The Market Implications of the California Special Election

I’ve been somewhat of a broken record stuck on discussing the May 19th special election here in California; but, after all, it is fast approaching.  One topic I haven’t touched upon yet, though, is the implications of the election for the financial markets.

Obviously, California doesn’t really have its own financial markets.  There isn’t even a Pacific Stack Exchange any more.  So, if the special election is going to have an impact, it’ll be on Wall Street and the national markets.  That doesn’t however, mean it will be ignored.

Right now, I’ve seen little if any discussion in the national financial press about the implications of the California election.  That doesn’t, however, mean it won’t have any.  If anything, it means the effects of the election will be felt even more strongly because they won’t have been anticipated and taken into account beforehand.

What will those effects be?  If, by some miraculous turn of events, most of the ballot measures pass (I’m ignoring Prop. 1F, which will have zero effect on financial markets [or almost anything else]), the effect would be positive.  It would send a message that California’s financial mess, while not totally solved, is at least being addressed and taken seriously.  What, however, about the more likely outcome?  What if most or all of the measures go down in flames?

I think the effects will be dramatic and negative.  The Governor is already raising the threat of major budget cuts, as well as poaching from cities’ and counties’ property tax proceeds (see, http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2009/05/07/BAPC17FU69.DTL&type=politics).  While the legislative leadership has been noncommital on specifics, it doesn’t seem the Democrats will have the stomach for another long and draining budget stand-off; especially when their last compromise solution was rejected by the voters.  The Republicans, on the other hand, will feel vindicated and strengthened by the elections results.  They’ve already indicated that they intend to push for even more and deeper cuts when/if the budget comes back to them post-election.

I can see one of two results; and neither would be good news for financial markets.  The first would be that a new, even more austere state budget gets approved — one not dependent on voter approvals.  That would mean the balancing would happen through cuts alone.  Look for major lay-offs of state employees — especially union employees, wage cuts for all employees not protected by a union contract, further drastic cuts in allocations for social services and education, and a grab for local property and sales tax revenue.  The misery would then trickle down to the local level, with major lay-offs of teachers and municipal employees and more than a few bankruptcies for vulnerable cities and counties.  (Vallejo, already in bankruptcy, might actually have to “disincorporate”, whihc, in turn, might drive Solano County into bankruptcy.)  The California municipal bond market would, needless to say, take an enormous hit.

In the alternative, the Democrats might stick to their guns, resulting in another budget impasse.  However, this time I don’t see a compromise forthcoming.  Those few Republicans leaders who might have been open to compromise have been removed form the party leadership, and those Republicans who supported the last compromised are already being threatened with retribution at the next election. 

If no compromise is reached, state bankruptcy could well be the end result.  That would, of course, have major repercussions in the financial markets.  Just for starters, the state’s huge bonded indebtedness would be put at risk.  At the very least state bonds would start to go into default on their interest payments.  The price of California bonds would plummet, and it would be a practical impossibility for California to issue any new bonds. 

My assumption would be that a federal judge would be assigned to preside over California’s financial restructuring.  As with Vallejo, all labor contracts (and other contracts as well) would be subject to being restructured or even voided.  Since a court couldn’t order any new taxes, the judge would have to order the same kind of drastic budget cuts the legislature would have faced; but a judge could ignore the protection of labor contracts.  Expect major cuts in the wages of state employees, as well a a huge wave of lay-offs in all state agencies.  Any expenditures not mandated by federal law would be subject to being reduced or eliminated.

One effect of all this would be that California’s unemployment rate would explode, hitting levels not seen since the Great Depression.  In fact, sad to say, I think there’s a (in)decent likelihood that the special election results and their repercussions might be enough to convert the “Great Recession” into a true depression, unless Obama can scrounge together enough federal funding to step in and save the day.  Even Obama, Superman cape and all, isn’t likely to be able to do that.

So go ahead, vote against all the ballot measures.  What the heck.  When have Californians ever thought much about the implications of their votes?  After all, we elected Ronnie Reagan governor — twice!

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2 Responses to The Market Implications of the California Special Election

  1. Stu, is the State of California even capable of filing for bankruptcy protection? My understanding — which could be wrong, as I’m not an attorney — is that Chapter 9 only protects municipalities that serve states, as in cities, counties and school districts, and that states themselves must repay any outstanding financial obligations.

  2. stuflash says:

    It’s apparently true that there’s no statutory provision specifically dealing with a state’s bankruptcy. If push came to shove, I could imagine Congress being asked to pass a bill to provide for bankruptcy protection. Without it, I can see a host of lawsuits being filed against California by bondholders and other debtors. The lawsuits would probably get consolidated under one judge, resulting in something that would be close to the functional equivalent of a bankruptcy proceeding. The big question is how the judgew would deal with there not being enough assets to go around. Would the judge be able to order the state to sell off assets? Lay off workers? Close down programs? I don’t know that any of this has been before the courts; certainly not since the 1930s.

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