Jim the Realtor is back with a bunch of foreclosures, REOs and short sales on the market in North County San Diego.  Some of these places look pretty nice.  In this particular video, the property is in Carmel Valley and on the market for $1.249 million. It is interesting for a couple of reasons.

The guy in the house has been on the foreclosure roles for a long time.  Apparently, he ran up loans 15% over the original amount, which suggests he may have been using the house price as an ATM when prices were going up. But now he is making partial payments to avoid being foreclosed.  The interesting thing is that by making a partial payment, the owner can get off the foreclosure roles and stay in his home.. until he misses another payment, which in this case has happened several times.

This is called “extend and pretend” otherwise known as “delay and pray.” Banks love this because they don’t have to write down the value of the loan immediately and the owner is looking for an exit strategy that doesn’t put him out on the street. It’s all good, right?

Obviously, the inventory levels would be a lot higher if short sales like these were foreclosed.

Another interesting factoid is that this place got multiple offers over list – and we’re talking cash buyers here. Jim’s prospective buyer came in with 50% down as well – and lost.  Jim calls this a “feeding frenzy.”

Clearly, record-low interest rates are doing the trick to reflate house prices in San Diego, a canary in the coalmine for the rest of the country (they led on the way up the first time and on the way down). This reflation is exactly why you delay and pray. For this particular seller it worked out as well as it could.

Related posts:

• Extend and pretend and the growing divide between delinquencies and foreclosures
• Cruising foreclosures, REO and short sales with Jim the Realtor
• Banks can do ‘You Walk Away’ too
• Manhattan Q2 Apartment Sales down 22%
• Case-Shiller Index: Less bad, but three markets cut in half

Here is some anecdotal evidence of the return of euphoria  in housing via Jim the Realtor.  Check out these videos of Carlsbad (North County section of San Diego) and the surrounding community to see what I mean – many but not all of these are going for well over list price. All of these are foreclosure sales.

It looks like we may just have hit bottom on the lower end. Will it trickle up?  We’ll see.

Related posts:

• Existing home sales add to the parade of bullish data
• Cruising foreclosures, REO and short sales with Jim the Realtor
• Case-Shiller: U.S. home prices up for third month in July
• Nationwide: U.K. house prices rise for second time in three months
• Case-Shiller Index: Less bad, but three markets cut in half

This came in overnight via the FT.  Most of the shortfall in revenue is made up through spending cuts.  Below are the relevant paragraphs:

The agreement involves cutting nearly $6bn from schools and community colleges and close to $3bn from the state’s university system, although Mr Schwarzenegger said education cuts would be fully “refunded”.

An additional $1.3bn will be cut from Medi-Cal, the health programme for low earners and the poor.

CalWorks, the state’s welfare-to-work programme – and the target of much criticism from Mr Schwarzenegger – will have its funding cut by $528m, while Healthy Families, a programme that provides health insurance for 930,000 low-income children, will be cut by $124m.

The state’s in-home support services programme for the frail and disabled will also have its funding slashed. Mr Schwarzenegger has maintained that the system is a hot-bed of fraud abuses and won approval to begin fingerprinting care-givers and recipients of aid.

Another contentious part of the agreement will clear the way for oil drilling to resume off the coast of Santa Barbara. The prospect of drilling in the area has attracted a lot of criticism and is likely to be fiercely contested by local residents and environmental campaigners.

I should also mention some thoughts from Tim Fernholz via Brad DeLong on why the Federal Government has not given states more money.  He claims it was moderate Senators in Congress who explicitly took out state aid from the February stimulus package.  He writes:

Robert Samuelson, typically known for butchering economics in his column, takes a break today in order to butcher political science. He says the stimulus isn’t working because it is composed of the wrong programs, and he blames President Obama specifically for not including things like fiscal aid to states…. But if Samuelson were to remember what actually happened last February, or even do some superficial research, he’d realize that it was the moderate members of the Senate, led by Sens. Ben Nelson and Susan Collins, who stripped out much of the state funding…. [T]hese senators never did get around to telling anyone the economic logic of their proposal…. So Samuelson will never criticize moderate senators for passing bad policy, so long as they do so in the name of deficit hawkery, but by God the president who signs such a bill — a much-needed bill to ameliorate the effects of a major recession — will be held accountable!

This should make plain why Obama rejected California’s request for aid apart from the Administrations own ideological reasons.  There was no chance the state would receive any aid given the mood in Congress, so why waste political capital in trying to do so?  Like it or not, the result is cuts in spending. Expect the same elsewhere, particularly in New York and Nevada where budget gaps are even larger in percentage terms.

Related posts:

• California is to begin handing out IOUs tomorrow
• Is the State of California bankrupt?
• Kansas and California and the race to U.S. state insolvency
• Text of Schwarzenegger letter to Paulson
• California will go bankrupt

The bloggers at bloggers at UMKC’s economics blog have been making the case that California’s IOUs are a currency.  Randy Wray’s entry last Monday was particularly provocative because he suggests a movement to loosen national government power is supporting similar moves in other jurisdictions. Wray writes:

Some commentators have argued that the proposed California "warrants" are similar to local currencies (see, e.g., Mark Thoma). In this piece I discuss experiments with local currencies and continue my argument that if California were to accept its own "warrants" in payment to itself, it could turn these into a functioning currency free of the defects of local currencies.

Interest in local currencies has soared in recent years, with nearly 100 U.S. communities experimenting with them. While proponents offer a variety of arguments in favor of local currencies, they share three common themes. First, there is concern that the use of a national, monopoly, currency creates a variety of economic, social, and environmental problems. Second, local currencies are said to improve regional communities, again across several dimensions including economic, social, political and environmental spheres. Third, many proponents want to reduce the power of national government, recognizing a relation between the monopoly of currency issue and centralization. They believe that decentralized money would shift power back to the communities.

However, previous adventures in local currencies have failed miserably as Wray later attests:

As discussed, most local currencies have failed (of the 82 created between 1991 and 2004, only 17 remained by 2004). Those that succeeded shared some combination of the following characteristics: an exchange rate pegged to a strong national currency by a trusted institution; substantial supplies of unemployed or underemployed workers; businesses operating below capacity; and a strong community spirit, led by liberal, middle class residents. These characteristics are not always easy to replicate nor are they necessarily desirable. If the goal is to displace the national monopoly currency, linking the local currency to it appears inconsistent—especially if one fears national government policy is inflating away the value of the nation’s currency.

So I have another idea, which I got from a knowledgeable reader nicknamed aitrader.  How about a Gold-backed IOU system.  In response to a recent post I wrote on the similarities in the troubles in California and Ireland, he wrote:

Now here’s a curve ball for ya: what would happen if a state or even a private bank were to issue currency redeemable in gold or silver? What would the implications be for the US Federal Reserve? This was the situation for many years in the US. Private banks often issued their own paper currency redeemable in gold and silver. There is nothing illegal about this, though one would assume a new law would be crafted and passed to prevent this from occurring. On that note here is what happened recently to a private currency issuer, http://en.wikipedia.org/wiki/Liberty_Dollar#Fed….
Interesting times…

So, let me explore his idea using Ireland instead of California.  I want to use Ireland as the example here because, in discussing my California-Ireland post, the Economist pointed out that Ireland is the place where true problems lie. The Economist says:

There is a problem with Mr Harrison’s thesis in the fiscal policy department, however. California has faced credit downgrades, but only because it is legally prevented from running deficits—it must default if it cannot make all its payments out of pocket. But California has a relatively small debt load, so far as nations go. If the state were allowed to run annual deficits, it seems highly unlikely that it would face pressure to balance its budget amid recession.

Ireland, on the other hand, is confronted by actual market pressures to prove that it can meet its obligations; it’s in trouble in an absolute sense. Ironically, both have fiscal difficulties that are not rooted in their federal status; Irish borrowing is limited by markets while California’s borrowing is constrained by the state constitution.

Point taken. So Let’s solve this problem.

Say Brian Lenihan is dispatched to consider how to prevent the government from sacking tens of thousands of workers in order to prevent the Irish from defaulting on its debt. 

He suggests that California’s IOUs are a model for Ireland, but he goes one step further adding a redemption in 5 years at a 40% premium to the present spot price for gold, which represents a 7% annual return.  Today, spot gold is trading at $950 an ounce. So, a 40% premium is about $1330 an ounce for gold.  Lenihan would offer this deal to any and all creditors of the State in lieu of cash.  The IOUs would be tradable in standardized amounts of 20, 50, 100, 1000, 10,000 and 1000,000 euros in order to facilitate a secondary market.

I got this idea from the high yield market where often bonds are issued with an embedded option to convert to equity at a premium or with PIK preferred shares thrown in as a kicker.  The point of these options is to provide a sweetener to investors in order to get the deal done.  These are the same kinds of deals that Warren Buffett did with General Electric and Goldman Sachs in 2008, and that he has previously done with USAir (now US Airways) and Salomon Brothers (now a part of Citigroup). If the embedded option increases in value significantly, the debtholder can make a lot of extra money.  For Buffett’s options in Goldman, this has already occurred.

Here’s what the ‘investor’ gets in the case of the Irish IOUs:

1. Bonds backed by the full faith and credit of the State paying a rate of interest that I suggest be a slight premium to the official 5-year bond.
2. A 5-year out of the money European option to buy gold for the full face value of the bond at today’s price.  Obviously,if you think gold is going up you would be willing to pay a lot for this option.
3. An IOU that is not just backed by the full faith and credit of the sovereign like most currencies, but that has a tangible link to a real asset, gold.

What does the sovereign get?

1. Ireland conserves cash without having to issue bonds.  Ostensibly this would mean interest rates on Irish bonds could remain lower. That’s a huge deal, especially since these IOUs would not be considered legal tender.
2. Ireland removes the restriction imposed by the Maastricht treaty as the IOUs are not cash and reduce the budget deficit.  In effect, the government is free to add fiscal stimulus without those restrictions.

Obviously, the Irish government would have to hedge their gold commitment by buying Gold futures. But, the Irish could then legitimately claim that its IOUs were more than just a piece of paper.  And, they would remove some of the constraints now impose upon it by foregoing their own currency.

Related posts:

• Pre-payments are reducing value of mortgage-backed securities
• Ireland: government blew the boom
• Gold hits all-time record high
• Spain and Ireland ‘thrown to the wolves’ after ECB move
• Ireland gets deflation

For quite some time now I have been of the view that there are a number of striking similarities between the goings on in Ireland and those in California, none of them good.  Both locations have seen extraordinary rises in home prices turn to massive busts. As a result, both locales have seen depression-like collapses in consumer demand and the local economy. Unemployment and government deficits are surging in both California and Ireland.  But, both California and Ireland have zero control over monetary policy and this is the crucial connection.

Ireland

Let’s rewind a bit to 1999 when the Euro came into being.  Ireland was a founding member of Euroland. So, on January 1st of that year, the Irish fixed their currency the Punt to the Euro for good at a rate of 0.7876. From that time forward, Ireland effectively had no control of the monetary spigot.  By 2002, Punts ceased to exist as money in Ireland and the Euro was ushered in.

What this change meant for Ireland is that it had the many benefits that go with being part of a large single currency market. Among the many advantages of a single currency are reduced foreign exchange costs, less currency volatility, less chance of a run on the currency, and a greater certainty in business planning that results from those benefits.  And these benefits can be huge in times of crisis – just ask Iceland.

There is a problem though which I mentioned before, namely the Irish have no control over their own money.  To be sure, hard money types probably see this as a good thing as it prevents countries inflating to get out of an economic pickle. But, the alternative for the Irish has been depression.

Back in February, I mentioned this problem in a post called “The European Problem.”

The Eurozone members have decided to forgo independent monetary policies. Individual member nations have free capital movement and a fixed exchange rate but zero control over monetary policy. That rests with the European Central Bank (ECB) in Frankfurt.

The problems mount in recession. Some members are getting devastated. Spain, for instance, is in depression already with unemployment at 14%. Ireland’s national budget is imploding with estimates for deficit reaching 10-12% of GDP. If you are Spain or Greece, you would like to print money– a lot of it. But that’s not happening in the Eurozone yet.

The result is a potential national bankruptcy for the likes of Ireland, one reason their credit rating is suffering. Will Ireland go bankrupt?  Perhaps.  It is unclear how willing other Eurozone members would be to support the country were it to run into that kind of difficulty.  The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency.  Bailing out a Eurozone member would come with many strings attached.

Then, there is the case of Austria.  They too are in the Eurozone.  They have a weak banking system because of excessive lending to Eastern Europe — reaching a full 85% of Austrian GDP.  (Whether the Austrians were mentally re-creating their lost Empire, stripped after World War I, is a case for the Austrian psychologist Freud). If the Eastern Europeans run into problems, Austrian banks will fail en masse, requiring help from other Eurozone members (read France and Germany).

So, Ireland, having no other choice, must cut spending…drastically.  Ambrose Evans-Pritchard reports.

Events have already forced Premier Brian Cowen to carry out the harshest assault yet seen on the public services of a modern Western state. He has passed two emergency budgets to stop the deficit soaring to 15pc of GDP. They have not been enough. The expert An Bord Snip report said last week that Dublin must cut deeper, or risk a disastrous debt compound trap.

A further 17,000 state jobs must go (equal to 1.25m in the US), though unemployment is already 12pc and heading for 16pc next year.

Education must be cut 8pc. Scores of rural schools must close, and 6,900 teachers must go. “The attacks outlined in this report would represent an education disaster and light a short fuse on a social timebomb”, said the Teachers Union of Ireland.

Nobody is spared. Social welfare payments must be cut 5pc, child benefit by 20pc. The Garda (police), already smarting from a 7pc pay cut, may have to buy their own uniforms. Hospital visits could cost £107 a day, etc, etc.

California

I hope this sounds familiar to American readers because this is exactly the scenario faced by California.  The state does not have the option of going out to the California Federal Reserve Board’s backyard to pick a few ten billion dollar notes off the money tree. This is a privilege reserved for the U.S. Federal Government, one I would add that has the Chinese worried.  Effectively, California is to Ireland as the United States is to the Eurozone.  And that spells depression for California.  Here are a few headlines:

• California prepares to shut 220 state parks to make up budget shortfall
• California’s Crisis Hits Its Prized Universities
• California closes state offices to save cash

Welcome to Reykjavik on the Pacific.  Don’t think this train wreck happened overnight. It has been building for months.  I first asked in October of 2008 is the State of California bankrupt.  Technically, they are not.  But, when a state refuses to honor its bills by handing out IOUs, that’s bankruptcy to me.

It is going to get worse for California. That is for sure. The problem here again is the depressionary bust that is likely to take hold as California starts firing workers and cutting spending. Remember, people with no jobs have little income. And having little income means foreclosure, which also means a surge in housing inventory and falling prices. That’s a recipe for still more foreclosures, continued house prices declines and a deflationary spiral.  I imagine Wells Fargo and Bank of America would be rendered insolvent by such a scenario.  So why is Obama balking at lending a helping hand?

I anticipated a bust in California and a helping hand from the Obama Administration, because I figured they wanted to mitigate worst-case outcomes. As far back as January 2nd, I was already saying this was the likely scenario.  I asked “Will federal largesse be countered by state and local cutbacks?”

There has been a general outcry for economic stimulus on the part of the North American, U.K. and Eurozone federal governments to counteract the fall in private sector consumption.  In the U.S. and the U.K. in particular, this message is being heard and largesse will be delivered in spades.

But, in the United States, there is a bit of a problem: state and local governments.  They will not, and often cannot, spend.  In fact some will be cutting.  Will local government budget cuts undercut federal fiscal stimulus?

Yes. Yes. Yes.  Doesn’t the Obama administration see this?  I would argue they did not understand this in January or the stimulus bill would have been larger and more front-loaded. But, perhaps they do now, but have chosen not to act because every state and municipality in America would be looking for a handout if they did try to act in California.  So, we’re in bit of a pickle here.

Conclusion

The foregoing analysis can’t leave you feeling like recovery is imminent in Europe or in America.  Certainly, it is not in Ireland or California.  The problem is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You cannot have all three. And California and Ireland both lack the monetary escape hatch. Depression will set in.

I see only three choices to solve this problem.

1. Bailouts: Of course, we are going to see requests for transfer payments here. Will Obama bite?  Will the Germans block this, afraid that the Austrians and Spanish would be next?  Obviously, transfer payments are part and parcel of a monetary union in order to achieve economic harmonization.  In the U.S., California gets less in federal largesse than it pays in taxes. This is a fact.  However, it is looking ever less likely that this fact will help Schwarzenegger receive the help he wants.
2. Backdoor currency: Marshall Auerback has argued that the IOUs in California are a backdoor currency system. No, they are not legal tender.  But, in a note to me, he said “California can turn its warrants into sovereign currency by agreeing to accept them in payments to the state. Note that I AM NOT arguing that California should make them “legal tender, payable for all debts public and private”—this is something it cannot do. But you could basically reduce the cost of CA’s borrowing substantially via this device and essentially reduce the need for muni bond issuance.  In fact, the implication that flows from my analysis is that you’d want to buy every single muni bond in sight as the IOU, by giving it an intrinsic value to pay state tax, effectively eliminates the need for muni bond issuance.”  Could Ireland do the same?
3. Immigration:   People are just going to have to move.  As jobs disappear in Ireland and California, the Irish and Californians will need to emigrate elsewhere. They have a huge market to chose from in both cases.

None of these are great options. I wish I had something more uplifting to say here. But, that is the situation we face.

Related posts:

• Ireland: the bust after the boom
• Did joining the eurozone bust Ireland?
• Ireland: government blew the boom
• Spain and Ireland ‘thrown to the wolves’ after ECB move
• Ireland: Next stop – IMF

This can’t be good.

A group of the biggest U.S. banks said they would stop accepting California’s IOUs on Friday, adding pressure on the state to close its $26.3 billion annual budget gap.

The development is the latest twist in California’s struggle to deal with the effects of the recession. After state leaders failed to agree on budget solutions last week, California began issuing IOUs — or "individual registered warrants" — to hundreds of thousands of creditors. State Controller John Chiang said that without IOUs, California would run out of cash by July’s end.

But now, if California continues to issue the IOUs, creditors will be forced to hold on to them until they mature on Oct. 2, or find other banks to honor them. When the IOUs mature, holders will be paid back directly by the state at an annual 3.75% interest rate. Some banks might also work with creditors to come up with an interim solution, such as extending them a line of credit, said Beth Mills, a California Bankers Association spokeswoman.

- Big Banks Don’t Want California’s IOUs, WSJ

Maybe the big banks are afraid they are undercapitalized and don’t want California’s IOUs because they think they are worthless.  Fitch has downgraded California to near-junk status.

Note: I should point out an error from a previous post.  I said that California IOUs would pay 5% interest.  Unfortunately, they will pay only 3.75%…that is if they are paid.

Video of the whole we-bailout-receiving-big-banks-wont-take-IOUs affair is below.

Oh, and if you are wondering, who gets IOUs and who doesn’t, then Felix Salmon has the answer.  News from 1930 shows that on July 7th, 1930:

At least 45 Florida towns and cities in default on bonds; committee recommends austerity, state sales tax on nonessentials.

Sound familiar?

Related posts:

• California is to begin handing out IOUs tomorrow
• California starts issuing IOUs as bankruptcy nears
• How about Gold-backed IOUs for Ireland?
• California will go bankrupt
• Kansas and California and the race to U.S. state insolvency

This is effectively bankruptcy. Bloomberg reports.

California is poised to begin its new fiscal year tomorrow without a plan in place to close a $24 billion deficit as the state prepares to conserve cash by issuing IOUs to vendors who are owed money.

Republican Governor Arnold Schwarzenegger and Democrats who control both chambers of the Legislature are scheduled to meet throughout the day to reach a compromise. Schwarzenegger has sought spending cuts that would eliminate welfare programs and push nearly 1 million low-income children out of government health insurance. Democrats want fewer reductions and some tax increases to make up the difference…

Schwarzenegger yesterday vowed to veto a $23 billion package of tax increases, spending cuts and accounting maneuvers Democrats passed by a simple majority rather than the required two-thirds vote. Democrats argued that the tax bills needed only the simple majority because they cut some taxes, while increasing others an equal amount and raised fees that don’t meet the two-thirds approval requirement…

“Is there anyone in this room who believes that we are going to magically solve this problem by midnight? It’s just not likely,” said Senator Mark Leno, a San Francisco Democrat.

While you may not have heard of similar problems in other states, 48 states have funding gaps to close.  And in some states the percentage gap is even larger than in California – New York and Nevada where budget gaps are nearly one-third of revenues -to name two.  By the way, the California IOUs will pay 5% interest.

Update 1 Jul 2009:  The impasse was not cleared. IOUs are coming.

Related posts:

• Is the State of California bankrupt?
• Banks to stop accepting California’s IOUs
• California impasse ends as Schwarzenegger reaches agreement
• Kansas and California and the race to U.S. state insolvency
• California starts issuing IOUs as bankruptcy nears

The Washington Post is reporting that the Obama administration has rejected initial pleas from the State of California for U.S. Government aid. However, the post report reveals that Tim Geithner told California it must get its fiscal house in order, suggesting that aid would be forthcoming if it did so.

Doubt lingers as to whether Obama will come to California’s rescue. This can’t be good for the municipal bond market. And it also makes it clear that the U.S. Government is going to have to get its own house in order if it wants any credibility on the fiscal discipline score. Let’s see what that means in the weeks and months ahead.

Source
Calif. Aid Request Spurned By U.S. – Washington Post

Related posts:

• California will go bankrupt
• Depressionary bust in Ireland is echoed in California
• California is to begin handing out IOUs tomorrow
• No bailout for CIT
• California impasse ends as Schwarzenegger reaches agreement

This case is going to the Supreme Court of the United States.  It will be a landmark ruling when the issue is decided. Take a look at what David Boies has to say about the issue.

Related posts:

• A conversation about the growing fiscal deficit on Charlie Rose
• What are the legal rights of lenders and homeowners in foreclosure?
• A conversation with Richard Posner on Charlie Rose
• Why pro-choice Dems have nothing to like about John McCain
• Muncipalities can tear up contracts

You can see this coming.  It is looming and has been for some  time.  Remember that California is the biggest loser in the housing crash and it has one of the highest unemployment rates in the United States.  I have been warning that this would be  a problem since last Fall when it was evident that revenue was going to come up short (see my post “Is the State of California bankrupt?)”.  The Wall Street Journal discusses the potential for bankruptcy in the video below.

I have said that Obama would step in here.  This is an option discussed in the video.  It will not be an easy politically for Schwarzenegger or Obama.

You should also note that tax revenue is a lagging indicator. The Journal’s blog Real Time Economics did a good job of pointing this out and putting some statistics together on state tax revenue.

Related posts:

• Is the State of California bankrupt?
• California is to begin handing out IOUs tomorrow
• Kansas and California and the race to U.S. state insolvency
• California starts issuing IOUs as bankruptcy nears
• California closed for business

This video seems to be making the rounds. I saw it over at Calculated Risk first. The video shows new homes in Victorville, CA, just south of LA, being destroyed because it costs more for the banks to keep them up than to demolish them. That’s one way to pare the housing inventory glut.

Related posts:

• More on California Housing data
• The irony of falling prices and first-time homebuyers
• Case-Shiller shows a further decline in prices
• Nationwide: U.K. house prices down 17.6% in year to Februay

Marshall Auerback here. Remind me again what Larry Summers was talking about when he spoke of the US as being a “nation of laws”, where “sanctity of contract” is sacrosanct?

In a case of first impression that could have far-reaching implications, a bankruptcy judge in California recently determined that municipalities that file petitions under Chapter 9 of the Bankruptcy Code (reorganization for municipalities) can reject existing collective bargaining agreements with public employee unions. In re City of Vallejo, Case No. 08-26813-A-9 (E.D. Cal. Mar. 13, 2009). Facing a $9 million budget shortfall, largely from collectively bargained payroll costs and benefits for firefighters and police officers, the City of Vallejo filed a petition for bankruptcy protection under Chapter 9 in May 2008, which allowed the City to attempt to re-negotiate contracts with employees, vendors and others. When efforts to re-negotiate the collective bargaining agreements with the unions representing firefighters (International Association of Firefighters, Local 1186) and electrical workers (International Brotherhood of Electrical Workers, Local 2376) failed, the City petitioned the bankruptcy court to void the contracts with those unions.

The primary issue before the bankruptcy court was whether a particular statutory bankruptcy provision, 11 U.S.C. section 1113 – which prevents outright rejection of union contracts in the private sector by requiring Chapter 11 debtors (reorganization of corporations or partnerships) to satisfy certain procedural and substantive prerequisites before they can void a collective bargaining agreement – is applicable to municipalities seeking protection under Chapter 9. After reviewing the statutory history, the bankruptcy court determined that section 1113 was specifically not incorporated by Congress into Chapter 9, and therefore, was not applicable to municipalities.

However, the bankruptcy court found that other, albeit less stringent, procedural requirements established by the United States Supreme Court in NLRB v. Bildisco & Bildisco,1 did apply to municipalities petitioning for bankruptcy under Chapter 9. In Bildisco, the Court determined that a collective bargaining agreement can be voided only if the debtor can establish that: (1) the collective bargaining agreement burdens a debtor’s ability to reorganize by proposing and implementing a viable plan of adjustment; (2) after careful scrutiny, the equities balance in favor of contract rejection; and (3) “reasonable efforts to negotiate a voluntary modification have been made and were not likely to produce a prompt and satisfactory solution.”2 Because the City of Vallejo had already successfully re-negotiated contracts with the unions that represented the police officers and managerial employees, and negotiations with the remaining unions were ongoing, the bankruptcy court deferred a final determination on whether those agreements were void.

Some observers believe that if this groundbreaking decision holds up, other financially strapped municipalities will use this decision as a blueprint to void their union obligations.

Source
United States: Municipalities Can Void Public Employee Union Contracts Through Bankruptcy – Littler

Related posts:

• The coming collapse of the municipal bond market
• Ireland: government blew the boom
• Obama ready to put Chrysler into bankruptcy
• Chrysler: bulls make money, bears make money, pigs get slaughtered
• Opel and Fiat spells bankruptcy for Chrysler and GM

California’s problems are well-known. They have been in the making for sometime. When I predicted a U.S. state would go bust this year, California was very much on my mind. But, frankly, Kansas was nowhere on my radar screen. Now both states have gotten my attention.

First Kansas (hat tip Marshall):

State tax refunds, Medicaid reimbursements and payments to local schools are all on hold because of a political showdown between Kansas legislative leaders and Gov. Kathleen Sebelius.

The Kansas Finance Council was to meet at 1 p.m. today to vote on whether to borrow $225 million from healthy state funds to cover expected payments to schools, state workers and taxpayers. The state did the same thing last December when it ran into a cash-flow problem.

But Republican leaders said they wouldn’t authorize the new loans until Sebelius, a Democrat, signs legislation designed to erase the state’s current year budget deficit. That bill, passed Thursday, cuts statewide school funding by $32 million and makes millions more in cuts to other state agencies.

If you recall, Kathleen Sebelius gave the Democratic rebuttal to the 2008 State of the Union Address. She was tipped as a potential running mate for Obama. And her name had surfaced after Tom Daschle withdrew his name for the post at Health and Human Services. Her ambitions for national office are not looking very good.

Update: Sebelius got the deal done and is decamping to DC as head of HHS. President Obama has faith in her skills. This is a great outcome.

But, then there is California. If they don’t get revenue up or spending down, bankruptcy is certain. They are looking to raise taxes in the teeth of a downturn to prevent a bad outcome — not exactly a good way to jump-start the economy. Note the highlighted section below.

California’s legislature adjourned from a marathon budget debate after falling one vote short of a $40 billion package of tax increases, spending cuts and borrowing aimed at reducing a record deficit.

Lawmakers went home at 9 p.m. yesterday after spending 28 hours in session while Republican Governor Arnold Schwarzenegger and Senate leaders worked to secure an additional Republican vote for the package of 27 bills. Schwarzenegger made rare appearances at closed-door party caucuses and urged a quick solution to the impasse.

“We are just searching for that one more vote that we need in order to get that budget done,” Schwarzenegger told reporters after the meeting.

Failure of the package would prolong a four-month stalemate over how to counter a record $42 billion deficit that drained California of cash, left it with the lowest credit rating among U.S. states, forced officials to delay paying bills totaling $3.7 billion and halted $3.8 billion of bond-financed construction on schools, roads and other public works.

The draft bills include plans to raise the state sales-tax rate to 8.25 percent from 7.25 percent; boost vehicle license fees to 1.15 percent from 0.65 percent of the value of an automobile; add 12 cents to the per-gallon gasoline tax; reduce the dependant-care tax credit to $100 from $300 and impose a surcharge on income taxes of up to 5 percent.

If you are investing in municipal bonds, you might want to do some serious due diligence on the creditworthiness of the issuers. The state and local bankruptcies are coming.

Sources
Kansas budget crisis: State tax refunds on hold – Kansas City Star
California Lawmakers Fail to Pass Budget Package by One Vote – Bloomberg.com

Related posts:

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This video from the Wall Street Journal demonstrates what happens to services when governments go bankrupt.

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I just picked up two reports on California’s desperate situation. California, whose legislature and Governor have been hold up in around the clock negotiations, is now issuing IOU’s instead of cash. They have also been downgraded by Moody’s credit rating agency. The first story came from the well-known political site Monsters & Critics.  And it demonstrates that California is on the verge of bankruptcy:

The world’s eighth largest economy started issuing IOU (I-owe-you) vouchers instead of checks Monday as an ongoing budget battle and a 42-billion-dollar deficit left the state without enough cash to meet its commitments.

Governor Arnold Schwarzenegger was meeting with legislators in a bid to resolve the standoff that has prevented the state from passing a budget. State comptroller John Ching has warned that the state could completely run out of cash by the end of this month if a solution is not found.

On Friday tens of thousands of state workers will begin taking two days a month of forced leave without pay.

A representative for the state’s Department of Finance said checks were not being issued for Cal Grant college scholarships, county social services and the California Highway Patrol. No state tax rebates will be issued until a plan is adopted to deal with the state’s huge deficit, the Department of Finance said.

Schwarzenegger has declared a fiscal emergency as California faces a 42-billion-dollar deficit through June 2010. The massive US state has been hard hit by the recession which has seen housing prices plunge and revenues dry up.

Issuing state bonds is also tough given the paralysis in the credit markets and a credit downgrade because of the lack of a budget. Attempts to bridge the gap through a combination of spending cuts and tax hikes have been stymied by Republican legislators who reject any new taxes.

But, that’s not all, MarketWatch has picked up a press release showing that California’s short-term debt is being downgraded from F-1 to F-2 (Hat tip Paul Kedrosky). And even this downgrade is predicated on California resolving its crisis (see my highlight in bold).

Fitch Ratings has downgraded the short-term rating on the State of California’s $5 billion 2008-09 revenue anticipation notes (RANs, or the notes) to ‘F2′ from ‘F1′. The downgrade is based on the severe erosion of state revenues and cash resources since note issuance, prompting payment deferrals while the state develops solutions to its deficits.
Since the notes were sold in October the state’s baseline forecast of fiscal 2008-09 cash receipts has dropped by 13%, to $89 billion. Although negotiations are underway on a $42 billion package of cash and budgetary solutions for this fiscal year and next, even with near-term action the state is likely to confront another downward forecast revision in the spring, as economic and revenue performance has worsened since the current forecast was completed in November. In the absence of corrective measures to date, the eroding cash situation has caused the controller to begin payment deferrals in order to ensure sufficient resources for constitutional and statutory priorities.

The downgrade to ‘F2′ assumes that the state takes action to alleviate near-term cash pressures. Fitch’s long-term rating on the state’s general obligation (GO) bonds, currently at ‘A+’, Rating Watch Negative, will be reviewed in the coming weeks based on the state’s ability to agree upon budgetary solutions, and the effectiveness and completeness of those solutions.

This news is sure to roil the municipal bond market because California will be seen as a harbinger of things to come on the state and municipal level. Not being able to print your own money will mean bankruptcy for many states and municipalities.

Sources
Near bankruptcy, California starts issuing IOU’s instead of checks – Monsters & Critics
Fitch Downgrades California’s $5B RANs to ‘F2′ – MarketWatch

Related posts:

• California is to begin handing out IOUs tomorrow
• Banks to stop accepting California’s IOUs
• Kansas and California and the race to U.S. state insolvency
• Text of Schwarzenegger letter to Paulson
• Is the State of California bankrupt?

There has been a general outcry for economic stimulus on the part of the North American, U.K. and Eurozone federal governments to counteract the fall in private sector consumption.  In the U.S. and the U.K. in particular, this message is being heard and largesse will be delivered in spades.

But, in the United States, there is a bit of a problem: state and local governments.  They will not, and often cannot, spend.  In fact some will be cutting.  Will local government budget cuts undercut federal fiscal stimulus?

To answer that question, we need to know why local governments in the U.S. are not spending more money.  The answer is two-fold.  First, state and local governments don’t have access to a printing press.  It’s not like they can tell their teachers, “wait a minute, let me just run out back and print off a few dollars to pay you.”   The federal government intends to do exactly that – print money.  This is what is commonly known as inflation, now given the hifalutin designation of quantitative easing.  So inflating one’s way out of crisis is not an option o the table for municipalities.

On the other hand, they are even more hamstrung by their own self-imposed rules.  In recent years, state governments have tried to exercise fiscal resonsibility by balancing the budget.  Politicians are so eager to put their hand in the till that legislatures were forced to enact balanced budget amendments that forbade deficit spending to keep spending down.

Here’s how the National Conference of State Legislature puts it:

The Nature of State Balanced Budget Requirements

Some states have strict, explicit balanced budget requirements that force policy makers to ensure that expenditures in a fiscal year are within the cash available for that fiscal year. In other states, the requirement is derived from a constitutional limitation of state indebtedness or some other budgetary provision such as Virginia’s constitutional requirement that the governor keep spending within revenues, and may lack a binding enforcement mechanism. In some states, of which Michigan is an example, constitutional provisions that are designed to prevent budget deficits allow unavoidable deficits to be carried to the next fiscal year for resolution. Vermont , uniquely, has no constitutional or statutory requirement for a balanced budget.

Not all states have constitutional language that clearly requires a balanced budget and many even lack explicit statutory requirements. The General Accounting Office has commented that “some balanced budget requirements are based on interpretations of state constitutions and statutes rather than on an explicit statement that the state must have a balanced budget.” GAO’s observation is supported by appendix B, which prints the language that legislative staff in 49 states have identified as the constitutional and statutory balanced budget requirement. The link between the constitutional or statutory language and a balanced-budget requirement can be obscure.

Whatever the source of the requirement-constitutional, statutory, or traditional interpretation-there are three general kinds of balanced-budget requirements, with differences of detail within each kind:

• The governor’s proposed budget must be balanced;
• The enacted budget must be balanced;
• The budget must be balanced at the end of a fiscal year or biennium (no deficit can be carried forward).

That is a problem now because tax revenue is imploding.  Sales tax revenue is down.  Income tax revenue is down.  Property tax revenue is down.  And when falling revenue and balanced budget amendments collide, the only remedy is budget cuts.  So, state and local governments in the United States are about to cut spending just as the worst recession since the 1930s hits.

What to do?  Ask for a bailout from the Federal Government, of course.  Here’s what Politico says about this:

A group of Democratic governors warned Friday that without as much as $1 trillion in federal assistance, many states will not be able to pay their bills in the next year.

“There are states that are talking as California has of not being able to meet their financial obligations in the coming months,” New York Gov. David Paterson (D) said on a conference call with reporters. California announced in December that all state employees would be forced to take two days of unpaid leave.

Paterson was joined by New Jersey Gov. Jon Corzine (D), Massachusetts Gov. Deval Patrick (D), Ohio Gov. Ted Strickland (D) and Wisconsin Gov. Jim Doyle (D) in warning that states across the country will be forced to make drastic budget cuts in the face of unprecedented deficits.

“We are not crying wolf, this is one of the worst situations our states have faced,” Strickland said. “This is a real crisis. These are real problems. And if we don’t get some significant assistance many of those in our states will suffer greatly.”

Strickland added that the situation facing the state of Ohio is so dire that in order to balance his state’s budget he would have to fund every state program at 75 percent of its current level. “If I were simply to flat fund the operations of this government I’d end up with $7.3 billion in deficit,” he said. “We’re just trying to keep afloat.”

In order to make up for the shortfalls, Corzine said the incoming Obama administration and Congress will need to free up $1 trillion in federal spending for state assistance. “We’re all going to be Herbert Hoovers if we’re not careful here,” he said.

The $1 trillion the governors are seeking would be spent to prevent cuts in social services and education, as well as “shovel ready” infrastructure projects that could begin with 18 months. The group has presented their plan to the transition team and congressional leaders. The New Jersey governor said both have been receptive to the idea.

“There is a need for the federal government to step in to bolster the social safety net,” Patrick said. “We’re really talking about a bridge from where we are and where we think the economy will be in two years.”

With the automakers and the banks already receiving handouts en masse and with the Obama Administration committed to massive fiscal stimulus, one can see that the United States is in for some trillions of dollars of deficits.

The question is whether states and municipalities should be welcome on the bailout gravy train as well. California is on the verge of bankruptcy and I have predicted at least one state will default and go bankrupt. Do we want that? Do we want teachers, police officers going without pay, firefighters being let go or trash collection being curtailed?

This is a predicament that was easily predicted as a result of the housing bust. However, with its consequences looming, there are no easy answers.

At a minimum, cutbacks at the state and local level would be very much working at cross purposes with federal stimulus. Ostensibly, state governors could play chicken with the Federal Government if they don’t get some bailout money. How the Obama Administration chooses to tackle this problem will be a contentious issue going forward.

Stay tuned.

Sources

State Balanced Budget Requirements: Provisions and Practice – National Conference of State Legislatures

States seeking $1 trillion to ‘keep afloat’ – Politico

Related posts:

• State and local governments: budget cuts likely
• State tax revenue down 26% in 2009
• State and local government weighed down by housing
• Is the State of California bankrupt?
• GDP: imports, inflation and local government are the story

Marshall here, as Ed is busy sunning himself in the Bahamas, whilst I am stuck in snowy Denver!

It sounds as if JMP Securities has also read the California report that I discussed recently. This is the first outside source that I have seen respond to that report.

It is so ironic. I think that the blue collar areas that were the most in danger financially have been corrected, perhaps even over corrected and yet the markets are focused on other things even though, housing was always what America’s monetary and fiscal authorities were looking to cure for the financial system to stabilize.

Am I missing something or could this be what Gladwell calls his “tipping point”? Here is the key section of the report and a Bloomberg article to follow:

Separately, JMP Securities said unsold inventory in California is falling. “We surveyed and calculated the months supply for many cities around the country recently and found that all of California and a number of other cities are actually well below the national average and continuing to improve,” JMP analyst James Wilson said today in a note to investors.

California
Declining prices have lured more buyers in California cities including Stockton, San Diego, San Jose, Los Angeles and the Inland Empire area southeast of Los Angeles, Wilson said. “As California led the nation into the housing bull market in 2002 and into the bear market in 2005, so too should it lead us into stabilization and recovery,” Wilson said.

Bloomberg story here:

Homebuilders Up on Bullish Mortgage, Inventory News
2008-12-03 21:49:10.920 GMT

By Sharon L. Lynch and Bob Ivry

Dec. 3 (Bloomberg) — U.S. homebuilders including Hovnanian Enterprises Inc., Meritage Homes Corp. and Standard Pacific Corp., rose in New York after mortgage applications surged and a report said housing supply is tightening in California.

The Standard & Poor’s Supercomposite Homebuilding Index gained 9.1 percent. Hovnanian jumped 17 percent and Meritage 16 percent. Beazer Homes USA Inc., the builder that reported its eighth consecutive quarterly loss yesterday, climbed 28 percent as JMP Securities LLC raised its rating to “market perform” from “underperform.”

The Mortgage Bankers Association’s index of applications to purchase a home or refinance a loan jumped a record 112 percent last week to 857.7, the highest level since March, from 404.4 the prior week, according to today’s MBA report. The group’s refinance index skyrocketed 203 percent, while the purchase index rose 38 percent.

New home sales have steadily fallen since July 2005 to an annual rate of 433,000 from a peak of 1.4 million, according to the U.S. Census Bureau. Builders nationwide have suffered both from the decline in sales and from falling prices. The median new home price dropped to $218,000 in October from a high of $262,600 in March of last year.

Red Bank, New Jersey-based Hovnanian rose 32 cents to $2.16 at 4:15 p.m. in New York Stock Exchange composite trading. Bloomfield Hills, Michigan-based Pulte Homes Inc. gained $1.32, or 13 percent, to $11.14. Scottsdale, Arizona-based Meritage climbed $1.61 to $11.49. Irvine, California-based Standard Pacific rose 9 cents, or 5.5 percent, to $1.72. Atlanta-based Beazer rose 39 cents to $1.77.

Beazer yesterday announced its fiscal fourth-quarter net loss widened on higher tax charges to $473.9 million, or $12.29 a share, from $155.2 million, or $4.03, a year earlier. Chief Executive Officer Ian McCarthy predicted a net loss for 2009.

“We distinctly heard a death knell strike that the end was near for Beazer,” homebuilding analyst Vicki Bryan of Gimme Credit LLC wrote in a note to investors today.

For Related News:
Top Bloomberg News real estate stories: TOPR <GO>
For stories on U.S. homebuilding: TNI U.S. HOM <GO>
For stories on the U.S. economy: TNI U.S. ECO <GO>

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Yesterday, California Governor Arnold Schwarzenegger wrote U.S. Treasury Secretary Hank Paulson to warn him that California was suffering a liquidity problem and needed federal assistance in order to avoid insolvency.

Below is the text of that letter.

First of all, let me commend you for your leadership to enact emergency economic stabilization legislation. This credit crisis has the power to grind the U.S. economy to a halt if swift and decisive action is not taken immediately. The federal rescue package is not a bailout of Wall Street tycoons – it is a lifeboat for millions of Americans whose life savings, businesses, retirement plans and jobs are at stake. I have communicated this message to the entire California Congressional delegation and will continue to press for passage of an emergency rescue plan.

Like many other states, California is feeling the enormous effects of this crisis on our economy. California’s economy is dynamic and resilient, but also uniquely sensitive to national and international economic conditions and fluctuations in the financial markets. The credit crisis has frozen investment and commerce, forcing businesses and families to stop purchasing goods and services. This has resulted in tens of thousands of lost jobs and billions of dollars in lost tax revenue to the state.

Most immediately, California and a number of other state and local governments are experiencing the lack of liquidity in the credit markets firsthand. Many states and local governments have been unable to secure financing for bond offerings and for routine cash flow used to make critical payments to schools, local governments and law enforcement. While some states may be able to absorb a delay or obtain high-interest financing through private banks, California is so large that our short-term cash flow needs exceed the entire budget of some states. We expect to issue $7 billion in Revenue Anticipation Notes for short term cash flow purposes in a matter of days.

Absent a clear resolution to this financial crisis that restores confidence and liquidity to the credit markets, California and other states may be unable to obtain the necessary level of financing to maintain government operations and may be forced to turn to the Federal Treasury for short-term financing.

Source
Schwarzenegger to U.S.: State may need $7-billion loan – LA Times

Related posts:

• Is the State of California bankrupt?
• Kansas and California and the race to U.S. state insolvency
• California starts issuing IOUs as bankruptcy nears
• California is to begin handing out IOUs tomorrow
• State tax revenue down 26% in 2009

It sure seems like California is insolvent. Just today we heard that Arnold Schwarzenegger contacted Hank Paulson to let him know that the State is having liquidity problems (see pdf) and needs help. California ranks as the world’s 9th largest economy with a population of over 30 million people, so this is quite worrying.

The state had an economy that was going gangbusters during the boom. That certainly aided U.S. GDP growth a few years back. Now, house prices are way down in California — San Diego down 31%, San Francisco down 28%, Los Angeles down 30%. And so goes housing, so goes California. The economy is a shambles, unemployment is skyrocketing and tax revenue is plunging. One city in California has already gone bankrupt. Could the whole state be next?

I certainly think so.

California Gov. Arnold Schwarzenegger warned U.S. Treasury Secretary Henry Paulson in a letter emailed Thursday that the state might need an emergency federal loan of up to $7 billion within weeks, the Los Angeles Times reported Friday, citing a copy of the letter that the newspaper obtained.

California, among several states frozen out of the bond market by the credit crunch, is nearly out of cash to fund day-to-day government operations and can’t access routine short-term loans it relies on to remain solvent. If the state’s inability to access cash continues, Schwarzenegger aides say, payments to schools and other government entities in California could be suspended and state employees laid off.
-Real-Time Economics

If a financial services company were in this kind of shape, it would be on its way to Chapter 11. Many of us have seen this coming for some time. With property tax revenue down and income tax revenue falling as the real economy begins to suffer, this was inevitable. Other states with huge housing busts like Florida, Nevada and Arizona may be the next areas we hear about in the coming weeks.

Update 2009-01-15:  Governor Arnold Schwarzenegger called California’s huge budget deficit a “rock upon our chest”and warned this is the top priority for policy makers.

The deficit and cash shortage developed rapidly after Schwarzenegger signed the current year’s budget in September. Since then, he’s called lawmakers into three special sessions and twice declared fiscal emergencies. On Jan. 7, he vetoed the only plan that has reached his desk from those special sessions.

Schwarzenegger’s fellow Republicans have blocked his proposal to raise taxes, which can’t be done without a two- thirds vote. Democrats, who control both chambers of the Legislature, have balked at deep spending cuts and proposals to ease environmental regulations and labor rules.

Last month, Schwarzenegger proposed a mix of spending cuts, tax increases and borrowing, as well as an economic stimulus package, efforts to curb home foreclosures and streamlined government operations.

State finance officials are preparing to withhold payments to thousands of vendors and say they will likely have to issue IOUs to people who are expecting tax refunds.

Saving Money

To conserve cash, Schwarzenegger has ordered state offices shut for two days a month and all workers to take two days of unpaid leave each month. The impasse forced a state panel on Dec. 18 to halt funding for $3.8 billion of construction on schools, roads and other public works, a decision officials said might cost tens of thousands of jobs.

“So now the bulldozers are silent. The nail guns are still. The cement trucks are parked,” Schwarzenegger said. “This disruption has stopped work on levees, schools, roads, everything. It has thrown thousands and thousands of people out of work at a time when our unemployment rate is rising.”

California, the biggest borrower in the municipal market, shares with Louisiana the lowest credit ratings among the states because of perennial fiscal shortfalls and legislative gridlock. It is rated A+ by Standard & Poor’s and Fitch Ratings, the fifth-highest grade, and an equivalent A1 at Moody’s Investors Service.

Part of the problem is that some want to raise taxes here to fix the problem. Raising taxes in the teeth of a major recession is a recipe for disaster. However, California will go bankrupt if some form of revenue raising or spending cuts are not taken. The Federal Government will have to step in here with some monies or things will unravel very quickly for California and that will have very negative consequences for house prices.

Sources
Hasta la vista, baby – FT Alphaville
Schwarzenegger Warns California May Need Federal Loan – Real Time Economics
Schwarzenegger letter to Paulson (PDF) – LA Times
Schwarzenegger Says Deficit has ‘Incapacitated’ State – Bloomberg.com
Gov. Arnold Schwarzenegger’s State of the State address – LA Times

Related posts:

• Text of Schwarzenegger letter to Paulson
• Kansas and California and the race to U.S. state insolvency
• California is to begin handing out IOUs tomorrow
• California will go bankrupt
• State tax revenue down 26% in 2009

The Mess That Greenspan Made has a blog entry with good visuals giving you a sense of how price appreciation, median prices and housing sales have changed over the past 4-5 years. I recommend it highly.

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• Case-Shiller: U.S. home prices up for third month in July
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