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October 20, 2011

For the fiscal year beginning July 1, 2011, the State of California passed a balanced budget.  However, the budget was only balanced due to the hope that tax revenues will exceed forecasts by $4 billion.  In the event the optimistic numbers fail to materialize, a series of cuts could be enacted that could impact many Californians.  Based on the success of the recent State of California bond deals, it is important for investors to understand the budget, and how it could impact their bonds.

For the current fiscal year, the State of California has a budget of $85.9 billion.  The figure represents a 6.1% decrease from the 2010/11 fiscal year budget.  Cuts were made to several different State provided services, but the California school system received the brunt of the cuts.  In the event revenues fail to meet the optimistic assumptions, certain cuts will be automatically triggered.  If revenues come within $1 billion of forecasts, no cuts will be triggered.  If revenues fall between $1–2 billion short of forecasts, $600 million will be cut from universities and healthcare.  If revenues fall short in excess of $2 billion, $1.9 billion will be cut from education and healthcare, including the possibility of shortening the K–12 school year by one week.  Through the week ended October 14, 2011, revenues were thus far $654 million below the optimistic forecasts.

Under the State Constitution, California must follow a series of payment priorities from its general fund.  School funding is first, general obligation bond debt service is second, and lease revenue and appropriation backed bonds are third.  While the State revenues funding local school districts may be less than in prior years, many school districts are exercising commendable fiscal discipline, and working to pair back expenses in response to declining revenues.  Some have not been quite as successful as others, and could be reviewed on a case-by-case basis.  Payment for schools, general obligation bonds, and appropriation and lease revenue bonds have a priority claim over other state expenses including public employee salaries, post employment benefit obligations, healthcare, and social services.  With State backed bonds taking payment priority over State employee salaries and benefits, among several other State expenditures, some California municipal bond investors are able to sleep rather well at night.

One aspect of the budget directly impacted California’s local redevelopment agencies.  ABX126 was approved to eliminate California’s local redevelopment agencies.  ABX127 was also approved, which would allow redevelopment agencies to continue if they pay a significant fee to the state.  The California Redevelopment Association, the League of California Cities, and various individual cities came together and filed a lawsuit against the State challenging the legislation.  They are arguing under the basis that voters approved Proposition 22 in November 2010, which is designed to keep tax increment revenues local.  Tax increment revenue is the revenue used to service redevelopment agency bonds, and redevelopment activities.  Despite Proposition 22, the State is standing behind the belief that they created legislation to establish redevelopment agencies, therefore they may create legislation to destroy redevelopment agencies.

The redevelopment agency case is currently being reviewed by the California Supreme Court.  The Court has granted a stay to redevelopment agencies, and a decision is expected in January 2012, though redevelopment agencies are prohibited from issuing new financing until a decision has been made.  Regardless of the Court’s decision, there are State and Federal Constitutional laws preventing the impairment of contracts.  Bonds are established under contracts, and the tax increment revenues supporting redevelopment agency bonds are legally protected.  If the Court finds in favor of the State, it will eliminate redevelopment agencies that cannot afford to pay the fee to the state.  From speaking with some redevelopment agency directors, many believe they would enact the continuation legislation and pay the fee.  For those agencies that do not generate sufficient revenues to cover both bond debt service and the payment to the state, they have a number of options including borrowing funds from their respective city.  In the event the Court finds in favor of the cities, redevelopment activities are likely to continue as usual.  Regardless, the revenues supporting previously issued bonds are protected.  What is less certain are future bond issuances.

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This report is prepared for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument or service.  Market prices and other data may be obtained from outside sources and is not warranted as to completeness or accuracy. Any comments, statements and/or recommendations made herein are subject to change without notice, and may not necessarily reflect those of Alamo Capital.  Alamo Capital has no affiliation with any political party. Investing involves risk. Consult with a Financial Professional for additional information to determine the suitability of this or any other financial product or issue as it relates to your particular situation.

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