-- James Saft is a Reuters columnist. The opinions expressed are his own --
By James Saft
LONDON, May 26 (Reuters) - California's fiscal train wreck should be watched warily by investors in U.S. Treasuries; as the start of a trend among states seeking bailouts, as a source of pressure on Federal funds and as a harbinger of hard choices at national level.
California voters last week rejected a finance bolstering proposal, setting the stage for billions of dollars worth of cuts in services, layoffs and a shortened school year.
It also leaves the state with a budget shortfall of more than $21 billion, an exacerbated seasonal revenue shortfall and a fragile reputation in the bond market.
These are just about the last things a state needs when unemployment is high and recession is deep, but California is trapped between its own high cost base, bond investors unwilling to give it the benefit of the doubt and a Federal government that is loath to play Santa Claus. Of the three, the last is most likely to give way, and if the U.S. does widen the bailout it is already giving to states it will have potentially profound consequences.
Treasury Secretary Tim Geithner knocked back, equivocally, a request from California Treasurer Bill Lockyer to use TARP funds to backstop the issuance of bonds by California. Lockyer fears that investors and banks will impose punitive costs on new borrowings, costs that will only worsen its overall position.
Though Geithner was right to say California wouldn't fit under the TARP, saying in essence that this was not the purpose of the vehicle, he was far from final on the whole issue.
Asked to rule out categorically a California bailout, Geithner told Congress:
"We will have to do exceptional things, as we have done already, to fix this mess ... That's not putting on the table or taking off the table any specific thing like that. But I just want you to know that there are things that we've had to do I would never have contemplated doing."
Christopher Thornberg, of Los Angeles-based Beacon Economics, thinks the stakes for California and the U.S. economy will prove too high.
"I don't think the Feds can afford to say no to California just now."
AS THE BAILOUT ROLLS
The economic and social impact of California's spending cuts are unpleasant. Also of concern is the health of the municipal bond market itself, the continued smooth functioning of which is systemically important and could force the government's hand. To be clear, Californian 10-year debt is still yielding a fairly reasonable 4.4 percent, a lot higher than equivalent Treasuries at about 3.3 percent but not ruinous. There are well founded fears about what the price will be going forward.
Treasury and Federal Reserve officials are understandably reluctant; after all, look at the mortgage market which continues to be hooked up to a government sponsored ventilator. Clearly too if Federal assistance were given to help California sell bonds, other states and localities would quickly get in line for their share.
And while California makes the headlines, the finances of other states are also dire.
Forty-seven of the 50 states face budget deficits in fiscal years 2010 and 2011 totalling a hefty $350 billion, according to the Center on Budget and Policy Priorities.
Much of that will be resolved through higher taxes and spending cuts, but a chunky part could end up being bankrolled in one way or another by the Federal coffers, which should give pause to Treasury investors already absorbing massive issuance.
California is in some ways a special case: it requires two thirds majorities to pass tax increases. But its political inability to get to grips with a set of unpleasant choices is perhaps a warning for the U.S. as a whole.
There is precious little consensus in Congress for more bailout money and even if another tranche of support for states on top of the $140 billion already offered makes economic sense, it may not be forthcoming. It's not hard to see political paralysis in Washington if more money is needed, for whatever reason.
Secretary Geithner has been lucky or smart to the extent that markets have decided that his tools and bankroll are equal to the task as far as banks go. That consensus may or may not hold and may or may not continue to matter.
If states or municipalities mean he must go back to a refractory Congress, confidence could ebb as rapidly and dramatically as we have seen it grow.
-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at saft@reuters.com and find more columns at http://www.reuters.com/news/globalcoverage/columns --
(Editing by Ruth Pitchford)