On May 14 Governor Schwarzenegger released his May revision to the upcoming 2011 fiscal year that begins on July 1. On May 18 the state's politically independent Legislative Analysts Office (LAO) released their review of the proposal. They note that while the $19 billion gap is small compared to last year's nearly $60 billion problem, most easy solutions are gone and this year's budget could be more difficult. This commentary is based on a review of the LAO report.

Summary
The budget problem is large and minimally different compared to the Governor's January budget proposal. There is a $17.9 billion gap for 2011 and, with planned funding of a $1.2 billion reserve, the budget challenge is $19.1 billion. Revenues had been running ahead of forecast, but April's results, which show $3 billion less than expected, leave revenues approximately $1.8 billion behind.

Proposed Actions
The Governor's solutions are predominantly to reduce expenditures, with cuts accounting for $12.2 billion, or approximately 2/3 of his actions. This would bring the state's General Fund spending back to approximately 1996 levels. The revenue forecasts in the revised version, which are slightly more conservative than LAO's numbers, are deemed reasonable by the LAO. One of the glaring risks of Schwarzenegger's January budget was the expectation of receiving $6.9 billion in federal funds. The plan now has a more reasonable $3.4 billion, reflecting items that look possible (but are still not certain), which accounts for approximately 18% of solutions. The proposal still has some "one-time items," such as borrowing and funding shifts, which accounts for approximately 10% of the proposed solutions. Sticking to his promise, though, the Governor has not planned general tax increases, but new revenues do account for 5% of proposed actions.

Structural Issues
The LAO indicates that even with full implementation of this proposal, the state will still face annual deficits of $4-7 billion in future years. This may be a more manageable level and is more likely to be recaptured by revenue increases from an economic recovery. A key factor will be whether the state can make structural changes equal to the amounts proposed or if it will have to fall back on one-time fixes that leave the structural problem larger. As the LAO points out, some of the cuts planned would cause dramatic policy shifts and come with significant loss of federal-matching funds. Based on comments from state legislators, passage of some of these provisions will be very difficult. However, the LAO offered suggestions for revenue increases, which may end up as part of a solution that saves some of these programs.

Cash Flow and Liquidity
We are still waiting for a detailed cash analysis from the Controller, but the LAO indicates that with a recent legislative change which allows the flexibility to delay up to $5 billion of payments to local governments, schools and universities, the summer cash position is likely to be positive. Further, the LAO notes that the state should not need to use IOU's again unless the budget is delayed past August or September, when the typical short-term borrowing would occur.

Revenues
This June will be more important to the state than in the past. Recent budget agreements have accelerated estimated annual tax payments into June from July payments that would have counted against next fiscal year. As a result of this and the weak revenue performance in April, June could be the largest revenue month for the state. It should be a good indicator of what the state's economy is doing and what 2011 revenues will be like.

Conclusion
California's credit picture remains challenging but unchanged. The budget remains well out-of-balance, and the political process, including the 2/3 budget approval requirement, means meaningful solutions will be hard to find. On the positive side, an increased focus by the Controller and other state officials on debt service and liquidity, along with the changes to payment timings noted above, means the repayment of debt service is well protected, despite other problems that will occur. Following recent rating recalibrations by Moody's and Fitch, the state is now rated A- with a Stable Outlook by Fitch, A1 Stable by Moody's and A- Negative by S&P.

Please contact me with any questions or if Mesirow Financial can be of further assistance.

Peter Bianchini
Managing Director, Senior Municipal Strategist
+1 925.386.0262