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June 7, 2012

Every year feels like the same story – California cannot structurally balance its budget. Political gamesmanship often leads to sensational headlines, and many California residents are left with plenty of opinions, but very few facts, surrounding the current budget debacle. The fact that many politicians dread to acknowledge, is that many of the budget problems are their own creation due to their inability to make difficult decisions. Despite the doom and gloom that plagues media outlets, California generates the most tax revenue of any state, and municipal bonds issued by the State tend to have a high priority on those revenues.

Personal income taxes (PIT) are the largest source of revenue for the State’s general fund, accounting for more than 60%. Much of that revenue is derived from capital gains from investments, thus general fund revenues are highly correlated with equity markets and the health of the economy. After peaking in October 2007, the S&P 500 followed a downward spiral to March 2009, and general fund revenues responded accordingly, and unpredictably. Lacking the foresight of a crystal ball, most investors, let alone governments, find it challenging to predict the direction of equity markets and the economy. Other revenue sources such as sales/use taxes account for 20%, corporate income tax 10%, and the remainder is generated through a combination of insurance, alcohol, tobacco, vehicle, and other taxes.

Schools and benefits for the less fortunate account for the majority of the State’s spending. It is often stated that schools are taking the brunt of the budget cuts. However, schools account for a majority of the State’s spending, which makes that line of argument somewhat logical and just. Combined, K-12 and higher education account for 50.9% of the State’s general fund spending, and thus receive a substantial portion of the cuts in dollar value when the State reduces general fund spending. Next in line is Health and Human Services accounting for 30.8%, and Correction and Rehabilitation accounting for 9.1%. That does not leave very much for the remaining expenditures including courts, general government, transportation, and natural resources. In total, general fund supported municipal bond debt accounts for 7.8% of the budget.

While bondholders should always be vigilant of their holdings, bonds issued by the State take priority over many other expenses of the State. General obligation bonds issued by the State are backed by the State’s full faith and credit, and are paid second only to schools. Bonds that are secured by appropriations from the State’s general fund follow immediately in payment priority. Of great importance, in my opinion, is that these payments are made before politicians get paid. We all saw what happened during the few days in July 2011 when politicians’ paychecks were withheld due to their inability to balance a budget – they did something.

In theory, the State government should be able to structurally balance the budget, and we should not find it necessary to deal with another budget debate in 2013. However, in practice, it is generally politically unpopular to cut funding to schools and the less fortunate. Raising taxes, an option in the event expenses are not sufficiently cut, is also politically unpopular. In recent local elections, voters showed an appetite for local tax increases that benefit their community, particularly for schools and public safety. We are not observing that increase in appetite at the State or Federal income tax levels, hence the need to structurally balance the budget. Regardless of what politicians decide to do, bondholders of the State of California have a high priority on the revenues the State does receive.

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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