California: Teetering closer to junk

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NEW YORK (CNNMoney.com) -- California's bond rating is far from golden.

Citing the Golden State's ongoing budget upheaval, Fitch Ratings on Monday downgraded California's long-term debt to BBB, one category above junk bond status. The next step is BBB- before the state's bonds would be considered speculative debt.

Fitch also maintained its so-called negative outlook on California. "[I]nstitutional gridlock could persist, further aggravating the state's already severe economic, revenue and liquidity challenges," Fitch wrote.

The agency had downgraded the state to A- on June 25.

While Gov. Arnold Schwarzenegger and lawmakers battle over closing a $26.3 billion budget gap, the state's controller last week was forced to issue IOUs for the first time in 17 years. Some county agencies, state vendors and taxpayers are getting paid in paper. The IOUs help the state controller stave off a deficit of nearly $3 billion for July.

"The fact that they have to take this step shows how tight the state's cash became and how limited their options are in the absence of a budget solution," said Douglas Offerman, Fitch credit analyst. "Without a budget, [the controller's] flexibility gets more and more reduced over time."

California has the lowest bond rating of any state, and therefore must pay higher interest rates than its peers when it issues debt. Whatever agreement officials come to will likely rely heavily on borrowing to balance the budget for the current fiscal year.

"This underscores the urgency to solve our entire deficit with the necessary cuts instead of kicking the can down the alley," Schwarzenegger said in a statement. "This is not the time for boycotting budget meetings -- all sides must come to the table and balance the budget immediately."

The other two major ratings agencies -- Standard & Poors and Moody's -- had previously placed the state on watch for a possible downgrade. They did not follow Fitch's lead Monday and have maintained California's ratings at several levels above junk.

Moody's put the state on watch in mid-June after Controller John Chiang warned of the pending cash shortfall. Standard & Poors affirmed its rating last week.

The IOUs, while not preferable, do allow the state to preserve cash to pay its debt obligations for several weeks, Standard & Poors analyst Gabriel Petek said in an interview Monday.

"We believe California retains the ability to take the actions necessary to meet its debt service payments in full and on time, although we remain concerned about the state's financial liquidity," Petek wrote in a report last week.

But it is on a short leash since the IOUs will only carry it for a few months, he said. By October, the state is looking at a $16.7 billion shortfall, according to the controller's office.

California officials say the state is in no danger of defaulting on its debts.

"It won't happen," Tom Dresslar, spokesman for Treasurer Bill Lockyer, said in an interview last week.

Few states, however, have ventured into BBB territory. California last had such a low rating from Fitch and Standard & Poors in 2003, during another fiscal crisis that resulted in the recall of Gov. Gray Davis. It was the only other time the state had fallen so low.

Standard & Poors has never relegated a state to junk territory. States are usually seen as a relatively safe credit risk. If a state such as California were to fall into speculative status, it would be "catastrophic" for its ability to issue bonds.