Franklin Templeton muni co-director Rafael Costas says the very high long-term cost of funding that California would suffer after a default will keep the state paying on its current obligations.
Miriam Sjoblom: Hello, I'm Miriam Sjoblom, a mutual fund analyst at Morningstar. Joining me today from Franklin Templeton's headquarters in San Mateo, Calif., is Rafael Costas, who is the co-director of the municipal bond team there. Thanks for joining us today, Rafael.
Rafael Costas: Our pleasure, Miriam. Thanks for having us on your show.
Sjoblom: Well, your team runs several California muni funds, including one of the oldest and biggest muni mutual funds, which is Franklin California Tax-Free Income. So, the topic that is most on our minds today is California and its budget crisis. The state is facing a $26 billion budget deficit that lawmakers haven't yet managed to close. The state took the step of issuing IOUs to some vendors just a few weeks ago. Budget problems certainly aren't new to the state of California, but things definitely seem worse this time. What's gone wrong here, Rafael?
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Costas: Well, it's kind of some of the same medicine that we've had before. We've had situations like this in a number of years since we've been in the business. I've been in the business since 1986, and it's not the first time we've gone through this. California has a lot of things that we think are somewhat dysfunctional in terms of its budgeting process and approval of expenditures and approval of bills and a lot of other issues that kind of set us up for this kind of imbalance that becomes really hard to bridge with the majorities that you need to get something passed and signed and so on.
Every time you go through one, it seems worse than the last time, and I think because of this imbalance in our structure of government, it probably is worse than the last one. So, what we're hoping to see this time around is a solution that's not based on accounting gimmicks, and is actually based on some hard choices that have to be made, but I think if you do that, then at least you have minimized the risk that you will be going through something this bad in the next few years.
Sjoblom: Right. Well, I think there are some concerns out there that a crisis like this could cause the state to default on its debt, but you don't think so, and many other managers I have talked to certainly agree. Why not?
Costas: Well, there are some constitutional type of reasons why we don't believe that would happen. This GO debt that we're talking about, general obligation debt, is constitutionally authorized by the voters, and therefore becomes a very serious and binding obligation of the state, but that still wouldn't preclude somebody from being so drastic that they would even consider doing this. So, let's assume that somebody at the legislature level or state office level is thinking about doing that. To us, a practical problem with a willing default--this is not an ability to pay issue. The money is there. People don't realize that as big as the numbers seem to be in terms of billions, the debt service of the state's GO debt is something like 5-6% of the general budget, so that is not a budget-breaker.
But, should they still say, let's take the easy way out and skip a couple of payments, the penalty for doing so in terms of the market penalty--I can't even imagine what it would be. Right now, the state of California GO bonds trade at a premium penalty, and I mean by that, they pay an extra interest rate of 1.5%, 150 basis points or more, depending on the maturity range you're looking at.
It's still rated A by S&P's and Moody's. It is BBB by Fitch, and they're kind of trading at BBB, but we're not even talking about being downgraded below investment grade, and this is the penalty we're paying. It would be multiples of that if you even talked about going into a default, let alone the amount of time that you'd be shut out of the market.
Last year alone, without this kind of dramatic problem, we were shut out of the market, along with many people, for about nine months. So, it would be a real--I don't want to use too severe of a word-- but it would be a real bad long-term mistake to even think about doing that when the solutions are there to not impose on the state a long-term cost.
I mean, we're talking about the next debt that gets issued being at a very high premium for the life of that debt, which, as you know, is sometimes 10, 15, 20, even 30 years. There's a recent example, relatively speaking, with the city of New York having a short-term default way back in the mid-70s, and it paid a market penalty for almost 20 years, let alone the structural things that it had to go through to be able to issue debt.
So, it is not a practical out for this kind of situation, and that is true for any state. As far as we can tell, and we got this information from Moody's not long ago, one state apparently defaulted on its GO debts in the Great Depression. It took the Great Depression to do that, and that was the state of Arkansas. I don't know anything more about it than to tell you that. The details are sketchy.
But, we're not in the Great Depression. We are in a tough recession that's impacting, not only California, every state out there, but to even consider defaulting on your debt is going to be a very expensive long-term mistake that you do not want to make.
