May 14 (Bloomberg) -- California faces a resurgent $15 billion deficit and unprecedented cash shortage that may leave the most-populous U.S. state unable to pay its bills for the second time since January.

Governor Arnold Schwarzenegger, a Republican, is scheduled today to release his annual May revision to the budget, in which he will detail how he intends to close the deficit. He said May 11 that the gap would swell to $21 billion if voters on May 19 reject a package of measures, including one to borrow $5 billion of bonds backed by lottery profits. Polls show the proposals heading for defeat.

“We’re steering away when the deficits are growing and it looks like it’s going to get worse down the road,” said Robert Millikan, who manages $5 billion in bond investments for BB&T Asset Management Inc. in Raleigh, North Carolina, referring to California debt.

The state’s immediate financial needs were underscored by Treasurer Bill Lockyer, who in a letter to Treasury Secretary Timothy Geithner yesterday asked that the federal government become a standby purchaser of short-term notes in the event of default. Such a guarantee makes it easier for states to purchase the bond insurance policies needed to attract investors.

“If we cannot obtain our usual short-term cash-flow borrowings, there could be devastating impacts on the ability of the state or other governments to provide essential services to their citizens,” Lockyer said.

Eighth-Largest Economy

California, a state that on its own would rank as the eighth-largest world economy, has been battered by collapsing revenue from income and consumer-spending taxes responsible for about 80 percent of its receipts. Tax revenue as of April 30 was down 16 percent from estimates at the start of the fiscal year. Income taxes slipped 13 percent and corporation taxes slumped 35 percent, figures from the state controller’s office show.

The state’s latest fiscal crisis comes just three months after Schwarzenegger signed a package of spending cuts and tax increases intended to plug a $42 billion gap that accumulated since July. The new deficit emerged as the state’s economy faltered further.

Reduced Ratings

The magnitude of California’s deficits, and protracted battles over how to fix them, prompted the three major credit rating companies to lower the grades on more than $46 billion of bonds in February and March, turning California into the lowest- rated of U.S. states.

California’s creditworthiness reflects its ability to manage its budget, not its ability to repay debts, said Kenneth Naehu, a managing director of Bel Air Investment Advisors LLC in Los Angeles, which oversees $5.5 billion in investments, including California debt. Debt payments are given priority, under the state’s constitution, above everything but spending on schools.

“There’s going to be tough decisions made -- programs will be cut, taxes may be raised,” Naehu said. “But at the end of the day, the debt service gets paid because it gets higher priority than just about anything else.”

California municipal bonds have delivered returns of 8.2 percent this year, outpacing 7 percent in the broader municipal market, according to Merrill Lynch & Co. indexes. A California general obligation bond maturing in 2038, which traded for as little as 81.5 cents on the dollar on Dec. 4, went for as much as 97.63 cents to yield 5.4 percent on May 12, according to Municipal Securities Rulemaking Board data. That compares with 5.03 percent for top-rated municipal general obligation bonds, as measured by Municipal Market Advisors index.

A ‘Buying Opportunity’

“I wouldn’t be surprised if there isn’t a pullback if the measures fail,” Naehu said. “That would be a tremendous buying opportunity.”

The state’s Legislative Analyst’s Office said in a report May 7 that California will probably need to borrow an unprecedented $23 billion of so-called cash flow notes or warrants by October to pay day-to-day bills. If voters approve the budget balancing measures, the amount would drop to between $13 billion and $17 billion.

The state’s growing deficit and pending cash squeeze may lead rating companies to further downgrade California, Matt Fabian, managing director at Municipal Market Advisors, the Concord, Massachusetts-based research firm, said in a report this week.

Cash Squeeze

“Rating downgrades are likely prior to June 30, and bondholders should be wary of potential illiquidity and price loss if the state cannot borrow for cash flow in a timely manner,” Fabian said.

Schwarzenegger today will propose raising more than $1 billion by selling state property, including San Quentin State Prison, where California’s condemned inmate executions are conducted, according to a copy of the proposal. If San Quentin were sold, the state would need to build a new execution chamber elsewhere.

The list of properties also includes: the Los Angeles Memorial Coliseum, where the Olympic Games were held in 1932 and 1984, and San Francisco area’s Cow Palace, where John F. Kennedy’s speech in 1960 outlined the Peace Corps. It would take at least two years for the state to see any of the money from the sales, which would need approval by lawmakers.

Schwarzenegger’s Options

One option Schwarzenegger’s considering is selling a dozen state office buildings to investors and then leasing back the properties. Proceeds from the sale would be used to pay off the bonds sold to construct the buildings; anything left over would be placed in the general fund.

Another proposed option is refinancing the construction bonds by selling new 25-year bonds, or by lengthening the terms of the outstanding debt.

California voters will head to the polls Tuesday in a special election called by the Legislature to consider budget- deficit measures that lawmakers approved in February.

Proposition 1A would limit state spending to inflation plus 3 percent above a 10-year average. Revenue above that cap would be deposited in a rainy day fund. If Proposition 1A passes, it would extend three temporary tax raises approved as part of the budget in February. In all, the measures would increase taxes by $16 billion, according to state finance officials.

Proposition 1B would require the state to pay $1.5 billion from the rainy day fund to schools for six years starting in 2011. If Proposition 1A fails, it nullifies Proposition 1B.

Siphoning and Stripping

Proposition 1C would allow the state to sell $5 billion of bonds backed by future state lottery proceeds and use the money to balance the budget.

Proposition 1D would allow the state to strip $600 million over five years from a program that spends tobacco tax revenue on children’s health. Proposition 1E would siphon $250 million a year from a mental health services program financed by an income tax increase voters approved in 2004.

Proposition 1F would prohibit state lawmakers and elected officers from salary raises in years when the state runs a deficit.

A Field Poll published April 30 found all the measures, except limitations on salary increases, lacking voter support.

To contact the reporters on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net; William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: May 14, 2009 15:04 EDT