Can California Default on Its General Obligation Bonds?
Holders of those issued by the state should know their investment is protected.
The news is rife with commentary about the dire financial condition of the great state of California. There's no doubt that this state has serious fiscal issues it must deal with, and soon. But in the interest of accurate financial education, it's important to understand how California's fiscal plight affects its ability to pay timely interest and principal on its general obligation bonds.
California generates revenues throughout the calendar year, no matter how good or bad the economy. The state is obligated to use these revenues to (1) pay for educational expenses and (2) interest and principal on its general obligation bonds. After these two have been fully satisfied, then and only then can the state pay its other expenses. This is important because even with declining revenues (and my, have they declined in recent years), California has more than sufficient cash flow to satisfy (1) and (2). And as a sovereign entity, California doesn't have access to bankruptcy-protection laws. This means the state cannot force its creditors to restructure their holdings. Corporations and municipalities are usually incorporated entities and as such, can file for bankruptcy protection, often resulting in creditors taking a permanent haircut to the face value of their investment.
In no way is the above intended to treat lightly the fiscal disaster that is California (and many other states, for that matter). The legislature needs to get serious about budget reform and prescribe the necessary medicine needed to cure the patient. However, holders of general obligation bonds issued by California should take comfort in the safeguards protecting their investment.
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