California's Default - The 2011 Scenario

Some might think short term lending is less risky than long. In the municipal market, for many issuers that is usually not the case, particularly today. When additional borrowing is necessary to redeem tax and revenue anticipation cash flow notes it is called a “rollover” - sell new notes to pay off the existing. It works as long as the market for the issuer’s notes remains open. If it closes, current note holders are unlikely to be paid in full on the maturity date unless the issuer can sell bonds to redeem the notes.

California issued $10 billion of revenue anticipation notes this past December. They are due this May and June. $8 billion were sold last year and $7 billion the year before that. Over that time, general fund tax revenues declined about 15%. The state’s ability to access the bond market could become an issue in the months ahead. More likely, if voters turn down an initiative to extend temporary tax rate increases worth $8 billion that are set to expire this June. The state just announced a decision not to issue any general obligation bonds this year. Any concerns about market access will be hard to divine and as a result, this is not good news for current note holders.

California can satisfy its revenue anticipation notes by delivering cash or warrants to note holders on the maturity date. That is because the notes constitute unsecured debt of the State, not general obligations. If warrants were issued, it would undoubtedly be viewed as a note default, although legally it is not.

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