As he delivered his budget proposal Jan. 9, Gov. Arnold Schwarzenegger warned voters of the consequences of failing to approve a $15 billion bond to cover the state's debt.

Holding up a chart -- one aides said he sketched himself -- the governor pointed to a plummeting line he said represented one scenario for California's fiscal future.

"If the bond does not pass in March, this is where we have to go with our cuts in order to make it work," he said. "It will be disastrous. ..."
What, exactly, would that "disaster" look like?

Failure by voters to pass the bond on March 2 might mean that the state would have to plug a multibillion-dollar hole in the budget in the near future, instead of stretching it out over five to 15 years.

But a rejection of the bond would not mean bankruptcy, insolvency or an immediate fiscal emergency, officials say.

The state is continuing to pursue a backup bond that was part of this year's budget.

If it survives a court challenge, it would yield only about $3 billion less than the bond measure Schwarzenegger has proposed.

If it doesn't, the state would be facing the need to pay off $14 billion in short-term debt in June. But banks have guaranteed those notes, meaning that in a pinch they would pay off the state's debt and take over the role of lender.

More likely, officials say, is that the state could try to roll over its short-term notes into new loans.

Still, setbacks at the polls and in the courts could leave the state facing some unpleasant realities. It might be forced to cede control to banks, squeezing normal functioning.

And the state would be looking at a much bigger immediate budget shortfall in the fiscal year that starts in July. The deficit would grow from $15 billion to about $26 billion, said Brad Williams, senior economist at the nonpartisan Legislative Analyst's Office.

Schwarzenegger's budget proposal already includes sweeping cuts, deferrals of spending, accounting maneuvers and borrowing.

"It would imply dramatic reductions in state programs or tax increases, or both," Williams said.

Early indications are that voters prefer such a dramatic solution to shunting the cost of current services onto Californians paying taxes 15 years from now.

Two polls released last week found skepticism about the bond measure, Proposition 57, despite Schwarzenegger's popularity. The Field Poll found that one-third of voters supported it, compared with 40 percent who opposed.

Another poll by the Public Policy Institute of California found similar numbers. That poll also found that half of respondents favored a mix of spending cuts and tax increases to deal with the debt. Only 8 percent said that the state should borrow money and run a deficit.

The bond proposal was the product of a series of budgets that failed to get spending in line with revenue. By last year, it became obvious that the state could not pay off this accumulated debt all at once without disrupting services or resorting to a massive tax increase.

The initial solution, included in this year's budget, was a $10.7 billion bond that would be sold without voter approval. It would be paid off over about five years with a half-cent of the current sales tax.

Soon after Schwarzenegger took office, he announced that he would ask voters to ratify the legally questionable borrowing, and increase the amount. Schwarzenegger's bond would be paid off in nine to 14 years, using a quarter-cent of the existing sales tax.

If voters reject the GOP governor's bond, the administration's first backup plan is to go ahead with the earlier bond included in this year's budget. The state has sought to have the $10.7 billion bond validated by a Superior Court, a step that is taken to clear up legal uncertainty over new types of borrowing.

Anyone can challenge the "validation" until the end of this month.

So far, the conservative Pacific Legal Institute, representing the Fullerton Association of Concerned Taxpayers, has filed a challenge.

The foundation argues that the bonds run afoul of the state constitution's prohibition against year-to-year debt without a vote of the people.

A similar argument prevailed in court last year when the state tried to sell bonds to cover about $2 billion of its pension costs. But some officials think the deficit bonds stand a better chance of legal success because the state has identified a source -- the half-cent sales tax -- for paying them off.

If the state did prevail and sell the $10.7 billion in deficit bonds, the proceeds would go a long way toward rubbing out the accumulated debt.

But taking into account the smaller size of the offering -- and the bigger annual payments to retire it faster -- the state would have about $2.9 billion less than Schwarzenegger anticipated in his budget proposal, Williams said.

A double defeat at the polls and in court would put the state in a fix. But despite Schwarzenegger's public use of the word "bankruptcy," the result would not be quite so dire.

The state has depended heavily in recent years on short-term debt, a routine device for getting it through cash crunches. In June, $14 billion of this debt comes due.

According to the state Controller's Office, the state would have enough cash to cover about $8 billion of that amount, leaving it about $6 billion short.

The Legislature is supposed to pass a budget by June 15. But if it looked as if lawmakers were headed toward another impasse, the Controller's Office might have to seek another $4 billion to $5 billion to meet obligations after the July 1 start of the fiscal year.

The best option at that point would be for the state to roll over the short-term debt, said Timothy Blake, a senior analyst for state ratings at Moody's Investors Service. In essence, that would mean borrowing cash to pay off the short-term loans, exchanging debt for debt.

"We would view that as an orderly plan," Blake said.

Less orderly would be relying on banks that guaranteed the earlier borrowing to, in effect, take over the loans. The state paid a premium for the guarantees to make its short-term notes more attractive to buyers.

The banks would get registered warrants from the state, Blake said, with relatively onerous repayment terms. On a daily basis, the warrants would allow banks to lay claim to the state treasury.

"They sort of act like a sponge," he said, "soaking up available cash. ... It puts repayment to the bank in competition with other state services. What I've heard some say is that it amounts to the state losing control of its finances."

Even if the state found new customers for its short-term debt, it might not be able to carry on as usual. In the early 1990s, in the last fiscal crisis, banks demanded that the state budget include "triggers" for automatic, across-the-board cuts if revenues lagged behind spending.

It never came to that, but lawmakers were not happy with the prospect of bankers, in effect, taking over.

The state's position could get even more complicated if the credit-rating agencies knocked down its rating two or three more notches to junk bond status. Institutional investors who buy much of the state's debt can't buy junk bonds, which would probably force the state to rely on the banks that guaranteed the earlier loans.

State Treasurer Phil Angelides, a Democrat who has criticized the bond measure, said Schwarzenegger should plan now for all these possible outcomes to avoid chaos later. Lenders will be willing to keep the state afloat if they believe it's making progress toward balancing the budget, he said.

But the governor may be reluctant to spell out contingencies because he wants to persuade voters that a setback at the polls would lead to an unthinkable fiscal doomsday, Angelides said.

"It may not serve the governor's political purposes to offer up a plan, but it's in the best interests of the state," he said.

Voters should be told the options, he said, and "if there's a rational Plan B that doesn't scare the wits out of them, they may like that better."

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What is a Bond?
A certificate issued by a corporation or government stating the amount of a loan, the interest to be paid, the time for repayment and the collateral pledged if payment cannot be made. Repayment generally is not due for a long period, usually seven years or more.
When issued by a government (such as a state, city, county or school district) in the form of a general obligation bond, the bond is secured by a pledge of the issuer's taxing or borrowing ability, and the issue must be approved by referendum or by an electoral body.