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You might have heard that California passed a budget lately.

Actually, it passed a budget revision because the budget passed in February was already in a $26b deficit. And the revision didn't close the $26b hole, either.

Now, Moody's, one of the three credit-rating agencies used by the bond market, says California faces an addition $15b deficit for the next year. Republicans will demand cuts and probably not agree to any taxes. Democrats may agree to some cuts, but they won't be able to close this. I am pretty sure the Democrats won't do a cuts-only budget again, even if that were somehow possible. Not in an election year. IOUs will run out or stop being accepted. California will have to stop paying something.

And, as I mentioned before it passed, the latest budget revision trades sovereign default for a wave of municipal Chapter 9 bankruptcies. Moody's agrees.

Moody's also criticized California's plan to take more than $1 billion from counties' redevelopment agencies this year to help close its $24 billion deficit, saying that could jeopardize those agencies' credit ratings.

But apparently, sovereign default is quite likely, or at least increasingly likely. The $1.9b in borrowing called for in the latest budget comes at a huge 8% interest rate. If the bond market takes Moody's report to heart, those 8% bonds will go down in price and increase yield. Oh, by the way, state bonds are tax free for state residents (and fed tax free). Very easily people with money in this economy could achieve a 10% tax free yield out of California tax payers. Inflation is low, so the deal is even better for the rentiers. If you can afford to do so, I would recommend buying these bonds. (Can readers tell me if these bonds can be called?)

Why? Because the market will treat them like the risk is real, but it's not. Name one bailout of late where the bondholders took a serious haircut, let alone were wiped out. Even in recent sovereign defaults in emerging markets, such as Ecuador, the bondholders ended up getting paid back significant amounts. Privatize profit, socialize risk.

So who will bailout California? Probably the Federal Reserve and the U.S. Treasury. As opposed to an IMF bailout where a bunch of pointy heads come in and tell the inferior intellects (snark) in the government to cut and cut some more and then restructure the debt, Californians have representation in the federal government. There probably will be no bailout for local government, who will simply enter Chapter 9.

Unless something changes—and today's GDP report still shows contraction—like, right now, this will be real.

Is there any hope? Check out this brilliant post.

Originally posted to Attorney at Arms on Fri Jul 31, 2009 at 11:28 AM PDT.

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