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California's Debt Crisis as Bond Holders Lose Confidence in the States Ability to Repay

Interest-Rates / US Debt Jul 16, 2009 - 01:13 AM GMT

By: John_Browne

Interest-Rates

Best Financial Markets Analysis ArticleBad for the Goose, Worse for the Gander - Last week, major banks announced they would no longer offer cash for the IOU's written by the state of California. At the same time, China proposed that the U.S. dollar be replaced as the world's official reserve currency. Although seemingly unrelated, these two developments have at their root the same issue: uneasy creditors.


Inspired by Washington's profligacy, California's Democratic majority long pursued a policy of populist politics, supercharged by referendums, which called for increasingly massive expenditures. Exploding deficits were the natural result. Now, it has reached the point where holders and potential buyers of California debt have lost confidence in the state's ability to ever repay.

Ever since President Nixon severed the dollar's link to gold in August 1971, the U.S. has embarked on a monetary policy that has been both a blessing and a curse. The blessing was found in the dollar's reserve status, which allowed for monetary flexibility that no other country could attempt. But therein lay the curse, as gross economic imbalances were allowed to grow unaddressed. Our currency's exportability obscured the fact that our government spending was financed largely by inflation and debt.

It appears that California politicians assumed that they could follow the same model. They began to authorize massive expenditures on freeways, schools, universities, and parks. In their thirst for votes, they introduced a vast array of referendums on entitlement issues. This is quite unlike Switzerland's successful forays into direct democracy, which restricted referendums to election laws and constitutional matters. Absent limits to their purview, California voters inevitably granted themselves new benefits from the public purse, financed by increased taxation and debt. This led to ever higher voter demands and a dramatic rise in real estate values.

In imitating the example of Congress, California's politicians made one crucial error. Like the Administration, they could tax and borrow. But unlike Washington, California could not print money.

Recently, California's politicians have realized that there are limits to taxation, and even debt levels. The real estate recession has hit California particularly hard, while rising unemployment and bankruptcies have reduced the local tax base significantly.

The resulting deficit has scared bond buyers. Creditors were further alarmed when President Obama expressed his unwillingness to divert federal aid to California. Unable to finance its expenditures, California has effectively tried to issue its own currency in the form of IOU's. But banks are now refusing them.

Congress faces a similar predicament. China, the world's largest gold producer and holder of surplus U.S. dollars (or IOU's), is concerned about America's ballooning debt and the depreciating value of the dollar. China is proposing that the dollar be replaced as the world's reserve currency. If this were to happen, the U.S. would lose its “reserve privileges”, which would adversely affect its ability to issue new debt and cause consumer prices to soar. Untold damage would be done to both America's morale and its potential for a quick economic revival.
Sacramento might have followed Washington down a blind alley, but it was first to hit the wall. When the central bank can no longer keep the federal government on life support, California's troubles will be America's. Watch the painful process of spending cuts that California is undertaking, as it portends our collective future.

The lesson is that Washington is a bad influence and a bad mentor. Our trust is placed where the governments' behavior justifies it: fast-developing countries, such as Brazil, India and China, as well as major natural-resource suppliers such as Canada, Australia, and New Zealand (collectively known as BIC-CAN).

The BIC-CAN countries offer very appealing investment opportunities, especially in the fixed-income world. Meanwhile, California and U.S. Treasury bonds are just too big a risk.

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read Peter Schiff's new book For an updated look at his investment strategy order a copy of his just released book " The Little Book of Bull Moves in Bear Markets ." Click here to order your copy now .

For a look back at how Peter predicted our current problems read the 2007 bestseller " Crash Proof: How to Profit from the Coming Economic Collapse ." Click here to order a copy today .

By John Browne
Euro Pacific Capital
http://www.europac.net/

More importantly make sure to protect your wealth and preserve your purchasing power before it's too late. Discover the best way to buy gold at www.goldyoucanfold.com , download my free research report on the powerful case for investing in foreign equities available at www.researchreportone.com , and subscribe to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp

John Browne is the Senior Market Strategist for Euro Pacific Capital, Inc.  Mr. Brown is a distinguished former member of Britain's Parliament who served on the Treasury Select Committee, as Chairman of the Conservative Small Business Committee, and as a close associate of then-Prime Minister Margaret Thatcher. Among his many notable assignments, John served as a principal advisor to Mrs. Thatcher's government on issues related to the Soviet Union, and was the first to convince Thatcher of the growing stature of then Agriculture Minister Mikhail Gorbachev. As a partial result of Brown's advocacy, Thatcher famously pronounced that Gorbachev was a man the West "could do business with."  A graduate of the Royal Military Academy Sandhurst, Britain's version of West Point and retired British army major, John served as a pilot, parachutist, and communications specialist in the elite Grenadiers of the Royal Guard.

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Comments

ric
17 Jul 09, 14:06
California's Debt Crisis as Bond Holders Lose Confidence in the States Ability to Repay

There is growing acknowledgment amongst some municipal bond analysts that downgrade risk has increased substantially and therefore significant investor risk of mark to market devaluation may occur. Investors should forget about liquidity when their municipal bond issue is downgraded ....unless they are prepared to take a capital loss.

It is astonishing that municipal bond investors are “blocked” about downgrade risk. Some investors think of municipal bonds as commodities like U.S. Treasuries which they are not. The credit element in a municipal bond is far more complex than a U.S. government bond. A municipal bond investment today should be considered more like a loan to a municipality or municipal agency . What is troubling for the investor is the closed nature of the municipal bond industry which is not much different than structured or derivative product markets which lack transparency.Municipal bond nvestors ignore the significance of rapidly declining municipalities' tax receipts, the Federal Government’s intervention via propping municipalities up with new financial instruments such as Buy America Bonds . States like California are on a slippery road to bankruptcy unless they manage a very severe budget correction soon. Other states like New York are equally in trouble .........no one talks about what is happening financially to New York State and New York City. Check the tables in this document published by the national Conference of State Legislatures:

http://www.ncsl.org/documents/fiscal/StateTaxPerformanceJune2009.PDF

You will see in this report the collapse of tax receipts for New York by a 48.9% decline through April 2009 versus 2008 in Personal Income tax receipt. By comparison, California’s PIT receipts were only down 20% for the same period. Without the lucky surplus New York has had, New York would this year be in the same boat as California, or worse. Next year could reap havoc for New York municipal bond holders when the budget surplus is gone. Are municipal bond analysts missing something? In the Corporate bond market, increased default or downgrade expectations are matched with increased borrower cost. Munis cannot remain immune to this market phenomena . Check these reports and you will deduce the true status of municipalities' ability to pay back investors:

http://www.rockinst.org/pdf/government_finance/state_revenue_report/2009-07-17-SRR_76.pdf

and:

http://www.nasbo.org/Publications/PDFs/FSSpring2009.pdf

Municipal bonds are high in their own stratosphere right now as a credit investment product. They should be compared to medium to low investment grade and to even below investment grade loans. The only time they came close to reflecting their true underlying credit reality was in Q4 2008. So when the Rockefeller Institute of Government says "sales tax in late 2008 was worst in 50 years" no one pays attention. No one should be told that muni rates have gone down because muni credit risk is declining. A shoe is going to drop in the muni market and when it does to it’s going to hurt investors. When some in the financial press tell people that investors are "gobbling up" munis I say watch out!

Imagine a perfect product: the whole world is in financial turmoil and there is an investment product called municipal bonds that you don’t have to pay taxes on, you don’t have to worry about default "because its negligible", don't fret about liquidity even if your bonds get downgraded because you got a 7-10 % effective yield and that beats DOW and S&P hand over foot. You just make money and don't even bother to look back.. Muni bonds become a kind of narcotic for investors who are lulled by their tax status and yield, ignoring the underlying risks which have become increasingly dangerous: no liquidity , risk of credit downgrade, and risk of default.


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