Executive Summary

The Little Hoover Commission has examined California's fiscal condition in light of the current two-year budget agreement, which relies on $10 billion in external borrowing and a trigger mechanism to make automatic cuts if resources do not materialize to pay back loans. Based on research and public testimony, the Commission is issuing this report to sound an alarm that deteriorating credit ratings, the size of short-term borrowings and reliance upon bank guarantees place serious external restraints on the State's financial condition.

The problem: While California's budgets appear to be in balance each year when they are adopted, the State has incurred a large structural deficit which has led to difficulty in financing its annual cash needs. In less than a decade, the State has gone from an entity that borrowed because it could make money on investing the proceeds to an entity that is caught in a vicious cycle of short-term borrowing to pay off loans related to a structural deficit. In July 1994, California borrowed $7 billion, the largest municipal financing ever sought anywhere in the nation. Although the State's faltering economy is improving, there may be refinancing difficulties despite a trigger mechanism that is poised over the budget to slash spending. This is due to reliance on short-term financing in record amounts, the possibility of more than $4 billion in adverse court rulings on previous cost-cutting budgetary decisions; and reliance on receiving almost $1 billion from the federal government in reimbursement for services to illegal immigrants.

The State's spending and borrowing practices have a distinct real-world effect that is reflected in the State's credit rating. The State has gone from having top ratings to seeing only two states in the nation with worse ratings. Its last short-term bond offering had a rating (MIG3) only marginally better than that assigned to junk bonds. The ratings not only mean that the State spends millions of dollars more in higher interest charges to borrow money but they also are a dismal signal to businesses, which avoid investing or expanding in states that may need to tax their way out of financial problems.

The solution: Policy makers must concentrate on the steps that will bring both the spending and cash flow budgets into balance and pursue a course that will restore California's tarnished credit rating. These include:

• Crafting a budget that is based on reasonable and sustainable estimates of revenues, federal reimbursements and debt obligations

• Focusing on a realistic cash flow plan to complement the budget plan.

• Cutting programs as deeply as necessary to end the 1995-96 fiscal year in a balanced position.

• Adopting long-term plans, budgets and policies that California's budgets will be balanced in reality, not through financial maneuvers. It is poor public policy to rely on automatic triggers, to divert funds clearly earmarked for special purposes and to allow either the financial markets or the need for bank guarantees to dictate the State's future.

The State can continue to put together new and innovative ways to package debt. Or it can find a way to live within its means and eliminate its structural deficits. The Commission advises that policy makers choose the latter course.

Dear Governor and Members of the Legislature:

For several years, California has borrowed money to stay afloat -- and then borrowed again when certain of those loans came due. At a personal level, such actions would be viewed as irresponsibly living beyond one's means and flirting with financial ruin. When a state does it, the consequences are no less grave -- and in fact are more so, since millions of lives may be affected.

The Little Hoover Commission has examined the State's actions in crafting the 1994-95 budget agreement, actually an unconventional two-year plan for $10 billion in external financing and a trigger mechanism to slash state spending if revenues do not materialize to repay the loans. The plan included the largest financing effort ever undertaken by any state or local government in the history of the nation's financial marketplace -- and was almost double any previous external borrowing by the State.
Because of the magnitude and unusual nature of the budget elements, the Commission reviewed California's fiscal condition, the context for its actions, the reaction of the financial markets and the implications for the long-term future of the State.

We found that policy makers met the State's short-term financing problems with creativity but with little success in dealing with the structural deficit created in prior years or other long-term policy considerations. Tough budget choices were made over the past four years during the deepest recession California has seen since the Great Depression, but a structural deficit that may be as high as $6 billion to $8 billion continues to exist. It is the Commission's position that a clarion call must be sounded strongly against the pattern of rolling over short-term debt to fund long-term structural deficits. Otherwise, California will join the ranks of governments -- like New York two decades ago -- that lived dangerously and lost.

Some have argued that the two-year budget agreement with automatic triggers is tacit recognition that the State has hit the bottom and has no choice but to face its obligations squarely in 1995-96. But the Commission fears that the hope for rosier revenues that a recovering economy has inspired may lead policy makers to continue relying on imaginative ploys to get by "just one more year." Instead, the Commission believes it is imperative to make structural changes in the budget and cash flow process, to cut expenditures further and to emphasize long-range planning and priorities. The Commission is concerned that the State should not rely on bank guarantees to sell short-term debt. Furthermore, although credit ratings should not be the sole criteria for public policy decisions, the State must also take immediate steps to improve its short-term and long-term credit ratings. And the Commission believes that leaving fiscal decisions to an externally imposed, automatic "trigger" mechanism is bad public policy.

The following letter report is designed as a primer for seasoned policy makers who may have overlooked the danger inherent in past practices; for newly elected legislators who are unfamiliar with the nuances that divide budgetary decisions from cash flow activities; and for the public, who intuitively understands that maximum accountability and efficiency require pay-as-you-go government programs. Many groups have addressed the State's fiscal problems in the past few years and many studies have identified potential solutions. Rather than competing with those recommendations, the Commission sees this document as bolstering the case that it is time for action due primarily to the external pressures that prevent a continuation of the "status quo."

Current Budget Agreement

The Constitution: While it is common belief that the Constitution requires balanced budgets, its actual provisions are more circuitous. The Constitution requires the Governor to offer the Legislature a budget that matches expenditures to revenues. The Legislature is responsible for maintaining a prudent reserve. And no debt in excess of $300,000 is to be incurred without a vote of the people.

The debt limit has been defined by the courts to mean the State cannot borrow more than $300,000 without voter authorization except in two cases: The State can issue notes (Revenue Anticipation Notes -- RANs) through the Treasurer's Office to help even out cash flow and pay bills as long as the notes are redeemed within the same fiscal year. When there is an unanticipated shortfall of funding at the end of a fiscal year, the State can issue warrants (Revenue Anticipation Warrants -- RAWs) through the Controller's Office that will be repaid within the next fiscal year. In both cases, state officials must certify that there is a reasonable expectation that funding will exist to pay off the notes and warrants when they become due.

The financial marketplace: Certifying the ability to repay is important from a legal and a marketing perspective. The notes and warrants would find few buyers if doubt existed that the money and interest would be repaid. In addition, the assurance greatly affects both the ability to borrow and the cost to the borrower, particularly when the amounts are as large as those required by the State.

To further enhance the attractiveness of the notes and warrants, banks may guarantee that the money will be repaid in case the State defaults. Although the banks charge a fee for providing the guarantee, the overall package can represent a cost savings if the guarantee allows a lower interest rate to be paid.

A key factor in the ability of the State to market debt instruments is the financial rating that is intended to tell potential buyers whether their investment is extremely safe, moderately safe or risky. Extremely safe investments in general pay lower interest rates and therefore are less costly from the borrower's perspective. Higher interest rates and therefore larger costs are associated with risky investments.

Through the late 80s, California had the highest possible financial rating (AAA or Aaa, depending on the system used by the service). By 1992, the effects of the recession and the State's budgetary responses had pushed the ratings down to AA, A+ and Aa. Shortly after the two-year budget agreement described below was enacted, all of the services downgraded the State's rating to A or A1. At this point, only two states in the country -- New York and Louisiana -- have worse ratings than California. The unfavorable perspective about California was also reflected in the short-term borrowing rating when Moody's gave the State's notes a MIG3 rating, less desirable than MIG1 or MIG2 and only a step above the junk bond rating of MIG4. This weak credit rating will serve to limit short-term financing flexibility due to the large amounts needed by the State relative to the size of the market and investors' desires for high-rated investments.

Representatives of the rating services told the Commission that significant factors in the downgrading were the State's unwillingness to address its long-term budgetary problems with structural changes and the repetitive pattern of borrowing funds to pay off other loans. They indicated that the State's future ratings will rely not so much on the widely acknowledged improving economy but on positive steps the State takes to address potential fiscal quagmires, like the anticipated three-strikes prison population explosion and court rulings that may affect prior budgetary decisions.

The two-year agreement: While some legislators and citizens raised questions about the legitimacy of planning to carry over existing debt into a new fiscal year, a consensus was formed in the Summer of 1994 for crafting a two-year budget and cash management plan with the following elements:

• As part of the forecasted revenue figures, a reliance on more than $3.6 billion in new federal funding as reimbursement for services provided to illegal aliens.

• A planned carryover deficit of $430 million at the end of 1994-95 and a year-end zero balance for 1995-96.

• The issuance of $4 billion in RAWs on July 26, 1994 to be redeemed on April 25, 1996 (21 months). The RAWs were marketed in two forms: unenhanced and backed by a bank consortium guarantee for repayment. After a cost analysis of the bids received, the State sold $3.9 billion in RAWs with the bank backing and $100 million unenhanced. (Bids for $3.6 billion in unenhanced notes were received, but almost all required interest payments that would have been more costly than the interest rate for the enhanced notes plus the bank consortium fee.)

• The issuance of $3 billion in RANs on August 3, 1994 to be redeemed on June 28, 1995. The issuance of another $3 billion in RANs in August 1995 to be repaid before the end of that fiscal year.

• A check-and-balance process for pulling a "trigger" if the State's year-end cash position was going to be worse than expected in November 1994 (the so-called first trigger) and October 1995 (the so-called second trigger). The Controller makes the assessment, which is double-checked by the Legislative Analyst. The trigger requires the Governor and the Legislature to take immediate action to address the shortfall, or across-the-board cuts on all programs not constitutionally protected will take place.

The Attorney General's Office, which issues legal opinions that are a prerequisite for selling the notes, had advised the Treasurer early in the budget process that any external borrowing plan had to include a realistic repayment method. In testimony to the Commission, the Controller said that, given the uncertain revenue picture (particularly the probability that most of the $3.6 billion in federal funds would not be received), the trigger was necessary for him to certify that there was a reasonable expectation of repaying the RAWs (whose issuance made the repayment of the RANs possible). While the bank consortium told the Commission it did not require the trigger as a condition for providing the credit enhancement, it did require some mechanism for lessening the chances that the State would default.

Avoiding the trigger: The first trigger was avoided on November 15, 1994, when the Controller certified that the State's cash position had not worsened but had actually improved -- despite the State only receiving $33 million of the first year's anticipated $763 million in federal funding. With the recovering economy providing greater revenues to the State, and with the Governor building his 1995-96 budget proposal around only $732 million in federal funds rather than the original $2.8 billion, the prospect for avoiding the second trigger has become brighter.

Questions remain, however: How did the State reach its present financial predicament? What were the optimum policy decisions for making the State fiscally sound? How can the State put an end to the quicksand of external borrowing?

Setting the Context

For instance, by 1989-90 fees and other revenues collected by all levels of government had grown to the point that they offset Proposition 13's dramatic property tax cut. Proposition 4 has been modified, both to enable more growth in government spending than allowed by the original formula and to redirect most excess revenues into schools rather than back to taxpayers. Proposition 98 contains provision not only for suspension in times of budget crisis but also for proportionate cuts in funding for schools when revenues drop. None of these high-profile directives have stopped policy makers from controlling fiscal decisions for the State; instead they have limited the range of choices.

The recession: The single most important factor that eliminated the flexibility of the State to address its needs was the recession, which most experts agree began in mid-1990 and has only recently been declared at an end. The recession saw a precipitous drop in the number of jobs and depressed state revenues at a time when demand for services was increasing, because of both the recession itself and exploding population growth from immigration and births.

The impact of the recession on the state budget can be seen in the following chart, which shows total revenues and total expenditures for the past six years:

Chart 1 GENERAL FUND REVENUES AND EXPENDITURES 1988-1994 (in billions of dollars)
Year	1988-89	1989-90	1990-91	1991-92	1992-93	1993-94
Total Revenues	37.01	39.08	39.94	42.22	41.03	40.15
Total Expenses	36.18	39.82	41.94	44.44	40.92	39.32
Difference	.84	-.73	-1.99	-2.21	.11	.84

Source: State Controller's Annual Report

As the highlighted area of the chart shows, the 1990-91 budget reflected the impact of the nascent recession, with revenues almost flat from the year before and expenses growing unchecked. Spending outstripped funding by almost $2 billion. Recognizing the dilemma they faced, policy makers approached the 1991-92 budget with a combination of tax increases and selective budget cuts to tackle a $14 billion gap between the anticipated unenhanced revenues and the caseload-driven increases in expenditures. Revenues rose but despite the budget cuts, expenses continued to increase dramatically. The result fell $2.21 billion short of a balanced budget.

Off-budget items: While the recession continued to erode revenues in 1992-93 and 1993-94, policy makers relentlessly pushed spending down even as caseloads were increasing. Some of the cutbacks were achieved by one-time -- and in some cases, questionable -- actions, such as deferring state worker pension contributions, accelerating tax collection and "loaning" schools almost $2 billion in funding that was not reflected in the budget. Other cuts, such as trimming welfare benefits and using cigarette taxes for general health care, had short life spans because of court reversals. (The Legislative Analyst has estimated that these adverse court rulings, which are subject to appeal, threaten to place a $4.1 billion burden on future budgets. These include rulings that call into question the school loans, the pension contribution deferral and welfare cuts.)The largest savings came from two actions: the elimination of the post-Proposition 13 bailout funds for local governments and 15 percent across-the-board cuts for many state programs for three years in a row.

The result has been that for the past two fiscal years, the State spent less than the revenue it took in. The prior deficits, however, continued to hang over the State's head, as the chart below indicates.

Chart 2 GENERAL FUND BALANCE AT BEGINNING OF FISCAL YEAR 1988-1994 (in billions of dollars)
Year	1988-89	1989-90	1990-91	1991-92	1992-93	1993-94
Beginning Balance*	-.01	1.23	.68	-1.09	-2.35	-2.04
Year's Net Gain/Loss	0.84	-0.73	-1.99	-2.21	0.11	0.84
Year-end Balance	0.83	0.49	-1.31	-3.31	-2.24	-1.2

Source: State Controller's Annual Report
*Restated year-end balance after accrual adjustments

While the recent year-end balances reflect progress on reducing the accumulated deficit, the final figure of -$1.2 billion does not include the off-budget items described above, making the structural deficit a much higher -- and difficult to determine -- figure. Even in strictly budgetary terms, beginning three years in a row with a deficit has made balancing the annual budget a Herculean task in light of depressed revenues and rising demands for services. The job, however, appears tame in comparison to addressing the State's cash management needs -- a real-world exercise that depends upon actual transactions.

Budget vs. cash flow: To understand the difference between the State's budget and its cash management process, one can use a family-oriented analogy. A well disciplined family might sit down once a year and determine all of the income that is anticipated and all of the bills that must be paid. If the income will equal or exceed the expenses, then the family knows the budget will meet the needs.

But no one lives on an annual basis. Income may arrive in regular amounts throughout the year, or it may increase at some point due to a raise or seasonal overtime, or it may decline for some amount of time because of unpaid leave or cutbacks in hours. Expenditures come in fits and starts: There are the regular monthly obligations, like the mortgage and utilities, and then there are the occasional large sums, like property taxes, insurance, holiday gift-giving or emergencies. On a month-to-month basis, it is not unusual to have revenues and expenditures that are not in sync with each other. And simply having a budget that says at the end of the year that all of the bills will be paid does little good if this month's paycheck is gone but the property tax bill is due.

Similarly, the State's budget reflects assumed annualized revenues and expenses. But much of the revenue arrives in the spring when taxes flow in -- and some even arrives after the budget year has ended. The outgo may be fairly steady, except when an earthquake strikes or a lump-sum pension payment is due or a court hands the State an unexpected liability. In addition, while the budget always presumes a clean slate at the beginning of the fiscal year, the cash management side of the ledger knows that a deficit soaks up cash that cannot be spent elsewhere.

The State has many of the same tactics at hand to deal with the mountains and valleys of cash management that a family does. A responsible family may set aside money in separate funds for special purposes: a Santa Saver account for Christmas, mad money under the mattress for a vacation trip and a regular savings account for emergencies. And when a bill comes at the wrong time, the family may borrow from one fund to cover another, and then replace the funds at a later date. Or the family may use a short-term loan to tide it over, knowing the income will be there when the loan is due.

California, for many years, was able to satisfy its cash management needs by surpluses or borrowing internally from the special funds that it has set aside. In fact, when it began borrowing externally in 1982, it did so because it could borrow the money cheaply and invest it at a higher rate of return. But in 1988, according to the Treasurer's Office, California began to market notes from need rather than financial advantage. By 1992, the State was borrowing money to pay back loans as they came due. The chart on the following page illustrates the State's borrowing practices in escalating amounts from 1988 through the anticipated levels for 1996:

As the chart on the previous page indicates, the State's borrowing has become more frequent and for longer periods. Where the bars overlap, new funding needed to be borrowed before the previous loans could be retired. For instance, in the 1991-92 fiscal year $4.1 billion in notes were issued on August 15, 1991 with varying maturity dates, the earliest of which was March 3, 1992. On March 3, 1992 a new note for $2 billion was issued with a due date of June 30, 1992. Then just days before that due date, warrants in the amount of $475 million were issued with a due date of July 24, 1992.

To put this practice into more familiar terms, one can use a credit-card analogy. A person who learns he is inheriting $10,000 might use his American Express card to buy a new houseful of furniture. However, when the American Express bill arrives, he discovers that the probate process will hold up the inheritance for at least six months. He then uses his Mastercard to pay off the American Express bill and begins paying a high rate of interest. The plot thickens when the long-awaited bequest turns out to be only $2,000. He applies to a crotchety uncle for bailout funds and in the meantime continues to juggle the debt by paying the Mastercard bill with a Visa card and then the Visa bill with the Mastercard. The cost -- and the anxiety -- mounts.

Similarly, the State's costs have risen as its debt load has increased and its financial ratings have declined. The chart on the following page tracks the State's borrowing for General Fund purposes from both internal and external sources:

Source: California Debt Advisory

*Projected

The chart clearly indicates that California is borrowing at historically high levels. In fact, the Commission was told during its hearing that the $7 billion RAW and RAN package in mid-1994 represents the largest amount of financing ever sought by any state or local government in the nation. The significance of the large size coupled with the weak short-term credit ratings means that there is a limit on the amount of borrowing available to the State. This would be particularly true if unforeseen additional needs are required.

The cost to the State is significant. Interest for RAWs and RANs in fiscal year 1994-95 will total close to $200 million, with another $35 million expended for bank and underwriting fees. The cost of short-term borrowing will rise dramatically in 1995-96, with an estimated $675 million going to interest.

Besides the direct cost of the borrowing, there are indirect costs. The more California is a viewed as a fiscally troubled entity, the more it must pay on any bonds, not just those associated with cash flow. In addition, to the extent California is viewed as weak financially, businesses will be reluctant to expand or invest because of concern that the problems will be solved through higher taxes and fees.

The Future

In mid-1993, a year before the present debt-heavy, two-year budget arrangement was created, the California Debt Advisory Commission conducted a hearing about the then-"cash crisis." Experts including bond counsel and rating service analysts were asked about financing solutions and, in general, offered four untested routes that were felt to require legislative action and court validation. They were:

• An extended RAN: Rather than limiting the external financing to one year, a note could be issued for two years. The reasoning ran that the courts have found RANs not to be debts because they will be paid with revenues anticipated within a short period of time. Since the courts have never defined "short period," a two-year RAN might be found to be constitutional.

• Asset-transfer lease financing: Basically, state property would be mortgaged and the State would make lease payments to retire the mortgage. The courts have recognized such arrangements as not falling under the constitutional debt limit.

• Formation of a separate entity: A method used by both New York and Louisiana, this skirts the debt limit by having a new body handle the financing of the deficit, with payments to be made through the "discretionary" action of the Legislature in appropriating funds from future budgets.

• Obligations imposed by law: Under this theory, a separate entity is created to issue notes to cover the cost of services that the State is required to provide by the federal government, such as health, welfare and immigration services. The courts have found that the constitutional limit on debts is not incurred when a government has an obligation under law to provide service and a financing package is needed to meet the obligation.

The Commission recognizes that policy makers, a year after the Debt Advisory Commission hearing, followed one of the recommended routes, albeit without court validation, by using a two-year RAW. The other concepts as yet remain untested in California. Each is a creative approach to restructuring the State's ability to continue financing a deficit that many believe will not be eliminated by mid-1996 as envisioned by the current plan.

But the creativity is driven by the belief that policy makers cannot live within the existing constitutional constraints -- that is, that a tough deficit-elimination program and an honest explanation to the public about what is needed could not win voter approval. The Commission believes, however, that the essence of leadership is making difficult decisions understandable and acceptable to the public. And at this point, what the State needs is more leadership rather than more creativity.

While the first trigger is safely behind the State and the second trigger lies comfortably far in the future, there are other tests the State faces in the coming months. The Governor already has proposed a budget that takes a leaner view of the reimbursements that are expected to arrive from the federal government to cover the costs of illegal immigrant services, paring the amount from more than $2 billion to around $700,000. Early indications from Congress, however, are that even that reduced expectation will not be met. In addition, lower courts have overturned various budgeting tactics, including deferring pension payments, the school "loans" and paying employees with IOUs. When appeals are exhausted, the State may face bills of more than $4 billion.

Conclusion

To break the vicious cycle, policy makers must take several steps:

• They must craft a budget that is based on real numbers, including reasonable estimates of revenues, federal reimbursements and debt obligations.

• They need a realistic cash flow plan to complement the budget plan.

• They must cut programs as deeply as necessary to end the 1995-96 fiscal year in a balanced position.

• And they must adopt long-term policies that both ensure the growth of the State and provide for a surplus to meet unanticipated cash contigencies.

Short-term borrowing has worked successfully for the State to date -- but the strategy has been costly and, as Mexico has found, the result can be devastating when the markets decide they will no longer take a seat at the table. California can continue to put together new and innovative ways to package debt. Or it can find a way to live within its means and eliminate its structural deficits. The Commission advises that policy makers promptly choose the latter course.

Sincerely, Richard Terzian Chairman

1.

Anthony J. Taddey, Managing Director, BA Securities Inc., testimony to Little Hoover Commission, December 7, 1994.

2.

California Constitution, Article IV, Section 12 (a); Article XIII B, Section 5; and Article XVI, Section 1.

3.

Floyd D. Shimomura, Senior Assistant Attorney General, letter to the Director of the Department of Finance, June 13, 1994.

4.

Testimony to Little Hoover Commission on December 8, 1994 from Renee Boicourt, Moody's Investor Service; Steven Zimmermann, Standard & Poor's; and Claire Cohen, Fitch Investor Service.

5.

State Controller Gray Davis and Anthony J. Taddey, Managing Director, BA Securities Inc., in testimony to Little Hoover Commission, December 7, 1994.

6.

State Controller Gray Davis, letter to Governor and Legislature, November 15, 1994.

7.

Cal-Tax News, April 1, 1994.

8.

"An Overview of the 1995-96 Governor's Budget," Legislative Analyst, January 20, 1995.

9.

State Treasurer's Office, January 17, 1995 memo to Little Hoover Commission.

10.

State Controller's Office, January 17, 1995 memo to Little Hoover Commission.