drag the bond market into the abyss.
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