Moody's cuts Calif rating, budget talks press on

SAN FRANCISCO (Reuters) - Moody's cut its rating on Tuesday on about $72 billion of California's debt to near junk status, citing the state's budget crisis, but a top lawmaker said a deal to close a $26.3 billion gap was near.

Moody's Investors Service in a statement said it cut the state's general obligation debt by two notches to Baa1, or three notches above speculative "junk" status and the rating may suffer further downgrades because of a growing risk to the state's ability to make priority payments.

They include payments to investors holding the state's debt.

Spokesmen for the state treasurer and state controller quickly countered Moody's, noting priority payments would be honored while Republican Governor Arnold Schwarzenegger and leaders of the state's Democrat-led legislature press on with talks to balance the state's books.

"We've never defaulted. We've never failed to pay bond investors on time and in full. We'll maintain that spotless record," said Tom Dresslar, a spokesman for State Treasurer Bill Lockyer.

California less than two weeks ago began to issue IOUs to pay some bills in a bid to conserve cash as it struggles to balance its budget.

Moody's said its downgrade "reflects the increased risk to the legally or constitutionally required payments ("priority payments") as the state deadlock continues and the controller has begun to make certain payments that are not legally or constitutionally required to be paid on time ("non-priority payments") with IOUs."

Without a solution to the state's budget gap, the risk to priority payments -- and eventually debt service payments to bond holders -- is increasing, Moody's said.

California began its fiscal year on July 1 without a balanced budget agreement, a situation which appeared to be drawing to a close, Assembly Speaker Karen Bass told reporters in Sacramento.

"We had three very productive days of negotiations over the weekend and there's no reason why today -- the latest tomorrow -- this can not close and be done with," Bass said.

HOPING FOR A BUDGET DEAL

Analysts said a budget deal could not come soon enough because the budget crisis is wearing thin on Wall Street.

Moody's downgrade followed Fitch Ratings' cut to its credit rating on California on July 6, lowering it to BBB, just two notches above junk.

"They're certainly entitled to send us a signal that they're disgusted that we're not able to sign a budget," said Steve Levy, director of the Center for the Continuing Study of the California Economy.

However, Moody's may be overly nervous about California's ability to pay its priority payments, Levy said: "They're right on the budget but I don't think we'll default on the bonds."

State Controller John Chiang "will do everything within his power to protect debt payments," said spokesman Jacob Roper. "Debt service payments have the second highest payment authority under the state Constitution."

Schwarzenegger sought to increase pressure on lawmakers on Tuesday by hitting the airwaves with a television commercial underscoring he would not waver from his budget demands. He said in the commercial that he would not sign a budget if it includes higher taxes and excludes changes in state government he has said will prevent welfare fraud.

"And I will not sign a budget that pushes our financial problems down the road, because the road stops here," he said.

The governor and top Democratic lawmakers have essentially agreed to balance the state's books with deep spending cuts. Democrats have conceded state revenues have plunged so dramatically that spending must drop as well.

They also have backed away from attempts to raise taxes, opposed by minority Republican lawmakers.

Democrats do not have sufficient votes to pass budgets and tax increases on their own, giving Republicans, if they remain united against taxes, an effective veto on spending plans.

Where Schwarzenegger and top Democrats differ most now is on the politically sensitive issue of education spending. To pare education spending he has proposed suspending a two-decade-old voter-approved measure that locks in funding levels for public schools. The idea was to be a focus of budget talks on Tuesday evening.

(Additional reporting by Ciara Linnane in New York and Marianne Russ in Sacramento, California; editing by Carol Bishopric)