Charles Schwab Makes The Mistake Of Telling The Truth

Maybe it's because their headquarters are on Montgomery Street in San Francisco instead of Wall Street in New York, but Charles Schwab Co. is telling investors that California is not about to go out of business.

In a rhetorical question-and-answer missive to investors, Schwab income planning director Rob Williams, says "California has severe financial problems, but we think it's unlikely that the state will default on its general obligation (GO) bonds."

Then he lists five reasons for reaching that conclusion, including constitutional guarantees; the fact the state can't file for bankruptcy, and the fact that "states can't just disappear."

So does the firm see the state's current travails as "a buying opportunity?" "No one can say for certain," says Williams.

Here's the document. As Williams says, general obligation bonds are guaranteed by the state constitution, and only education is ahead of paying off these bonds. Here's a sample:

Many analysts point out that the state’s revenues are collapsing, its spending is out of control, and the structure of government prevents the state from ever being fiscally stable. Are these concerns valid?

All of these statements may be true, depending on your political view. But these troubles don’t inevitably translate into default on California GO bonds, for all of the reasons cited above.

However, they do translate into serious concerns for other parties interested in the state’s solvency—of which there are many. The politics of the situation can also be noisy, leading to steady reporting of the budget drama and ebbs and flows in market sentiment, likely adding to uncertainty and reducing confidence among investors. As confidence drops, the prices of outstanding bonds drop, and yields rise.

The situation has also resulted in changes to the state’s bond rating, including a downgrade by Fitch Ratings to BBB on July 6 and Moody’s to Baa1 on July 15. These ratings are two and three notches, respectively, from "junk" bond status. The rating is also on negative "Rating Watch," meaning that the rating will remain on review for additional downgrades "if institutional gridlock" persists.

While ratings alone should not drive an individual investment decision, comments in Fitch’s rating report are worth quoting: "The BBB rating indicates that expectations of default risk remain low, although the rating is well below that of most other tax-supported issuers. GO debt in California has a constitutional prior claim on revenues, although after education."

In other words, diving into Fitch's rating report, they essentially admit that their rating is bullshit. They are dropping the ratings because of perceptions of crisis that don't match constitutional obligations. This is gouging. It's almost the textbook definition of it.

And if you don't think that goes on, check out this investigative report from last November:

Goldman, Sachs & Co. urged some of its big clients to place investment bets against California bonds this year despite having collected millions of dollars in fees to help the state sell some of those same bonds.

The giant investment firm did not inform the office of California Treasurer Bill Lockyer that it was proposing a way for investment clients to profit from California's deepening financial misery. In Sacramento, officials said they were concerned that Goldman's strategy could raise the interest rate the state would have to pay to borrow money, thus harming taxpayers.

"It could exaggerate people's worries about our credit," said Paul Rosenstiel, head of the public finance division of the treasurer's office.

That's exactly what's happening. The big banks are sparking irrational worry over California's ability to repay bonds to increase their yields. The federal government needs to step in with a backstop, not just to save the state money, but to prevent the commission of a crime.