california's cash flow crisis, 2009-10 budget analysis series

8/14/2019 California's Cash Flow Crisis, 2009-10 budget analysis series

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January 14, 2009

mac TaylorLegislative Analyst

2009-10 Budget Analysis Series

CaliforniasCash Flow Crisis


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CSH-2 L e g i S L a t i v e a n a L y S t S O f f i C e

2009-10 Budge t anaLySiS Se r i eS

Acknowledgments

This report was prepared by Jason Dickerson,and reviewed by Michael Cohen. The Legislative

Analysts O fce (LAO) is a nonpartisan o fce which provides fscal and policy in ormationand advice to the Legislature.

LAO Publications

To request publications call (916) 445-4656.

This report and others, as well as an E-mailsubscription service, are available on theLAOs Internet site at www.lao.ca.gov. TheLAO is located at 925 L Street, Suite 1000,Sacramento, CA 95814.


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CSH-3L e g i S L a t i v e a n a L y S t S O f f i C e


Summary

Double Whammy of Weak Revenues and Limited Credit Market AccessHas Hurt the States Cash Position

In a typical year, a ter the Legislature and the Governor agree to a balanced annual budget, the state must borrow rom available special unds balances and municipal bond investorsto smooth out cash ow defcits, particularly during the early months o the fscal year. In200809, weakening revenues and limited access to the credit markets have reduced the statesresources to address monthly cash ow defcits. As a result, the states cash cushionitsavailable liquidity to allow the General Fund to make all budgeted payments on timeis unacceptably low.

Absent Prompt Action by the Legislature, Delays in SomeState Payments Are Likely

The State Controller is the o fcial responsible or managing the states cash ows. Absentprompt action by the Legislature to begin addressing the states massive budget and cash owcrises, the states cash cushion is likely to be depleted in the coming weeks, and the Controllerwill be orced to delay certain budgeted payments, including some vendor payments and taxre unds.

Key Considerations for the Legislature and the Public

When Will the State Run Out o Cash? Strictly speaking, the state can never run out o cash because tax and other payments ow into state co ers every day. Instead, what may happen in the next ew weeks is that available cash may no longer be su fcient to make all statepayments that have been appropriated by the Legislature on a timely basis. The state wouldmost likely reach this pointabsent any corrective action by the Legislature or the Controllerin late February or early March 2009.

Which Payments Will Be Delayed in the Next Few Weeks? In the weeks be ore the statescash on hand reaches zero, the State Controller must start taking corrective action. Specifcally,he must delay payments classifed as lowerpriority under the law. The Controller must do thisto help ensure that the state can keep making payments deemed as higherpriority under thelaw. The Controller has broad discretion to determine which payments are priority payments.The states priority payments appear to include many related to schools, debt service, state employee payroll and benefts, and MediCal. Other categories o payments, such as tax re unds,student aid grants, and payments to local governments and vendors, may be delayed in thecoming weeks.


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When Will State Funding or In rastructure Projects Resume? A board consisting o theState Treasurer, the Controller, and the Director o Finance recently decided to stop a key

source o initial unding or many in rastructure projects unded by state bonds. The statesweak cash position and its current inability to access the bond markets or fnancing caused theboard to take this step. Legislative action to address much or even most o the states colossal$40 billion budget gap will be necessary or the state to improve its cash position and regainaccess to the bond markets. This would allow state o fcials to resume unding or the importantpublic works projects.

Is Bankruptcy an Option or the State? When individuals, companies, and local governments are unable to pay their bills, fling or protection under the U.S. Bankruptcy Code is anoption that allows them to renegotiate or restructure their fnancial obligations. States, however,are believed to be ineligible or bankruptcy protection.

Balancing the Budget Is the Best Way to Address the Cash Crisis

Balancing the budgetby increasing state revenues and decreasing expendituresis themost important way that the Legislature can shorten the duration and severity o the states cash

ow crisis. Absent prompt action to begin addressing the states colossal budget gap and othermeasures discussed in this report specifcally to help the states cash ows, state operationsand payments will have to be delayed more and more over time. In the event that the Legislature and the Governor are unable to reach agreement to balance the budget by the summer o 2009, major categories o services and payments unded by the state may grind to a halt. Thiscould seriously erode the confdence o the publicand investorsin our state government.To avoid this, it is urgent that the Legislature and the Governor act immediately to address thebudgetary and cash crises that have put the state on the edge o fscal disaster.


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DiStinguiShing Between the BuDget

Situation anD the CaSh Situation

The states budget situation , which is theprimary fscal ocus o the Legislature each year,can be distinguished rom the states cash situation, which only recently has become an equallyimportant concern. It is important to understandhow the two situations are di erent and howthey relate to one another.

The Annual Budget and the Annual State Cash Flow Plan

Annual Requirement to Enact a Balanced State Budget. Unlike the ederal government,the state may not enact an annual budget that isout o balance. There are practical reasons orthisprincipally, that the states ability to borrowis more limited than that o the U.S. governmentand the state cannot print currency. Moreover,Proposition 58 amended the State Constitutionin 2004 to require the Legislature to enact a

balanced budget each year in which estimatedresources or the year meet or exceed estimatedexpenditures. Proposition 58 also authorizes theGovernor to declare a fscal emergency in themiddle o a fscal year and propose correctivemeasures to the Legislature i it is determinedthat the state aces substantial revenue short allsor spending increases.

Annual State Cash Flow Plan. State law requires the Governor to submit to the Legislature astatement o estimated monthly cash ows eachyear. Typically, a ter the Legislature passes thebudget act, an updated General Fund cash owestimate is prepared principally by the Department o Finance (DOF) in consultation with theController and the Treasurer. This cash ow plandetails how the state will meet its budgeted Gen

eral Fund expenditures (also known as disbursements) in each month o the year. As describedin more detail below, the cash ow plan mustuse various techniques, such as borrowing on atemporary basis rom special unds or bond market investors, to deal with the act that disbursements typically are higher than revenues (alsoknown as receipts) during several months o theyear. This process o managing cash ows duringweaker revenue periodsthrough borrowing

rom available sources during leaner periodso the yearis typical in both the public andprivate sectors. The intent o the process is toensure that budgeted obligations can be paid ontime in each month o the fscal year.

Differences and Similarities BetweenThe Budget and Cash Flow Situations

Di erences Between the Budget and Cash

Flow Situations. When the Legislature balancesthe General Fund budget each year, it must enactmeasures to ensure that General Fund revenuesand expenditures match over the course o theentire year . The cash ow plan, by contrast,

ocuses on the state meeting its payment obligations in each individual month o the fscal year.

How Do the Budget and Cash Flow Situations Relate to Each Other? The states annualbudget and cash ow plans are distinct documents, but they relate closely to each other. Inparticular, as the states budget situation improves (with stronger tax collections, smallerexpenditures, or larger reserves), its cash owsituation typically improves as well, resulting inthe need or less borrowing rom special unds orinvestors to smooth out monthly cash ows. On


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the other hand, when the states budget situationdeteriorates (with weaker tax collections, largerexpenditures, or smaller reserves), its cash ow

situation generally deteriorates, requiring moreborrowing rom special unds or investors tosmooth monthly cash ows. In the long run, thestates cash ow and budget situations both aredriven by the same undamental actthe needto balance revenues and expenditures. When the

budget alls out o balance, there ore, it is inevitable that the states cash ow situation will benegatively a ected. When the budget alls deeply

out o balance in a relatively short period o time,as has occurred during the current fscal year,state cash ows can prove insu fcient to supportthe amounts o state payments previously appropriated by the Legislature.

how State CaSh FlowS work

in a typiCal FiSCal year

In this section, we discuss how the statesGeneral Fund cash ows are managed in a typical year. We use the 200708 cash ows as anexample because they demonstrate how statecash ows work in a typical yearprior to theextreme cash ow distress that has emerged inthe current 200809 fscal year.

General FundReceipts

State ReceivesMuch o Its Receipts inthe Second Hal o theFiscal Year. The statesfscal year runs rom July1 to June 30. Figure 1shows the quarterbyquarter trend o General Fund receipts anddisbursements duringthe 200708 fscal year,which began on July1, 2007, and ended on

June 30, 2008. The tim

ing o receipts is driven heavily by statutory andregulatory tax payment schedules. For example,the April 15 personal income tax fling deadlineresults in a surge o collections or this majorrevenue source during that monthresultingin April being the General Funds peak month

General Fund Receipts and Disbursements by Quarter

2007-08 (In Billions)

Figure 1

5

10

15

20

25

30

35

$40

First Quarter(July-Sept.)

Second Quarter(Oct.-Dec.)

Third Quarter(Jan.-March)

Fourth Quarter(April-June)

Receipts

Disbursements


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Short-Term Borrowing Is the StatesMain Tool to Address Cash Flow Deficits

Public and Private Entities Use Borrowing

to Address Periodic Cash Defcits. Like manyprivate businesses (and even individuals), thestate and other public entities use borrowing toaddress cash ow defcits that occur during someparts o the year. Large banks and corporations,

or instance, o ten issue commercial paper (atype o shortterm fnancial instrument) to address periodic cash ow defcits. Smaller companies and individuals may use credit cards orlines o credit rom fnancial institutions to meetcash ow needs rom time to time. The stateand other governmental entities also resort toshortterm borrowing to meet cash ow needstypically rom two main sources:

The governments own borrowableunds (known as internal borrowing).

Municipal bond market investors (knownas external borrowing).

Internally Borrowable Resources Are Mainly the States Special Funds. In addition to thestates General Fund, there are about 600 special

unds and other unds that are classifed by theState Controllers O fce (SCO) as borrowable

unds under current law. State law allows SCO toborrow rom these unds on a temporary basisrepayable, in many cases, with interest or cash

ow purposes. The combined balances o these

approximately 600 undsincluding the statesBudget Stabilization Account (BSA) and SpecialFund or Economic Uncertainties (reserve undsthat are also available or cash ow borrowing)vary rom month to month. In 200708, thestates internally borrowable unds typically hadcombined balances o between $13 billion and

$16 billion. The balances o these unds generallyare invested in the states Pooled Money Investment Account (PMIA). (See the nearby text box

or background in ormation about PMIA, thegoverning board o which voted recently to shutdown unding or certain in rastructure projectsdue to the states cash ow crisis.) For each und,i balances are borrowed or cash ow purposes,the General Fund pays back these temporaryloans when it has unds available to do so orwhen the und needs money to pay law ul appropriations. There ore, the cash ow borrowingis designed never to a ect a unds ability to pay

or the programs it supports.External Borrowing From Investors Is Also a

Key Cash Management Tool. Available balancesin the states internally borrowable unds vary

rom month to month. These available balancesare not always su fcient to allow the GeneralFund to address its monthly cash ow defcits.Accordingly, the state regularly pursues externalborrowing rom municipal bond investors. In a

typical year, the state uses one or both o theshortterm external cash borrowing instrumentsdescribed in the text box on page CSH10revenue anticipation notes (RANs) or revenue anticipation warrants (RAWs). The most commonlyused external borrowing instruments are RANs.The state has issued RANs in 19 o the last 20fscal yearsthat is, during good and bad budgetary situations. The RAWs, which span fscalyears and result in higher costs or the state, are

less requently usedtypically during times o severe budgetary problems. The state has issuedRAWs in only 6 o the last 20 fscal years. Likemost internal borrowing, RANs and RAWs mustbe repaid with interest by the General Fund in arelatively short period o time.


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The STaTe S Pooled Money InveSTMenT a ccounT (PMIa)What Is the PMIA? The PMIA is the states shortterm savings account. Moneys in

the General Fund and state special unds are held in the PMIA and invested according toconservative guidelines. Some cities, counties, and other local entities also invest in the Local Agency Investment Fund (LAIF), which is a separate part o the PMIA. As o November2008, the PMIA had a balance o $63 billion, o which $21 billion was in the LAIF.

Who Administers the PMIA? The Investment Division o the State Treasurers O fce

manages the PMIA. The PMIA is governed by the Pooled Money Investment Board (PMIB),which is chaired by the Treasurer and also includes the Controller and the Director o Finance. In addition to the PMIB, the Local Investment Advisory Boarda fvememberboard also chaired by the Treasurerprovides oversight or the LAIF.

Why Did the PMIB Cut O Funding or In rastructure Projects? The states weakening cash cushion has a ected the balances o the states portion o the PMIA. Under statelaw, the PMIA provides shortterm loans (known as AB 55 loans) to jump start projects

unded by the uture sale o state general obligation and leaserevenue bonds. The AB 55loans are repaid rom state bond or commercial paper issues. On December 17, 2008, thePMIB voted to begin the process o shutting down the AB 55 loan program, which may puta halt on hundreds o in rastructure projects. The deterioration o the states cash cushionin the PMIA and the states inability to access the bond or note marketsdue in part to itsbudget and cash criseswere the reasons cited or the action. By addressing these budgetand cash crises, the Legislature would lay the groundwork or the PMIB to restart the AB 55loan program.

How Borrowing Allowed the State to Pay Bills on Time During 200708. As discussedabove, the timing o General Fund receipts and

disbursements means that the state experiencesperiodic monthly cash ow defcits, particularlyduring the frst hal o the fscal year. Figure 3(see next page) shows the General Funds cash

ow defcit as it accumulated through 200708and the sources o internal and external cash

ow borrowing that were used to address thatdefcit. The accumulated cash ow defcit grewsteadily during the frst ew months o the fscalyear as General Fund disbursements outpaced

receipts. By the end o October 2007, the accumulated cash ow defcit had consumedmost o the available internally borrowable und

balances. As a result, $7 billion o RANs wereissued to investors in November. The proceedso the RANs allowed the General Fund to repaya portion o the borrowed special unds. The$7 billion o RANs were repaid with interest in

June 2008.State Needs to Close Fiscal Year With

Signifcant Cash Cushion. At the end o the200708 fscal yearas the result o the normal

ourthquarter surge o receiptsthe state had


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Revenue a nTIcIPaTIon n oTeS (Ran S) and

Revenue a nTIcIPaTIon W aRRanTS (RaW S)RANs. The states most commonly used device or external cash ow borrowing is the

RANa lowcost, shortterm fnancing tool. Typically issued early in the fscal year, RANs mustbe repaid prior to the end o the fscal year o issuance (usually in April, May, or June). TheRANs are secured by money in the General Fund that is available a ter providing unds or thestates priority payments (which are described later in this report). The State Treasurers O fceworks with fnancial frms to issue RANs almost every year.

RAWs. The main reason the state sometimes resorts to RAWs is that they can be repaid in asubsequent fscal year a ter their issuance. In act, one Cali ornia RAW issued in July 1994 matured 21 months later. The ability to have a later maturity date means the state can borrow orcash ow purposes even i the states cash outlook is challenging in the near term. Because o this longer maturity schedule and the act that RAWs typically are issued when the state aceschallenging budget times, they generally are more costlywith higher interest and other issuancecoststhan RANs. The states $7 billion o RAWs in 1994, or example, resulted in interest andother issuance costs o over $400 million, and the $11 billion o RAWs in 2003 resulted in over$260 million o costs. The State Controllers O fce works with fnancial frms to issue RAWs.

Sources of Borrowing to AddressAccumulated Monthly Cash Deficits2007-08 (In Billions)

Figure 3

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4

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8

10

12

14

$16

Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

Internal Borrowing

External Borrowing (Revenue Anticipation Notes)

a small accumulatedcash defcit, as shownin Figure 3. The state

generally needs to closethe fscal year on June30 with its GeneralFund cash ow roughlyin balance. This leavesthe states borrowable

unds largely untappedas a cash cushion thatis available to cover thelarge cash ow defcitsthat emerge during thefrst hal o the new fscalyear beginning on July 1.At any given point duringthe fscal year, the statescash cushion consists


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General Funds Cash Cushion

2007-08 (In Billions)

Figure 4

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4

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8

10

12

$14

Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

$2.5 Billion Target Minimum Cash Cushion

o available borrowableresources not needed atthat point in time to ad

dress the General Fundsaccumulated cash owdefcit. Figure 4 showsthe amount o the statescash cushion at the endo each month during200708. To ensure thatthere are enough undson hand to address unexpected General Fundor special unds needs,SCO typically pre ers tomaintain a cash cushiono no less than $2.5 billion. In 200708, theendo themonth cashcushion never dippedbelow $2.5 billion.

Cash Flow Borrowing Is Di erent From

Budgetary Borrowing. The types o internaland external cash ow borrowing describedabove are di erent rom the multiyear borrowing o special unds that is sometimes authorizedby the Legislature to help balance a fscal yearsbudget. The latter type o multiyear borrowingis known, along with other types o budgetbalancing actions, as budgetary borrowing. Internaland external cash ow borrowing is shorttermin nature and, except or certain RAWs, generally

is repaid within one year. Budgetary borrowing,on the other hand, o ten is repaid over multipleyears. For instance, the state currently has about

$1.4 billion in outstanding budgetary borrowingloans rom special unds that will not be repaiduntil 201011 or later. Budgetary borrowingprovides resources that help balance the annualstate budget; in other words, unds rom budgetary borrowing o ten are counted as revenue orpurposes o ensuring that annual budget revenues match annual expenditures. By contrast,proceeds o cash ow borrowing generally arenot counted as a resource or purposes o balancing the annual budget. Instead, the proceedso internal and external cash ow borrowing

merely help SCOthe department responsibleor paying the states billsmake payments on

time throughout the fscal year.


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the 200809 CaSh Flow CriSiS

The states cash ows have deteriorated

steadilyalong with its budgetary situation and,particularly, state revenuessince the end o 2007. This means that the states cash cushionhas weakened considerably during 200809. Thissection traces the history o the current state cash

ow crisis and how 200809 state cash ows aremuch di erent rom those in a typical fscal year.

Legislative Actions AffectingCash Management in 2008

The Legislature enacted several measures toaddress the declining cash ow situation during2008. These measures (1) delayed certain statepayments to later in the fscal year in order to reduce monthly cash ow defcits and the amounto external borrowing and (2) made some state

unds available or internal cash ow borrowingor the frst time.

Delaying State Payments. When the Governor called a fscal emergency special sessiono the Legislature in January 2008, he noted thestates deteriorating cash situation and proposedto shi t $4.7 billion o payments (to schools, social services programs, local governments, MediCal providers, and others) rom July and Augusto 2008 to later months o 200809. The goal o this package was to bolster the states cash owsprior to issuance o RANs during the all o 2008.The Legislature adopted the proposal in February

2008 with some modifcations, including makingthe payment de errals e ective or 200809 only(rather than ongoing as originally proposed). Asthe Legislature considered the 200809 budgetduring the spring a ter the special session, theadministration submitted proposals to delay anadditional $3.6 billion o payments to later in

the fscal year. The intent o these proposals was

to reduce the size o the states RAN borrowing. The Legislature also passed these measureswith some modifcations as part o the 200809budget plan. The adopted plan included a $3 billion shi t in school unding rom January throughMarch to April through June. These changeswere approved on a onetime basis or 200809.Additional, smaller changes in payment schedules a ecting the University o Cali ornia andother entities were approved on a permanent

basis.Increasing Internally Borrowable Resources.

The budget plan also included legislation toreclassi y 18 existing state unds as internallyborrowable resources, an act that increasedthe states total borrowable resources by about$3.5 billion. In addition to the Legislatures actions, SCOusing its existing administrative authorityreclassifed other unds with combinedbalances o about $500 million to make them internally borrowable. In total, these actions addedabout $4 billion to the states cash cushion.

The Double Whammy: Weak Revenues And Credit Market Access HurtThe States Cash Cushion

Weak Revenues Have Placed Major Stresson State Cash Flows. The administration recentlyestimated that 200809 General Fund revenues

would be $14.5 billion lower than assumedwhen the Legislature passed the 200809 Budget

Act. These sharply lower revenue estimates correspond to the states declining economy and re

ect broadbased weakness in personal income,sales, corporate, and other state taxes. Loweredrevenue estimates translate into lowerthanex


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pected levels o receipts to support General Fundcash needs. This is the key reason or the statescurrent cash ow crisis.

State O fcials Decide to Seek $7 Billion inExternal Cash Flow Borrowing. The state cashow plan prepared by DOF in May 2008 esti

mated the state might need to access the creditmarkets and issue $10 billion o RANs during thefrst hal o 200809. The actions o the Legislature (discussed above) to delay certain statepayments and increase the states internally borrowable resources helped reduce the size o theneeded RAN o ering and its anticipated interestexpenses. The Legislature and the Governorsdelay in agreeing to a budget package until lateSeptember also meant that some anticipated payments during the frst quarter o 200809 weredelayed, and this reduced cash ow pressuresduring the frst part o the fscal year. Accordingly, soon a ter enactment o the budget, theController determined that the state needed areduced amount o external cash ow borrow

ing$7 billionto meet its cash obligationson time through the end o 200809. The Treasurer and other state o fcials, who had alreadybeen preparing or months or the states cash

ow borrowing, went to municipal bond marketinvestors in earnest beginning in early October toattempt to issue $7 billion o RANs.

Financial Market Crisis Limits States Ability to Access Credit Markets. In October 2008,Cali ornia had the mis ortune o approaching

investors to sell RANs at the moment o theworst worldwide fnancial crisis since the GreatDepression. On September 15, 2008, LehmanBrothers Holdings Inc. announced it was fling

or bankruptcy protectionin part due to thefrms exposure to weakened mortgage assets.On September 16, the Federal Reserve autho

rized an up to $85 billion loan to American International Group Inc., one o the worlds largestinsurance companies, to prevent the companys

ailure. In the ensuing days, as ederal o fcialsconsidered a proposed $700 billion stabilization package or the fnancial industry, equitymarkets declined worldwide, money marketsexperienced unprecedented tumult, and creditmarketsincluding the municipal bond market roze, meaning that the normal volume o bondand note transactions declined dramatically. Fora number o days, the states prospects o achieving any signifcant credit market access were uncertain, and, as a result, the Governor wrote theSecretary o the Treasury on October 3 to alerthim to the possibility that Cali ornia might askthe ederal government or shortterm fnancingin the event that the RANs could not be issued.State o fcials also initiated an unusually broadmarketing campaignincluding radio advertisements eaturing the Governorto convince individual Cali ornians to invest in Cali ornia and

purchase RANs through authorized brokerages.The response rom these retail investors provedto be unexpectedly strong, o setting very weakdemand rom large fnancial institutions and

unds that usually purchase the states securities.On October 9, the Governor again wrote theTreasury Secretary ollowing fnal enactment o the ederal fnancial market packageto expresshis optimism that no ederal loans to the statewould be required. During the week o October

13, the Treasurers O fce success ully coordinated a sale o $5 billion o RANsprimarily toretail investors. The notes were sold with twomaturity dates: $1.2 billion o RANs to matureon May 20, 2009, with a 3.75 percent yield, and$3.8 billion o notes to mature on June 22, 2009,with a 4.25 percent yield. While the RAN pro


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ceeds have been important in helping the GeneralFund meet its obligations to date during 200809,the $5 billion issued in October is $2 billion less

than the Controller estimated was needed in earlyOctoberbe ore the severity o the states budgetsituation became ully apparent.

Cash Cushion Seriously Hurt by Weak Revenues and Credit Market Access. The twinblows to the states cash ows o (1) sharplyweakened General Fund revenues and (2) limitedcredit market access have represented a doublewhammy or the states cash position in 200809.Figure 5 shows how the cash cushion orecastedby DOF or 200809 has weakened in recentmonths, with the most recent estimates beingthose presented this month with the Governorsnew budget proposal. While the Legislaturesactions to strengthen the cash cushion during the2008 session helped the General Fund preservea relatively healthy position during the frst hal o

Projected End-of-Month Cash Cushions for 2008-09 Have Gone Way Down a

(In Billions)

Figure 5

aFrom cash flow forecasts prepared by the Department of Finance. The January 2008 and May 2008 forecasts reflect some proposals of theGovernor, such as a May Revision proposal to use $5 billion of lottery securitization proceeds to balance the 2008-09 budget, which were notenacted by the Legislature. Data displayed for the January 2009 forecast exclude the effects of the Governors proposed fiscal emergency measures.

-6

-4

-2

0

2

4

6

8

10

12

$14

Jul Sep Nov Jan Mar MayAug Oct Dec Feb Apr Jun

January 2008Governor's Budget Forecast

May 2008May Revision ForecastOctober 2008

Revenue AnticipationNote Forecast

January 2009 Governor's Budget Forecast(Assuming No Corrective Action)

200809, the cash cushion has weakened steadilythroughout the all and winter. Addressing thedecline in the cash cushion already has been a

ocus o the Legislature and the Governor duringsuccessive special sessions since November.

Actions Will Occur to Cope With theInsufficient Cash Cushion

Cash Cushion Insu fcient to Allow Normal Cash Flow During the Rest o 200809. Theprojected $3.2 billion cash cushion at the end o

January 2009as shown in Figure 5is insu fcient to ensure that the General Fund can continue normal cash ow operations with currentlybudgeted appropriations through the end o 200809. (In act, the state entered January 2009with $445 million less on hand than estimated inDOFs most recent cash ow orecast, and thismay mean that the cash cushion at the end o the month will be even less than estimated.) For


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comparison purposes, note the states $10.6 billion cash cushion at the end o January 2008, asshown in Figure 4. The General Fund needs a

large cash cushion at the end o January becauseFebruary and March typically have signifcantcash ow defcits. In some other years, thestate might have been able to rely on accessingexternal borrowing through issuance o RANs orRAWs to supplement a weakerthanexpected

January cash cushion. At the present time, however, credit marketswhile recovered somewhat

rom their reeze last allremain weak, andinvestors are displaying a marked pre erence orhighly creditworthy entities. Cali ornias wellknown fnancial troubles and the lack o consensus among elected leaders on balancing the statebudget make it unlikely that the state can issuebillions o dollars o RANs or RAWs to add to thecash cushion right now.

Absent Corrective Action, Cash CushionWill Be Depleted in February 2009. Strictlyspeaking, the state can never run out o cash

because tax and other payments ow into stateco ers every day. As displayed in Figure 5,however, the General Funds cash cushion is

projected to be entirely depleted sometime during February 2009ending the month with a$500 million defcitwithout prompt corrective

action. Absent corrective action, monthly General Fund cash ow defcits in February 2009would likely continue into March 2009. In total,through the end o March 2009, the cash defcitcould rise to $4.2 billion. The state does not havethe practical or legal ability to spend amountsin excess o its cash on hand at any given time.This means that corrective action to address theFebruary and March cash ow short alls will occur. Such corrective action could be achievedby the Legislature (which can increase revenues,decrease expenditures, expand the states list o internally borrowable unds, or delay budgetedpayments) or the Controller (who, as discussedbelow, has the authority to delay certain statepayments). In the absence o agreement betweenthe Legislature and the Governor to promptly address the projected cash ow defcit, the Controller must take action to determine which state

payments his o fce will make on time and whichpayments will be delayed.

what will the Controller Do?

Controller Must Focus on MakingPriority Payments

Controller Has the Ability to Delay Payments With a Lower Legal Priority. The Controllerthe o fcial responsible or paying the statesbillshas broad constitutional and statutorypowers to manage state cash ows. In particular,state lawas well as contracts and disclosuresmade to the states bond and note investorsestablishes that certain state obligations arepriority payments. Priority payments are those

that have a higher legal claim on state unds thanother, nonpriority payments. Accordingly, whenthe states cash resources are insu fcient to meetall budgeted obligations, the Controller has the

power and responsibility to make priority payments be ore making nonpriority payments.

What Are the States Priority Payments?The law about which payments are priority andwhich are nonpriority is murky. In large part,this is because the state has never experienceda prolonged period o extreme cash ow stress,which might have resulted in these questions


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being answered more defnitively by electedo fcials and the courts. The clearest statementsabout which obligations are believed to be prior

ity payments are those listed in the states RANo ering documents. The RAN o ering documents list the states priority payments as ollows:

Payments, as and when due, to supportpublic schools and public higher education system (as provided in Section 8 o Article XVI o the State Constitution).

Principal and interest payments on thestates general obligation bonds and gen

eral obligation commercial paper notes. Repayments rom the General Fund to

special and other unds or internal cashow borrowing.

Payment o state employees wages andbenefts, including state payments topension and other employee beneft trust

unds.

State MediCal claims. Payments on leaserevenue bonds.

Any amounts required to be paid by thecourts.

Determining which state payments all into thesebroad categories is a challenging task, and shouldthe state ace a prolonged period o cash owstress, litigation likely would result in the Control

lers priority payment requirements becomingmuch more specifc. Nevertheless, absent additional statutory or court direction, the Controllerhas a broad ability to determine which paymentshave legal priority. The Controller then has theduty during a period o severe cash ow distressto make those priority payments frst, while delaying payments that have a lower legal priority.

Controller Has Various Options toDelay Non-Priority Payments

The Controller has several ways that he can

delay nonpriority payments in order to ensurethat priority payments are made on time.

Registered Warrants Were Developed During the Depression to Delay Payments. Oneo the key tools that the Controller has to delaynonpriority payments was developed by theLegislature in the depths o the Depression. In1933, the Legislature anticipated that the GeneralFund might be exhausted be ore the end o the193335 budget biennium. Legislation was enacted to provide that SCO could issue registeredwarrants when the state was presented with validclaims unable to be paid or want o unds.The registered warrantsnow o ten re erred toas IOUscould bear interest o 5 percent peryear. While the Treasurer challenged the constitutionality o the practice, the Cali ornia SupremeCourt upheld the registered warrant law as avalid use o the Legislatures authority to appro

priate state moneys, writing that it is well settledin this state that revenues may be appropriated inanticipation o their receipt just as e ectually aswhen such revenues are physically in the treasury. The court urther ound that the IOUs didnot run a oul o the Constitutions debt limitationclauses. Accordingly, under the current versiono the registered warrant statutes, the Controller may issue IOUs that bear interest o up to5 percent per year, as determined by the PMIB.The law also allows the state to set a specifcmaturity date in the uture when the IOUs maybe redeemed. By issuing IOUs, SCO can delaymaking payments until the time when the IOUsare able to be redeemed rom available GeneralFund resources. The state issued IOUs during theDepression and also during a budget impasse


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or two months in 1992, when numerous bankscashed IOUs that the state used to cover statetax re unds, vendor payments, and some other

expenses.Controller Can Also Simply Not Pay SomeState Bills. Another option or the Controllerto delay nonpriority payments is simply not topay certain bills when they are presented to hiso fce. Instead, SCO can wait to pay the billsuntil the General Fund has available resourcesto do so at a later date. This is somewhat similarto what SCO does in a year with a prolongedbudget impasse, when certain state payments arenot made until a budget is enacted. This type o cash management can result in the state incurring additional costs or penalties, which are akinto the interest payments the state must pay whenit issues IOUs. For example, the states PromptPayment Act establishes penalties or the statewhen valid invoices rom certain vendors are notpaid within 45 days rom receipt.

Bankruptcy Protection Is Not an Option

to Delay Payments. While the Controller hasseveral options to delay nonpriority payments,the state does not have the option o seekingbankruptcy protection, as individuals, businesses,and local governments might i they were unableto pay bills on time. Local governmentssuchas the City o Vallejoapply or the ability to restructure their obligations under Chapter 9 o theU.S. Bankruptcy Code. Chapter 9, it is generallybelieved, does not a ord states an ability to fle

or bankruptcy protection.

Controller Has Indicated IOUs May BeIssued Beginning in February 2009

What the Controller Has Indicated HeWill Do. On December 30, 2008, the Control

ler released a statement indicating that, withoutbudget solutions rom the Legislature and theGovernor, SCO would have no choice but to

pursue payment de errals or the issuance o registered warrantsas early as February 1. TheController stated that IOUs may have to be issued in lieu o salaries and per diem payments tolegislators, state elected o fcers, judges, and theirappointed sta (all totaling about 1,700), as wellas tax re unds owed to individuals and businesses. In a letter to state agencies the same day, theController stated that the purpose o issuing theIOUs was to ensure that the state can meet itsobligations to schools, debt service, and othersentitled to payment under the State Constitution,

ederal law or court order. With the letter, theSCO provided to departments and the Legislaturea list o expenses currently paid through regularelectronic unds trans ers (EFTs) that the SCO saidcould be a ected in the event registered warrantsare issued. The list o EFT payees that SCO askeddepartments to prepare to transition to registered

warrants is displayed in Figure 6 (see next page).These payments include personal income taxre unds and Cali ornia Student Aid Commission(CSAC) grants, including, potentially, Cal Grants.

SCO Expected to Provide More Detail onIts Plans Soon. The SCOs December 30 letterindicated the possibility that the payments inFigure 6, among others, could be subject to issuance o registered warrants or payment delays.We understand that SCO soon will release more

in ormation on its plans. The Controllers plansprobably will change and evolve over time i thecash crisis persists. The longer the crisis persists,the longer the list o a ected programs and payees may become.


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legiSlatureS optionS For

aDDreSSing the CaSh Flow CriSiS

Figure 6List of Programs to Be Converted From Electronic FundsTransfers to Prepare for Possible Registered Warrants

Administering Agency orDepartment Program

Assembly Payroll and Legislators' Per Diem PaymentsCalifornia Student Aid Commission Student Aid GrantsHealth Care Services Medi-Cal (Fund 0001 Claims and Abortion

Claims)Franchise Tax Board Personal Income Tax RefundsFranchise Tax Board Bank and Corporate Tax Refunds

Judicial Council Court-Appointed Counsel (Appellate andSupreme Courts)Legislative Analyst's Office PayrollSenate Payroll and Legislators' Per Diem PaymentsState Controller's Office Citizens Option for Public Safety (COPS)

ApportionmentsState Controller's Office Homeowners' Exemption ApportionmentsState Controller's Office Williamson Act ApportionmentsState Controller's Office Trial Court Trust Fund Apportionments

The Legislature can avert the issuance o IOUs and the delay o certain state payments bythe Controller only by taking substantial budgetbalancing and cash management actions almostimmediately. Even i the Legislature is unable toavert the delay o some state payments by SCOin the coming weeks, it has the power to shortenthe duration and severity o the states cash owcrisis by acting soon to address the states hugefscal problem.

Balancing the Budget Is Key to Addressing the Crisis

Increasing Revenues and Cutting Spending Key to Fixing Both the Budget and Cash. As we discussed at the beginning o this report,the states budget and cash ow situations arerelated. The Legislature must address a GeneralFund budget gap over

the next 18 months thatwas recently estimatedby the administrationto total $40 billion. Byincreasing revenues andreducing expenditures,the Legislature cannot only balance the200910 budget, but alsodramatically improve thecash situation by reducing the General Fundsmonthly cash ow defcits. The sooner that theLegislature enacts budgetsolutions, the sooner

that these solutions can beneft the states cashsituation.

Recommend Passing Measures toIncrease Borrowable Resources

And Delay Some Payments

Administration Has Proposed Another Signifcant Package o Cash Flow Measures. In itsspecial session and January 2009 budget proposals, the administration has proposed anotherseries o measures intended to relieve state cash

ow pressures and expand the General Fundsweakened cash cushion.

Recommend Approving Expansion o Internally Borrowable Resources. Proposed trailerbill language would authorize internal borrowing rom several additional state unds, and DOFestimates these unds would add about $2 billion


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to the cash cushion. Borrowing rom these undswould occur in a similar ashion to the borrowing that already occurs rom the 600 internally

borrowable state unds discussed earlier in thisreport. We recommendthat the Legislature approve this administrationproposal.

Recommend Ap proving at Least SomePayment De errals onOneTime Basis. TheGovernor also submittedwith his 200910 budgetpackage a proposal todelay by a ew monthsseveral categories o payments to schools, localgovernments, regionalcenters, and others (inaddition to the $2.8billion school unding

de erral proposed tohelp balance the budget). These proposedpayment de errals arelisted in Figure 7. Someo the payment de errals,such as a twomonthor threemonth delay insome school apportionments now scheduled

to be made in July andAugust, are similar toproposals enacted by theLegislature on a onetimebasis in 2008. The payment de errals could addabout $1 billion to the

states cash cushion during the last our monthso 200809 and expand the cash cushion by$3 billion to $5 billion above what it would be

under current law in July, August, and September

Figure 7

Additional Payment Deferrals Proposed by the Governor

K-14 Education

Defer $2.7 billion of payments to schools from July and August 2009 toOctober 2009.

Transportation

Defer transfers of $700 million of gas tax revenues to counties and citiesfor local street and road projects spread over several months beginning inFebruary 2009.

Defer $270 million of Proposition 42 transportation payments from Apriland June 2009 to October 2009.

Medi-Cal

Defer $874 million of various Medi-Cal payments from March 2009 toApril 2009.

Payments to Counties

Defer $1.8 billion of various social services payments to counties spreadacross several months beginning in February 2009. Payments would bedelayed until September 2009.

Defer $92 million of mental health cash advances to counties fromJuly 2009 to September 2009.

Defer $85 million of reimbursement payments to counties for the Febru-ary 2008 election beginning in January 2009 to June 2009. (We under-stand that these payments have already been made to counties.)

Developmental Services

Defer $400 million of payments for regional centers from July andAugust 2009 to September 2009.

Payments to Health Plans for State Retiree Health Benefits

Defer $194 million of payments for state retiree health benefits fromMarch and April 2009 to May 2009.

Mandates

Defer $142 million of local mandate reimbursements from August 2009 toOctober 2009.


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o 2009. Each one o these proposed de erralscould result in di fculties or the entities whosepayments would be delayed. In considering the

proposals, the Legislature may wish to explorewith the a ected entities whether any measurescould be enacted that would lessen the impacto the payment de errals without additional coststo the state. We recommend that the Legislatureapprove on a onetime basis at least some o theproposed changes, as it did in 2008 or severalgroups o payments. Given current projections

or a slow economic recovery and the statesongoing structural budget problems, it is likely, i the Legislature approves these de errals on a onetime basis, that the administration will proposethese payment delays again in 2010.

Legislation to Facilitate RAW Issuance May Be Needed

Governors Proposed RAW Is Central or Both His Budget and Cash Flow Plans. In thefrst report in the 200910 Budget Analysis Series:

Overview of the Governors Budget , we notedour concerns with the Governors use o about$5 billion o proceeds rom RAWs to balance hisbudget plan. We acknowledge, however, thatregardless o whether RAW proceeds are usedto balance the annual budget, a RAW may needto be issued or General Fund cash ow purposes be ore or during 200910. In its summaryo the Governors 200910 budget proposal, theadministration opined that in order or a success

ul RAW issuance to proceed, three conditionswould have to be met:

A sustainable, balanced state budget.

A plausible plan or repaying RAWs in asubsequent fscal year.

Enactment o legislation to protect RAWholders, including a trigger that automatically increases taxes or cuts pro

grams i needed to ensure timely repayment o the RAWs.

The administration is correct that investors willneed to be assured that the state has a viablebudget plan in order to issue RAWs, RANs, orother debt instruments. In the past, enactment o trigger legislation has acilitated the states issuance o RAWs. Specifcally, Chapter 135, Statuteso 1994 (SB 1230, Committee on Budget and

Fiscal Review), helped state o fcials sell a 1994series o RAWs to investors. Chapter 135 requiredthe state to reduce most categories o expenditures i cash ow projections showed that timelypayment o the RAWs was threatened. Giventhe need to preserve the Legislatures constitutional prerogatives over the state budget, we arereluctant to recommend passage o such triggerlegislation. We concede, however, that, giventhe current environment in the fnancial markets

and investors shaken confdence in Cali orniascredit quality, such legislation may be necessary to market RAWs and sustain a normal cashcushion or the General Fund during 200910.When the administration submits any proposedtrigger legislation, we will review it and providerecommendations or any modifcations to theLegislature.

Few Good Options to Control HigherCosts Once Cash Cushion Is Depleted

IOUs and Payment Delays Mean Higher State Costs. The state may experience increasedcostswhich are not re ected in the 200809budget or the Governors proposed 200910budget planbeginning in 200809 i registeredwarrants or other payment delays are required


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as the states cash cushion is depleted. This isbecause registered warrants must be paid alongwith interest to the person or entity whose

payment was delayed. In addition, the PromptPayment Act and other laws require payment o interests or penalties in some cases o late statepayments. It is virtually impossible to estimatethe total amount o these higher costs in advance. In general, the longer and the more severe the states cash crisis, the more the state willbe exposed to these types o payments.

Reducing Registered Warrants MaximumInterest Rate Would Be Problematic. Section17222 o the Government Code provides that thePMIB may set the interest rate paid by the stateon registered warrants at up to 5 percent peryear. One option or the Legislature to reduce thecosts o state payment delays would be to reducethis maximum interest rate. This, however, wouldbe problematic. A key purpose o the registeredwarrant law is that the IOUs be negotiable instruments. This means that registered warrants can

be traded in a ashion somewhat similar to thestates debt securities. This, in turn, increasesthe probability that banks will cash the IOUs, asmany did in 1992. Given the states weakenedcredit condition, fnancial institutions will needto be able to earn an appropriate return in orderto eel com ortable cashing these investments

or their depositors and others. There ore, lowering the maximum registered warrant interest ratemay reduce the number o banks willing to cash

the IOUs.Modi ying or Suspending the Prompt Pay

ment Act Also Would Be Problematic. ThePrompt Payment Act provides or fnancial penalties i the state ails to meet certain deadlines ormaking certain state payments, particularly thoseto vendors. Reducing these penalties, restricting

the scope o payments covered by the act, orsuspending or repealing the act altogether couldreduce the costs o state payment delays. Such

an approach, however, would invite litigation,as vendors have entered into business relationships with the state based on the assurances andprotections provided by the Prompt PaymentAct. Over the longer term, the states ailure tolive up to the requirements o the Prompt Payment Act may discourage some businesses romdoing business with state departments or resultin them demanding higher payments or servicesto compensate or the risk o not being paid in atimely manner.

Over Longer Term, Building StateReserves Would StrengthenThe Cash Cushion

Legislatures 2008 Budget Re orm PackageSeeks to Increase Reserves. The 200809 budgetpackage included a measure to be submitted tovoters to make changes to the states BSA reserve

und, which was created by Proposition 58 in2004. As mentioned earlier in this report, theBSA is one o the states accounts that is borrowable or cash ow purposes. Under current law,an annual trans er equal to 3 percent o GeneralFund revenues is made into the BSA. Onehal o the trans er is saved as a reserve, and theother onehal is used to make a supplementalpayment to pay o outstanding defcitfnancingbonds. The Governor can suspend the annual

trans er in any year by issuing an executive order(as was the case this year and is proposed or200910). The proposed ballot measure wouldincrease unds in the BSA in a number o ways.First, the ability to suspend the annual trans erwould be limited to those years in which prioryear General Fund spending (grown or in ation


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and population) exceeded estimated GeneralFund revenues. Second, unanticipated revenuesexceeding the enacted budgets estimate by more

than 5 percent would be automatically trans erredto the BSA. Third, the target cap on BSA undswould be raised rom 5 percent to 12.5 percent o annual revenues. Finally, unds could be trans

erred out o the BSA only to (1) meet emergencycosts or (2) increase General Fund revenues upto the level o prioryear General Fund spending(grown or in ation and population). In addi

tion, i voters approve the measure, the Governor would gain new authority to reduce certainGeneral Fund appropriations during a fscal year.

These measures, as well as actions taken eachyear by the Legislature during the budget process,to expand reserves would bolster the states cashcushion in the long run. Relying more on such internally borrowable resources to smooth monthlyvariations in cash ows would reduce the statesdependence on the credit markets or externalcash ow borrowing.

the FiSCal DiSaSter that woulD reSultFrom prolongeD inaCtion

State Faces Fiscal Disaster i Cash and Budget Defcits Remain Unaddressed. As wenoted in our Overview of the Governors Bud

get , it is urgent that the Legislature and Governor act immediately to address the budgetaryand cash ow situations that have put the state

on the edge o fscal disaster. Given the recentinability o the Legislature and the Governor toreach agreement on budgetbalancing actions, itis now quite likely that some state payments willhave to be delayed by the Controller in Februaryand March. Even i this occurs, the sooner theLegislature and Governor begin to act to addressthe states fscal crisis, the less the duration andseverity o the states cash crisis will be.

Outlook in the Event ofProlonged Inaction

During the Rest o 200809, Delays in Tax Re unds Could A ect Many Residents.I theController decides to delay payments or issueIOUs beginning in February, it appears likely thatpersonal income tax re unds to millions o Cali

ornia households could be delayed signifcantly.This would reduce the ability o those residentsto spend re unds in their local communities,thereby producing an added drag on an already struggling economy. Some businesses andlocal governments might experience delays in

their state payments, thus reducing the strengtho their own cash ows and potentially subjecting their employees to layo s or reductions inwork hours. Some CSAC student aid grants maybe delayed. Some state employees might not bepaid on time, and this could a ect recruitmentand retention, particularly i fnancial institutions reach the point when they are unwilling toprovide those sta with temporary assistance orcash IOUs. Other programs, such as those listed

in Figure 6, also could be a ected.Summer 2009 Promises to Be a Cash

Abyss i Few Solutions Are Enacted. As discussed earlier in this report, the General Fundtypically needs to close the fscal year on June30 with a substantial cash cushion and a limited accumulated cash ow defcit. I ew or no


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solutions are enacted in the next ew monthsbe ore the beginning o the 200910 fscal yearthe state may begin July with no cash cushion

and hundreds o millions o dollars o IOUs anddelayed claims. In that scenario, it seems unlikelythat the state could access billions o dollars o external fnancing to supplement its cash cushion. I the summer progressed urther with aprolonged budget impasse, the Controller couldbe orced to delay more and more nonprioritypayments. I the state proceeds urther into thissummer cash abyss, it is possible the Controllerwould need to start delaying even some priority payments in order to ensure that schools and

debt service payments are made on time. Inthis scenario, tens o thousands o state workerscould see their paychecks delayed. Many Medi

Cal services might cease. Repaying internal cashow borrowing to special unds could be di fcult, and this could cause departments undedby special unds to implement major reductionsin their operations. Financial institutions willingness to cash IOUs or Cali ornians could wane.Gradually, more and more o state governmentspaymentsas well as services provided both bythe state and local governmentscould grind toa halt.

aCtion neeDeD NOW to Begin aDDreSSingthe CaSh Flow anD BuDget CriSeS

Un ortunately, the worstcase scenariodescribed above is a plausible outcome i theLegislature and the Governor are unable to beginreaching agreements very soon on tough, pain

ul measures to begin addressing both the statesestimated $40 billion budget gap and the cash

ow crisis. The most important thing that theLegislature can do to ensure the state can payits bills on time and access the credit markets isto address the colossal budget gap. Approving

measures to increase the states cash cushion inthe short term and acilitate external borrowingin 200910 also may be required. I the massivebudget gap is not addressed promptly, the states

insolvency may signifcantly erode or years tocome the confdence o the publicas well asinvestorsin state government itsel . The Legislature and Governor, there ore, must act immediately to address the fscal crisis that has put ourstate on the edge o disaster.


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california's cash flow crisis, 2009-10 budget analysis series

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