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Signs point to California facing new budget gap

By Jim Christie

SAN FRANCISCO (Reuters) - California's summer vacation from its state budget woes didn't last long.

California's latest monthly revenue report shows revenue weaker than expected even before the stock market, a key source of revenue for the state, began sliding in response to Standard & Poor's downgrade of U.S. debt, anxiety about Europe's finances and the risk of the U.S. economy slipping back into recession.

For officials in California's capital, underwhelming July revenue and Wall Street's hard times suggest they will have to draw up plans for cutting more spending early next year.

Beyond Sacramento, if revenue swoons in coming months, it will assure renewed headlines of how the government of the most populous U.S. state is facing yet another budget shortfall.

Californians, and the state's bond investors, should brace themselves for that in light of how a choppy stock market can hurt the state's revenue, said Neil Hokanson of Hokanson Associates, a family wealth manager in Solana Beach, California.

California is like a household where one spouse is a sales person, Hokanson said, noting: "It has good years and it has bad years."

LOOKS LIKE ANOTHER BAD YEAR

This year was supposed to be a not-so-bad year for California, with revenue improving after a few years of declines sparked by the housing crash, recession and plunge in stock prices following the Lehman Brothers bankruptcy.

Governor Jerry Brown and state lawmakers closed a roughly $10 billion deficit in June with a plan that balanced California's books with spending cuts, deferred payments, some fees and, most important, the assumption that an additional $4 billion in revenue would flow into state coffers.

The money would be generated by the state's gradual economic recovery and wealthy taxpayers who pay the bulk of personal income taxes, the state's most important revenue source, as their capital gains increase with the stock market extending its climb from its March 2009 low.

That plan may soon need to be revised.

Even before volatility struck the stock market this month, California's revenue was not meeting expectations: July revenue was $538.8 million, or 10.3 percent below its projected level in the state's recently enacted budget, the state controller said on Tuesday.

'HEADLINE RISK' RETURNS

A new budget shortfall in California will rattle many investors in the U.S. municipal debt market, where the state's finances are closely watched, given how much debt it sells.

Some will steer clear of California's general obligation debt as lawmakers resume their perennial partisan fight over balancing the state's books, which routinely drags on for months and past deadlines for having spending plans in place.

Many bond investors will, however, look beyond "headline risk" and snap up the state's tax-exempt general obligation debt. It has sold briskly in recent years, thanks to high yields and talk of tax hikes in Washington and Sacramento.

"California has found equilibrium in the bond market ... precisely because investors are yield starved and because they expect taxes to go up," Hokanson said.

Additionally, investors have been reassured by California debt's top priority in terms of state payments.

"There is a high degree of confidence the State of California is going to be here by next week," said Bill Mullally, president of broker-dealer Alamo Capital in Walnut Creek, California.

The prospect of another California budget gap is for now of small concern to clients of Brian Berberet at investment advisory firm Carrick Bend Advisors in San Mateo, California. He said they're focused instead on the national economy and European debt issues and how they could escalate.

"It pales in comparison," Berberet said. "There are so many other things that are top of mind."

(Reporting by Jim Christie; Editing by Jan Paschal)

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