Those Oblivious Fools... How to Make Money Off 'em

Greetings from Southern California... Ground zero of denial.

Here in California, home prices have dropped more than in any other state. They're down 27% in the past year... and as much as 44% in the "hottest" bubble markets like San Francisco. Unemployment here has jumped from 5.9% in late 2007 to 9.3% (as of December).

But as I drove up the coast this past weekend, I passed Bentley and Ferrari dealerships from Newport to Laguna Beach. It seemed every other car was a Mercedes... driven by teenagers and twentysomethings.

Friday night, I was in the Gaslamp district of San Diego. The streets were packed with kids... fashionably dressed kids, everywhere, partying away, blowing their money (or their parents' money). 

The Gaslamp Strip steakhouse doesn't take reservations. But I walked up with a few colleagues at 7 p.m., and the wait was nearly three hours. Doesn't sound like times are bad in San Diego.

California's government has been as deep in denial as these kids. It's increased its budget by 40% over the last five years. A big chunk of its money comes from property taxes... Apparently, it expected house prices would actually make it to the moon. California has behaved so foolishly, it has the lowest credit rating of any state. 

It's a terrible situation, but today, we have the chance to make some money off it...

You see, finally, Governor Arnold Schwarzenegger is facing the problem.

Schwarzenegger says the state is over budget by more than $40 billion and has to make cuts now. He suggests things like cutting the school year short by a week and cutting two Fridays out of the work month (essentially reducing pay for state workers by about 10%). And California might not send out tax refunds or welfare checks next month to conserve cash.

But that's not enough for investors in California government bonds (municipal bonds). They've panicked and run away.

For example, the PIMCO California Intermediate-Term Municipal Bond Fund had hovered around $10 a share for most of its decade in existence. Then last month, it dove down to a low of $8.21 a share. 

But PIMCO's bond managers have done their homework. One study they often cite (from Moody's) shows that, going back to 1970, the cumulative default rate on municipal bonds was 0.04%. 

PIMCO looked back even further... and found compelling evidence in favor of municipal bonds. Apparently, only Mississippi really defaulted – and that was long before the Civil War. According to the Wall Street Journal: "PIMCO says that from 1929 to 1937, the annual default rate across all municipal bonds, including those issued by cities and towns, was 1.8%. Bad, but not cataclysmic."

The Wall Street Journal concluded: "If the federal government stepped in to save GM and Fannie Mae, what are the odds it would allow California to file for bankruptcy? They seem pretty slim..." While Californians seem in denial about their current situation, Governor Schwarzenegger gets it. And California won't be allowed to file for bankruptcy.

Today, for the first time in decades... even a century... municipal bonds in general are a bit of a gamble. Because the state was in denial for so long, California bonds are the biggest gamble of the bunch.

But the PIMCO fund I mentioned currently pays 4.5% interest – tax free. You'd have to earn close to 7% interest in a taxable account to match the interest you can earn in California state bonds now. Plus, you could make a nice capital gain as investor panic subsides and the PIMCO fund heads back toward $10 per share. 

Good investing,

Steve