Bankruptcy

California and the Argentine Option

By Stephen Lubben

As a person who still considers Los Angeles home, I often find myself reading the Los Angeles Times webpage.  Yesterday I saw that Los Angeles County's recent note offering got a lower than expected credit-rating, in part because of the State's financial problems.  A county official quoted in the article explained that S&P had based the rating on a "worst case scenario."  My initial response was, are they doing that now?

Several people have asked me whether California might not follow GM into bankruptcy court.  The easy answer to that is "no," since states, unlike cities and counties, can't file under the federal Bankruptcy Code.

But the financial press has also picked up on the issue and noted that California might be forced to default at some point this year if it becomes impossible to continually refinance its outstanding debt. In a recent Bloomberg column, Kevin Hassett breathlessly proclaims that "California leads nation to bond default abyss." He goes on to trace the problem to California's high corporate and personal income taxes, and then makes the entirely predictable argument that this shows that federal taxes should not be raised either.

Of course this ignores the fact that California has high corporate and personal taxes because its property taxes are extremely low. Proposition 13 instituted a kind of rent control scheme for property taxes in the late 1970s that caps increases in property taxes save for when the property is sold.  In a state like California where property values increased much more rapidly than inflation over the past few decades, and the state population has been rapidly increasing, this provided a windfall to generally older, long-time homeowners, that the legislature made up by increases in other taxes.

But what about the basic question of a California default. Could it happen? Certainly. It has happened before.

California and many other states defaulted on their outstanding bonds in the nineteenth century. California ultimately refunded the defaulted debt -- which California argued had been issued in violation of the State Constitution -- with new bonds and the default was largely forgotten.

In recent years defaults by states -- as opposed to municipalities or counties -- have been rare. But there are plenty of examples of government defaults in sovereign debt context. Most notably, Argentina defaulted on its debts in the early part of the decade.

The Argentine example also is relevant here because California, like foreign nations, enjoys some degree of sovereign immunity that precludes suits in federal court to enforce the debt. In short, if California were to default, it would be very difficult to enforce its debt obligations in court. And as in the international debt context, there is no easy way to solve a state debt default, as there is no legal mechanism to bind dissenting creditors to a deal.

On the other hand, as with Argentina, any default would probably prevent California from using the debt markets, at least in the near term. California is a very large economy -- larger than Argentina, close to that of Brazil or France -- and it would be very difficult for it continue to fund its daily operations without some access to finance.

Well, wouldn't the U.S. Government step in, as it has in GM? Maybe, they certainly are the only obvious lender here, but consider all of the political criticism that the Obama Administration has received for its role in the GM and Chrysler chapter 11 cases. The administration may be hesitant to save the Republican governor of California, and the Republican minority in the legislature (who have an effective veto on tax increases), only to have Republicans in Congress criticize the administration for leading the country down the road to socialism.

It is a situation that bears watching, because if you thought AIG's default would have had serious economic repercussions, California would bring a whole new level of systemic risk.

Full post as published by Credit Slips on June 10, 2009 (boomark / email).