California's (De)Fault Lines

Forbes ^ | 6/23/2009 | Matthew Craft

[bruinbirdman]

Credit markets see a rising risk of default in the Golden State.

What are the odds that California defaults on its debt payments? Using the market for credit insurance as a guide, one in four within five years. Those are amazing odds, signalling that those who buy insurance on debt think that the federal government will allow California to fail where it thought that AIG and Citigroup simply had to be rescued.

In the past month, rating agencies have warned that California’s $24 billion budget shortfall for the fiscal year beginning in July threatens its credit ratings -- its mark of A already makes it the lowest-rated state in the U.S. on Standard & Poor’s scale -- and the Obama administration has reportedly spurned requests for a bailout. The price of credit default swaps, a form of insurance on bonds, has made a predictable turn: a 5-year credit default swap on California’s debt jumped from a midpoint of 250 basis points on May 22 to 325 on June 23. On Tuesday, dealers asked for 339 basis points, which works out to $339 million on $10 million in debt, implying a 26% chance of default.

Credit default swaps allow bondholders to protect themselves from default. They can be used as insurance or as a straight bet on the likelihood of a country, state or company going under. The price of protection rises as other players in the credit markets believe the prospect of default increases.

Trading in credit default swaps can be illiquid, opaque and subject to swings in sentiment like any market, making it an unreliable forecasting tool. Even so, it provides a snapshot of what players in the credit markets expect.

It may seem unlikely that the federal government would let California default on its debts. If insurer AIG

[SERKIT]

They could drill.....

[spyone]

They could cut spending.

[blam]

The one good news from California is that my son decided not to buy the house in Sierra Madre.

[staytrue]

It may seem unlikely that the federal government would let California default on its debts

Here is where the Chrysler BK comes back to haunt California.

If they follow the Chrysler example, the feds will cramdown the bond holders in exchange for a bailout. That is when CA defaults, the feds will "rescue" the bondholders from getting nothing by offering 10 cents on the dollar while the Public employees union gets 50 cents on the dollar.

The high rate of insurance, and the high cost of CA credit default swaps and the low credit rating is a direct result of the Chrysler cramdown possibly being used in a California default.

Thank you Barack for increasing the costs to all of California in exchange for bailing out the UAW.