Breaking Views

Default is not an option for California

The Golden State's credit and reputation could not handle the bondholder backlash.

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By Jeff Segal and Martin Hutchinson, breakingviews.com

(breakingviews.com) -- California has to choose a way to erase its $24 billion budget deficit. But unlike recent examples in corporate America, default and bankruptcy can't be on the table. Stiffing state bondholders would only destroy the state's fragile credit and intensify future budget trouble. The Golden State's only real option is to make big cuts now and balance its books.

Like other states, California has to have a balanced budget. It needs to close the gap in its 2009-10 projections by the end of this month. And with tax receipts down 27% from last year, it's set to run out of cash sometime in July.

Some residents have proposed that the state should declare bankruptcy a la General Motors (GMGMQ), allowing it to cut fat more easily. But there's no bankruptcy protection available for states. Chapter 11 is for companies, and the more relevant Chapter 9 is only for municipalities and other sub-state entities.

Of course, states can choose to default. Nine states, or nearly a third of the 28 existing at the time, repudiated their debts in some form during the depression of the 1840s. Aside from a clutch of southern states' defaults stemming from the civil war, it hasn't happened since.

Back then, however, the bondholders were largely canal and bank financiers in London. States could cut them off and still stand a chance of raising new debt locally or in New York.

Today, the majority of California's bonds are domestically owned, many by retail investors -- hardly a constituency it would be advisable to leave high and dry. Moreover, credit markets are global now. California already has the worst bond rating of any state, and a default could make borrowing impossibly expensive, crimping future budgets even more.

Of course, the state may be able to grab federal help to plug at least part of the gap. And it could just use an accounting fiddle to arrive at a balanced budget, as New York did in 1976. Such moves could tide it over the worst, but arguably only serve to push the problem down the line.

California's only real option is simple. It needs to cut its spending down to programs that are absolutely necessary. This will remove some of the Hollywood glitz from Californian life for years to come. But that is far better than the alternative of defaulting. To top of page

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