California must be dreaming: Agnes T. Crane

-- Agnes T. Crane is a Reuters columnist. The views expressed are her own --

By Agnes T. Crane

NEW YORK (Reuters) - Don't underestimate the power of California, and its ability to suck in a reluctant federal government to bail it out of a fiscal mess of its own making.

But the Obama administration and Congress should resist.

Not only is the federal government shouldering the already heavy burden of sorting out the auto and banking industries, the housing giants Fannie Mae and Freddie Mac and the hard-to-get-rid-of American International Group (AIG.N), but such action would undermine the state's need to revamp what has become an ungovernable system built on gerrymandering, ill-conceived tax schemes like Proposition 13 and unrealistic restraints like needing a two-thirds majority to pass a budget.

Intervention in California would open another too-big-to-fail Pandora's box, but one that is much more difficult to navigate politically since the federal government would be dictating which state, and by extension which voters, are worth saving. California, though the most extreme case, isn't the only state suffering.

In fiscal year 2009, 38 states are experiencing revenue shortfalls, according to a joint survey by the National Governors Association and the National Association of State Budget Officers. Over three quarters of the states have already slashed their budgets by $31.6 billion, but that won't solve the more than $180 billion gap still projected between 2009 and 2011.

It would also further encourage complacency in the $2.7 trillion municipal bond market, where the assumption persists that no matter how disastrous a state's finances, investors need not worry about default.

That California has itself to blame as much as the slump in revenues should also make it a hard sell for a bailout.

The embarrassing budget impasse has left the Golden State with a $24 billion gaping hole in its state finances and a cash crunch that will force the state controller to send out IOUs for the second time this year later this week.

So far the cash crunch is limited to a $2.8 billion shortfall in July that can be plugged by handing out IOUs to local governments, state vendors and recipients of income tax refunds. But by September that shortfall will swell to $6.5 billion, according to the state controller, and by October, California will need to pay off the IOUs issued this month.

Of course this could be remedied by the governor and state legislators if they could agree on a budget and painful measures to address the cash shortage, but even the June 30 deadline hasn't been enough to force them to overcome the entrenched dysfunction in the state government.

It should be said that the prospect of defaulting on the state's roughly $70 billion of bonds outstanding -- that includes its general obligation bonds and its Economic Recovery Bonds -- is likely some months away, but the rapid deterioration of the state's finances, the size of the budget gap and the governor's insistence that short-term borrowing in the credit markets is off the table as a solution, brings the possibility into much sharper focus.

The scope of the mess and state government's inability to tackle it has caused those with an aversion to drama to sell California municipal debt, pushing up 30-year yields to a lofty 6.2 percent this week, up from the 5.3 percent to 5.4 percent seen in the beginning of May, according to Municipal Market Advisors. The cost of protecting the bonds has also been rising.

Given the unprecedented nature of a California default -- you have to go back to The Depression to find a state, Arkansas, failing to meet its debt obligations -- there's an expectation that the federal government would intervene to ensure bond holders are protected, at least partially.

That's because a state the size of California -- it would be the world's eighth largest economy if it stood alone -- would have an extremely difficult time managing its finances without access to the capital markets.

It also promises to darken the United States' black eye from the credit crisis since it would show how weak such big states, which contribute to federal coffers, are. That could pressure its own cost of borrowing higher as international investors become even less enamored with government debt.

California has already asked the U.S. Treasury for a healthy heaping of funds from what has become the catch-all Troubled Asset Relief Program, which was initially created to buy toxic assets from financial institutions, but Timothy Geithner has kept his distance, signaling back in May that any decision to lend a helping hand to the state should come from Congress.

The pressure is likely to mount in the days, weeks and months ahead, however, if there's no resolution from the state on how to right its finances. Fitch Ratings has already downgraded California's ratings, and Moody's Investors Service and Standard & Poor's have warned that they could do the same if nothing is done. Negative press surrounding hardships from those receiving IOUs in lieu of cash will also turn up the political heat to do something.

The federal government, however, should stay out of the mess and signal more strongly to state politicians and investors alike that they're on their own.

(Editing by Martin Langfield)