A warning bell on California muni bonds

    As sure as the sun will set on the Golden State, analyst Martin Weiss says California is going to default.

    By Jon Birger

    Known for his early warnings on Bear Stearns and Lehman Brothers, analyst Martin Weiss of Weiss Research is now sounding the alarm about state of California municipal bonds.

    In a new report, Weiss has some rather blunt advice for California muni investors: "Sell all California paper now!" His reasoning? California is facing a $24 billion budget gap with no obvious way to close it.

    The state has appealed to Washington for a federal bailout, but it got a cool response from the Obama Administration. The next step is draconian cuts in state services and payroll, but Weiss says that will only deepen the "depression" in California, where the unemployment rate is 11.5%, by further cutting into tax revenue.

    Asked to put odds on California defaulting on its $59 billion in outstanding general obligation bonds, Weiss doesn't hedge. "It's unavoidable," he tells Fortune.

    If he's right, the impact on investors would be far broader and deeper than Bernie Madoff, General Motors (GMGMQ) or any of the other investment implosions that have occurred over the past year. Municipal bonds tend to be a retail product, which means that those most affected by a large muni bond default are not endowments, banks, or foreign governments but mom-and-pop investors.

    A California default would be especially devastating for two reasons: Munis have generally been viewed as a safe haven and California is the nation's largest issuer of tax-exempt bonds. According to Morningstar, assets in California muni bond funds now total $46 billion -- with billions more of California bonds held in national muni funds and individual bond portfolios.

    But if the situation is so dire, why do credit rating agencies Moody's and Standard & Poor's still give the Golden State an investment-grade, single-A rating? Weiss says that the rating agencies have been consistently behind the curve, and this crisis is no different. "They're very hesitant to downgrade," he says.

    That said, both Moody's and S&P have put the state on a watch list and warned of possible downgrades. A downgrade below triple-B would likely precipitate a mass stampede by money market funds out of short-term California notes and make it much harder for the state to roll over maturing debt.

    While Weiss believes the numbers point to a California default, he doesn't rule out last-minute intervention by Congress or the Obama Administration. Washington may be suffering from bailout fatigue, but the political consequences of allowing the largest state in the nation to default on its bonds may prove too great.

    The last time a leading municipal bond issuer was on the verge of default was 1975, when New York City was going through its own financial crisis. Then-President Gerald Ford gave a speech vowing to veto any federal assistance for New York -- a speech immortalized by the next day's New York Daily News headline, "Ford to City: Drop Dead."

    Even though Ford later approved federal loans to New York, the political damage was done. New York had voted Republican in 1972, but four years later, Ford wound up narrowly losing the state to Jimmy Carter, which ultimately cost him the election.

    Analysts think Obama is unlikely to make a similar mistake. "The most important factor here is that California has 55 electoral votes," says Greg Valliere, Washington policy strategist at Soleil Securities. "At the end of the day, that's why I think Washington blinks."