Schwarzenegger Bids California Farewell, Leaving Brown Burdened With Bonds

Arnold Schwarzenegger swore after his first month as California governor that he’d rip up the state’s credit cards. Instead, the Republican former action- movie hero pushed through at least $52 billion of borrowing.

Debt of the world’s eighth-largest economy almost tripled in Schwarzenegger’s seven years, to $91 billion on June 30 from $34 billion in 2003, state Treasury figures show. Californians owed $2,362 per person last year, up from $977 before he went to work. Under Schwarzenegger, the state’s workforce grew 9.9 percent to 348,213, according to his finance office.

When Democrat Jerry Brown takes over the biggest U.S. municipal borrower on Jan. 3, he’ll inherit interest and principal payments that consume 7.1 percent of general-fund spending, twice what greeted Schwarzenegger. That will rise to 10 percent in 2012, leaving less for services and to tackle a budget deficit that may reach $28 billion in 18 months.

“Every dollar you spend on debt service is a dollar you don’t have available to educate kids or for health-care or to spend in other ways,” Treasurer Bill Lockyer said at a Dec. 8 meeting in Sacramento to address fiscal conditions.

Schwarzenegger, 63, a former body-building champion, never held public office before he was elected governor with promises to fix California’s finances. While he sold debt for roads and schools, he also borrowed to help close more than $100 billion of deficits that plagued the most populous state since 2004.

Eroding Revenue

With his second term in its waning months, the longest recession since the 1930s has cut California’s tax collections 8 percent since 2007. Even after Schwarzenegger and lawmakers slashed spending by more than $45 billion and raised taxes by $12.5 billion in the last 27 months, the state faces a cash shortage of as much as $4.6 billion by September that may require it to pay bills with IOUs, as it did in July 2009, Controller John Chiang said Dec. 8.

California shares with Illinois the lowest credit rating of any state from Moody’s Investors Service. The A1 grade is Moody’s fifth-highest. Standard & Poor’s rates California A-, its fourth-lowest level for investment-quality securities. That hasn’t stopped investors from buying California bonds. The state sold $9.3 billion of long-term debt and $10 billion of one-year notes in 2010.

California, which grew by 4.7 million people in the last decade to 39 million, has the fifth-highest personal-income tax rate in the U.S. That makes its bonds, many of which are exempt from federal and state taxes, appealing to the wealthy.

Investor Demand

Record demand from individuals drove down the state’s interest cost for $1.25 billion of tax-exempt securities sold last month to 1.09 percentage points more than 30-year AAA bonds, or 5.5 percent for a bond maturing in 2040. Similar bonds sold in March yielded 1.41 points more, or 5.65 percent.

Under Schwarzenegger, the extra yield investors demand to buy 10-year California bonds compared with top-rated municipal bonds reached the highest in at least 16 years, at 1.71 percentage points in July 2009. It was 1.29 percentage points on Dec. 14 compared with 0.51 point on Oct. 7, 2003, the day he was elected.

“The debt situation in this state is absolutely a horrific situation,” said Jon Coupal, president of the Howard Jarvis Taxpayers Association, which backed property-tax-limiting Proposition 13 in 1978. “He absolutely did not live up to his promises.”

Confronting Unemployment

Brown, a 72-year-old Democrat who was governor from 1975 to 1983, will have to confront the problem with the state mired in 12.4 percent unemployment in October, higher than the 9.8 percent national rate in November.

“We’ve done a lot of borrowing because it was too tough to face the music and find new revenues,” Brown said on Dec. 8. “California is facing a very serious budget crisis.”

Schwarzenegger won a 2003 recall election to oust Governor Gray Davis, a Democrat whom voters blamed for a $38 billion budget gap. Davis had spent an $8 billion surplus on social programs and increased pensions and benefits, costs that now consume 5.1 percent of the general fund.

Under Davis, spending grew 36 percent as the state workforce expanded 12 percent to 316,860. That opened deficits as the 2001 recession caused California’s worst one-year decline in tax revenue since World War II. Davis borrowed $18 billion to balance his last budget and pushed to sell $11.5 billion of bonds to repay the state for buying power for utilities.

Steamrolled

“Schwarzenegger tried his best, but then he caved,” said Marilyn Cohen, chief executive officer of Envision Capital Management in Los Angeles. She manages $250 million of fixed- income assets and told clients this month to “hold” two issues of California general-obligation debt. “He was run over by a steamroller.”

Promising to end “crazy deficit spending,” Schwarzenegger defeated child actor Gary Coleman, Hustler magazine publisher Larry Flynt and 132 other candidates in the 2003 vote. The day after he was sworn in, he warned about a state bankruptcy unless it borrowed $15 billion to pay off $14 billion of notes and warrants coming due.

“It is what basically a financial counselor would do,” the governor told the State Building and Construction Trades Council of California in February 2004. “Let’s consolidate the debt. Let’s refinance it for lower costs. Then let’s tear up the credit cards.”

Passed by Voters

The borrowing, which Schwarzenegger labeled “Economic Recovery Bonds,” was approved by voters in March 2004 along with a measure forbidding future governors from selling debt to fund deficits. More than $7 billion of those bonds remain outstanding, with taxpayers obligated until 2024, according to Lockyer’s office.

Another early Schwarzenegger decision still burdens California, said state Senator Mark Leno, a San Francisco Democrat and chairman of the budget committee. Keeping a campaign pledge, the governor rescinded an increase in car- registration fees imposed by Davis. That deprived the budget of $4 billion a year, Leno said.

“He has been a major cause of the continued dismantling of our fiscal soundness,” Leno said in a telephone interview. “Rather than deal with the problem honestly, he did the exact opposite and instituted a tax cut. He wouldn’t have needed those bonds if he hadn’t cut the car tax.”

There would be more borrowing in Schwarzenegger’s first term. He endorsed a successful ballot measure in October 2004 authorizing $3 billion of general-fund-backed bonds for stem- cell research.

Public-Works Package

In 2006, facing re-election, he proposed a $37.4 billion public-works bond package for roads, schools, housing and flood protection. Voters approved the debt in November, along with $5 billion of bonds for water supply. They also awarded Schwarzenegger a second term.

Two years later, Schwarzenegger backed a successful ballot measure allowing the state to sell $10 billion of bonds for a high-speed rail line. In November 2009, the legislature approved his plan to ask voters this year for another $11 billion of bonds to overhaul the aging water system. He was forced to postpone the vote for two years in August as the budget fell $19 billion into deficit.

Borrowing for infrastructure is “absolutely appropriate,” said Schwarzenegger’s budget spokesman, H.D. Palmer.

“Long-term bonds are not like credit cards,” he said. “Credit-card debt suggests that you’re making a decision to finance your groceries and pay for them over a 30-year period. That’s not what you’re doing with a long-term asset like a highway.”

Internal Borrowing

The governor has also borrowed internally to balance budgets, including $1.9 billion of property-tax revenue meant for local governments in 2009, $1.6 billion owed to programs such as the Beverage Container Recycling Fund and almost $4 billion of deferred subsidies to schools and health-care clinics.

“Nobody in Sacramento seems to care when we get downgraded and continue to pile on debt,” said Cohen of Envision Capital. “The day of reckoning will come: Hello Greece, Ireland; here comes California.”

California is still not the most-indebted state, said Edith Behr, a senior credit officer at Moody’s. Debt equal to 3.7 percent of gross state product in 2009, the 12th-most among states, is “very manageable,” she said in a telephone interview.

Higher Debt Service

The budget Schwarzenegger signed in October cut spending by $7.8 billion, including $3.4 billion from schools and $1.6 billion from payroll and benefits. Debt service increased 12.3 percent from the previous year to $5.2 billion. California is obligated by its constitution to pay debt before all other costs except schools.

This year, Schwarzenegger’s administration is trying to sell 11 state office buildings and lease them back to help close the deficit. Proceeds will repay $1.1 billion of bonds used to build the properties, with the rest going to the general fund. A state appeals court blocked the sale on Dec. 13 pending a review of a lower-court dismissal of a challenge to the plan.

“The only reason they are doing that is to avoid voter approval,” said Coupal of the Jarvis association. “Like a bond, they are getting a lot of cash up front. You end up with the long-term obligation. Instead of bond payments, we’ve got lease payments.”

To contact the reporters on this story: Michael Marois in Sacramento at mmarois@bloomberg.net

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net

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