California budget nightmare

NEW YORK (CNNMoney.com) -- Note to Californians: Get ready for larger class sizes, fewer police patrolling the streets and more public offices shuttered on weekdays.

State officials are now scrambling to close a $21.3 billion fiscal shortfall, a gap that grew by $6 billion overnight after residents voted down five budget propositions Tuesday.

The state must make "severe cuts now," Gov. Arnold Schwarzenegger said Wednesday. He and state legislative leaders will have to hammer out a budget deal before the fiscal year ends on June 30.

"There will be around $5.3 billion in additional cuts in education, there will be severe cuts in health care, which is another area where you know we spend a lot of money, and then of course you have to go and look in other areas like prisons," said the governor, who was in Washington, D.C., meeting with the Obama administration.

While most states are facing cash crunches as the economy weakens, California's problems are larger than most. Only three months ago, state officials agreed on a budget deal that closed a $40 billion gap by cutting $15.8 billion in spending, temporarily raising the state sales tax by a penny, borrowing $5.4 billion and using nearly $8 billion in federal stimulus funds.

Back at the budget table

Now they are back at the table, facing another massive shortfall. And unless the budget problems are addressed, the nation's most populous state won't have enough money to pay many of its bills on time in the coming fiscal year, the California Legislative Analyst's Office said earlier this month. The state comptroller already had to delay $3 billion in payments in February because of a lack of cash.

California's options are more limited than most. Leaders are constrained by having the nation's lowest state bond rating, which makes borrowing more expensive, and by a multitude of voter-approved propositions that dictate their spending.

"They are not flush with choices," said Jerry Nickelsburg, senior economist with the UCLA Anderson Forecast. Officials will look to education, health care and prisons because "they are about the only places you can find the money."

The defeated proposals would have allowed the state to divert money earmarked for early childhood education and mental health programs into the general fund and to borrow funds from the state lottery.

Even if these measures had passed, Schwarzenegger said he still needed to cut $3 billion from education spending, reduce funding for the state's Health and Human Services department, reduce the state workforce by 5,000 people and obtain $6 billion through short term borrowing to close a $15.4 billion gap.

Last week, the governor said that if the propositions are defeated, he'd be forced to cut another $2.3 billion from the education budget, eliminate funding for substance abuse treatment, crime prevention, HIV education and prevention and outreach efforts by the state public college systems. He would also have to borrow $2 billion from local governments, forcing them to cut back their spending on law enforcement and other services.

California residents will likely see teachers laid off and a shorter school year, said Daniel J.B. Mitchell, professor of management and public policy at the University of California at Los Angeles. Already, the Los Angeles court system announced it will be closed one day a month to conserve funds.

"There's no end to the things you can cut," Mitchell said. 

Senate OKs credit card curbs

WASHINGTON (CNNMoney.com) -- The Senate on Tuesday voted 90-5 to approve a bill that will make it tougher for credit card issuers to raise fees and interest rates starting early next year.

The bill includes an unrelated measure that would allow people to carry concealed weapons into national parks.

The bill now goes to the House, which is expected to take it up on Wednesday and pass it before the weekend. The bill would get to President Obama's desk before Memorial Day, as he called for.

"To have the industry reaching and be as abusive to consumers, it needed to stop and it needed to change," said Sen. Chris Dodd, D-Conn., a bill sponsor.

The legislation is moderately tougher on card issuers than are new Federal Reserve rules that take effect in July 2010.

The Senate's bill would take effect in nine months and make it harder for people under age 21 to get credit cards. It would also ban rate hikes unless a consumer is more than 60 days late - and then restore the previous rate after six months if minimum payments are made.

The banking industry decried the bill, saying it would exacerbate the credit crisis and force banks to drop some risky credit card holders.

"We are concerned that the Senate bill will have a dramatic impact on the ability of consumers, students, and small businesses to obtain and use credit cards," said American Bankers Association president Edward Yingling

The credit card legislation has been a long work in progress. The House passed a bill in 2008 and again earlier this year. The legislation, which stalled in past years, was propelled by public outrage and pressure by President Obama.

"I'm very glad to have these reforms within reach at long last," said the bill's House sponsor, Rep. Carolyn Maloney, D-N.Y. "To Sen. Dodd's credit, he has enhanced my bill in a few areas - especially in extending from 30 to 60 days before penalty rate hikes can kick in on existing balances."

Maloney added she thought it "unfortunate," that the measure to allow concealed weapons in national parks remained on the credit card bill, especially since Memorial Day kicks off the summer season at national parks. She planned to vote against the gun provision but said it shouldn't block the bill's final passage.

In recent few months, credit card companies have been raising fees and interest rates. From November 2008 to February 2009, rates increased from an average to 13.08% from 12.02%, according to a Federal Reserve Board report.

At the same time, more people are not able to make their credit cards payments and are walking away from the debt, according to a Federal Reserve report.

However, Treasury Secretary Tim Geithner said Monday he was not concerned about a consumer debt "bubble."

"Americans are going to be reducing how much they borrow, improving their balance sheets, saving more," he said. "Banks are still going to have losses they're going to have to adjust to. And that's what's going to make the process of repair here longer. . .But that's a necessary, healthy process of adjustment for us to go through." 

Green shoots? Check the yield curve

NEW YORK (CNNMoney.com) -- If you're looking for a sign that the economy may be on the mend, look no further than the Treasury yield curve -- a closely monitored harbinger of the economy.

The benchmark yield curve measures the difference between the 2-year and 10-year note yields.

When the spread between the two yields widens, it typically signals that the economy is headed for recovery. That's largely because it is viewed as the market rewarding investors for putting their cash away for a longer period of time.

When the spread narrows, or even becomes negative, it typically signals that the economy is headed for rough waters because it means that jittery investors are desperate to sink their cash in a short-term bunker trade.

On Wednesday, the spread between the 2-year and 10-year notes widened to 2.38%, or 238 basis points, marking its broadest since mid-November. It pulled back to 235 after the Federal Reserve released the minutes of its latest meeting. But to show just how wary investors had become, the spread was a full 100 basis smaller in late December.

Does this give investors reasons to cheer? Well, yes and no, said David Ader, head of government bond strategy at RBS.

"Traditionally, the answer is yes [but] we have never dealt with this type of a deficit before ever, ever, ever," said Ader. "It is not clear to me that this steepening that we are seeing here is a sign that the economy is coming out of a recession."

Government debt is considered one of the safest places to invest. In times of financial market turmoil, short-term Treasury prices skyrocket, thus lowering the yield. Government debt prices and yields move in opposite directions.

In early December, for example, the yield for the 3-month Treasury bill bottomed out all the way to zero, indicating that investors were more concerned with keeping their investments safe than making any kind of a profit.

Fed's role. Economist say the widening of the benchmark spread may have more to do with the government's never-before-seen attempts to right the staggering economy than as an indication the economy is in recovery mode.

The Federal Reserve has kept its key rate at a target range of between 0% and 0.25% since December in an effort to spur lending.

The front end of the yield curve, including the 2-year note, is tied closely to the Federal Reserve's key lending rate. "You have a front end that is locked," said Ader. "It fluctuates 10 or 15 basis points up or down," but as long as the Fed's hands are tied to keeping interest rates low, then so are shorter term Treasury yields.

It's all in the 10-year. With the 2-year note at a virtual standstill, much of the spread's movement is being led by the 10-year note, which has seen its yield rise above 3% in recent weeks.

In mid-December, the 10-year yield was just over 2%. Wednesday, it was hovering near 3.13%. (Full story)

"The end of last year - the last quarter of 2008 - was panic," said Ader. Investors were freaked out as major financial institutions were crumbling and Wall Street was sinking. As part of "the great deleveraging trade," investors sold out of everything except Uncle Sam's debt, and "that gave the 10-year sector something of an exaggerated bid."

Furthermore, the government unveiled unprecedented spending initiatives to prop up financial institutions and restore investor confidence. The government started backing debt and buying mortgage backed securities. In order to pay for the various stimulus programs, the government has had to bring a record amount of new issuance to market. The sheer volume of supply has put downward pressure on bond prices, sending yields higher.

In an effort to try to stabilize sinking Treasury prices and rapidly rising yields, the government entered into a program of quantitative easing, where it set out to buy back its own debt. The Fed announced it would buy $300 billion of long-term Treasurys through August in order to stimulate demand.

"Even though the Treasury has bought back $300 billion, it pales in comparison to the size of these other programs," said Ader. The supply of debt that has been flooding the market is sending bond yields higher, widening that 2-10 year spread.

Inflation worries. As the government spends at a breakneck pace in order to jumpstart the economy, some economists fear that inflation will turn around to bite the recovery efforts.

0:00/5:15Economist: Low demand is a risk

Fears of inflation would also pressure the prices of longer maturity Treasurys, sending those yields higher. While Ader admits that inflation could end up affecting the market down the road, he said that the "supply dynamics" in the Treasury market were overwhelming the effect of inflation.

He noted that gold and inflation protected bonds - or TIPS - have been holding relatively steady. If inflation fears were dominating investor woes, those marketplaces would show more action.

The spread in the benchmark yield curve has more complex factors widening it than in other periods of economic slowdown. "Interest rates may not indicate that there is a recovery right around the corner," said Ader, "or if it is, it is a corner way down the road." 

You haven't learned your lesson

NEW YORK (CNNMoney.com) -- Thrift is the new black. Cheap is chic. Well, it is for now at least.

Much has been made about how consumers and investors have finally learned a hard lesson as a result of this severe economic downturn. Too much debt is bad. So is conspicuous consumption.

Forget about buying a new car just because your neighbor bought a new SUV. Stick with the one you have for a couple more years. Why shop at a fancy department store when you can go to Wal-Mart (WMT, Fortune 500) or Costco (COST, Fortune 500)? And why eat out when you can stay at home and cook a nice meal that costs a lot less?

General Electric (GE, Fortune 500) CEO Jeff Immelt has dubbed what's going on in the economy as a "permanent reset."

0:00/02:05Economy is not yet recovering

But have people really learned that they have to change their ways? According to a survey released Tuesday by HSBC Direct, the online bank operated by British banking giant HSBC (HBC), an overwhelming majority of those polled said that they didn't expect people's newfound sense of stinginess to last.

According to the survey, 85% of respondents said that they have in fact modified their savings and spending as a result of their recession. But interestingly, 76% of respondents said that they also thought most Americans would go back to their old habits once financial conditions improved.

So it looks like a lot of people think that they are going to be more responsible, but that you won't. I guess you could call it the paradox of the paradox of thrift.

To be sure, it is a good idea for people to save more in general. The problem though is that aforementioned paradox.

If everybody hunkers down, it's going to be tougher to get out of this economic funk. Businesses are not going to start hiring more people and producing more again until it's certain that demand for goods and services is returning.

In other words, it's nice to encourage people to save for the proverbial rainy day. They don't, however, need to save for a flood of biblical proportions.

"It's incumbent on banks, governments and regulators to instill a savings mentality in consumers from an early age," said Neil Brazil, vice president of public affairs with HSBC Direct "Disciplined saving is healthy. But there has to be a balance."

Talkback: Do you think people will really start saving more and spending less? Leave your comments at the bottom of this story.

Not everybody thinks that Americans will return to their reckless spending patterns of the past. Robert Prechter, president of Elliott Wave International, an investing research firm based in Gainesville, Ga., said he sees comparisons to what happened in Japan during its so-called lost decade.

Prechter thinks consumers are going to be afraid of debt for some time -- and that's one factor behind the continued credit freeze. The Federal Reserve has tried to get banks to start lending more freely. But even if banks do start to lend more to responsible consumers, those consumers may be unwilling to borrow.

"The reigning adage has changed from go into debt and invest and speculate to get out of debt and stay thrifty," he said. "I think that what has happened over the past year will change behavior for at least a decade. That's one reason why it has been so difficult for the Fed to expand credit."

Along those lines, a survey done by advisory firm AlixPartners in March showed that Americans expect annual spending to return to just 86% of what it was before the start of the recession. What's more, Americans said they plan to save 14% of total earnings.

But cynics would argue that consumers may never learn their lesson. It is human nature to speculate and try and latch on to the next big thing -- whatever that turns out to be -- once the market improves.

"I do not believe that Americans will have a cathartic realization that they need to save," said Michael Pento, chief economist with Delta Global Advisors, Inc., a money management firm. "Interest rates are low and that's going to eventually provide a lot of easy credit and influence consumers to engage in unhealthy practices of spending more and saving less."

I hope he is wrong. But history does have a way of repeating itself.

After all, did investors really learn a lesson from the tech bubble's bursting in 2000? I guess they learned that it didn't make sense to use money on margin from their online broker to buy unprofitable Internet companies like Pets.com. So people did learn that dot-com stocks wouldn't go up forever.

But investors started to speculate elsewhere once the economy bounced back. Instead of going into debt to buy overpriced Internet stocks they went into debt with no-money down option ARMs to buy overpriced houses they couldn't really afford. Because it would be easy to flip those properties for a big profit since, you know, housing prices would go up forever.

So what's going to be the next new bubble? You could make the case that some bank stocks are starting to look frothy now that many have more than doubled in just two months. The same might be true for oil and other commodities.

But rest assured, as long as the free market continues to function (and it is, despite massive government meddling), you can rest assured that investors and consumers will find something new to get excited about -- even though it's probably not going to be housing again. We did learn some lessons, mind you.

"When an asset bubble bursts, it's never the first to recover. So home prices will probably be the last thing to bounce back," Pento said. "But whatever the next big up cycle is, it will be led by something different than this one."

Talkback update: Greetings Buzz readers. There is a new way to post comments for this column. If you have a Facebook account, you can submit your feedback using the Facebook Connect feature that will appear at the bottom of the page. If you don't have one, it is free to sign up.

The good news is that reader comments will now appear immediately and on the same page as the column as opposed to a separate page. I trust that loyal Buzz readers will continue to actively share their thoughts with this new feature. And rest assured, I will still be using the best reader reaction as fodder for video installments of The Buzz.

So with that in mind, here is today's question for readers. Do you think people will really begin to save more and spend less? 

Seven lucky consumer businesses

NEW YORK (CNNMoney.com) -- With shopping no longer their favorite pastime, Americans appear to be spending their money in other ways, such as acquiring new skills, getting help with their finances and visiting the dentist.

This change in spending behavior is helping trade schools, accounting firms and even your neighborhood dentist survive the economic downturn better than other businesses, according to an industry report.

"Our data show that companies selling non-discretionary products and services, things that people really need, are doing pretty well," said Brian Hamilton, CEO of Sageworks Inc., a Raleigh, N.C.-based company that analyzes weekly financial data such as sales, balance sheets and income statements for privately held companies across 1,600 industries.

0:00/2:28How to sell a car

Hamilton said seven industries are clearly benefiting from a pickup in sales over the past 12 months.

Auto repairs, home repairs: April's retail sales numbers showed consumers are still shunning big-ticket purchases. So instead of buying new cars or upgrading to bigger homes, they are spending money on maintaining what they already own.

Auto repair shop sales grew 2.4% over the last 12 months while car dealership sales declined by 9.7%, according to Sageworks.

As more people remodel and fix their homes instead of moving, revenue for electricians, plumbing and heating contractors has grown 4.6% in the last 12 months while home builders' sales declined by more than 5%.

Supermarkets: Many consumers are looking to save money by eating at home more than eating out. This trend has favored grocery stores, resulting in a 6.7% sales increase for supermarkets in the last 12 months.

By comparison, Sageworks' data showed family-style restaurants logged a slower 3.9% sales increase.

Trade schools: With an average of 600,000 Americans losing their jobs every month, many are going back to school to learn new skills and improve their chances of rejoining the workforce when the economy rebounds.

Revenue at trade and technical schools has grown by 9.1% in the last 12 months, a faster pace than the 5.9% growth in 2007.

Dentists' delight: Hamilton said health care has been one of the most recession-resistant sectors, since people regard it as a necessity.

Sageworks' data showed the average dentists' office logged sales growth of 6.9% in the last 12 months, up from 4.9% in 2007.

Looking good: Personal care extends to looking good through the recession. While Americans may be making concessions on high-end services, they are still getting regular haircuts and manicures.

Hair salons, barber shops, nail salons and spas logged sales growth of 4.5% in the last 12 months, according to Sageworks.

Help with finances: Many consumers aren't shying away from paying for financial advice to help them make it through the recession.

Sageworks' data showed that the accounting industry ranked among the top 10 industries in terms of revenue growth, with a 10.2% gain in the past 12 months.

"These patterns show that the recession has been lopsided," said Hamilton. "Although the economy has slumped, we're not getting a decline across all industries. Very specific industries like real estate are creating a big drag on the broader economy." 

4 economic pitfalls for Obama

(breakingviews.com) -- President Barack Obama may be making a broadly decent fist of tackling the financial crisis and the recession. But he is also revealing leanings that could undermine economic recovery and efficiency in the longer term. It's still early days - but fighting these traits is crucial.

Of course, the president can rightly claim a mandate from the U.S. electorate for decisive action. Also, many of the stabilizing programs Obama and his team have continued or initiated appear to be broadly on a sensible track.

Yet four aspects of his approach could court trouble in the future.

First, he seems too prone to browbeat those who disagree with him, even when the other side has a good case. He referred to Chrysler creditors who wanted to uphold the traditional rules of bankruptcy as "speculators". That made the group sound unpatriotic. It folded soon after, before the bankruptcy court had a chance to rule.

Any creditors of General Motors (GM, Fortune 500) tempted to hold out against government plans are likely to face similar treatment. Obama was also slow to distance himself from hot-headed moves by Congress to tax some bankers' bonuses at punitive rates. Presidential bullying isn't unprecedented in the U.S., but too much political interference in commerce can undermine confidence in the fairness and predictability of the system - and that could be far worse for the economy than a less union-friendly restructuring of the auto industry.

Second, the government seems too relaxed about getting the needed financial restructuring right. Obama sometimes sounds determined to bring about a much needed reduction in the industry's influence in Washington. But the effect of the authorities' myriad investments and liquidity-boosting initiatives has been to extend the overlap between government and finance. It's not always clear that the government has the upper hand.

The unwillingness either to fully nationalize or to wind down Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), the giant housing finance businesses, is discouraging. The willingness to try to force markets to do the government's bidding - through the Treasury, the Federal Reserve, the Federal Deposit Insurance Corporation and other tentacles of government - also suggests a financial dictatorial streak.

Third, Obama's team sounds somewhat complacent about the need to reverse the extraordinary monetary and fiscal measures of the last year or so. To start, the huge budget deficit, the largest ever in peacetime as a share of gross domestic product, is expected to decline only very slowly.

Then there is the Fed. The central bank's fast-growing balance sheet has reached $2.2 trillion and its liquidity programs are still keeping the banking system in business. Ben Bernanke, the Fed chairman, has talked several times about the importance of having an "exit strategy", but he has been shy about details, despite pressure from China, the country's largest creditor.

Economist John Taylor, who gave his name to a well-known rule of thumb for setting interest rates, said last week that the Fed may need to raise rates soon to avoid making money too easy - a tendency, he said, that had contributed to the credit bubble. But it's hard to imagine even the supposedly independent Fed having the inclination and courage to follow Taylor's advice any time soon.

Finally, there's the trade deficit, which arguably created the debts that helped blow up the credit bubble in the first place. While the Obama team seems happy to force constraints on industrial and financial companies and markets, it seems less concerned to impose discipline on itself over this politically sensitive imbalance.

The trade deficit fell sharply as the recession deepened, but it rose again last month. If it keeps going in that direction, the administration should perhaps be more wary about the risks of credit once again getting out of hand.

It's perhaps churlish to expect Obama and his officials to be thinking too far ahead just yet. The administration's symbolic and almost unimaginably demanding first 100 days are only just behind it, and the still new president deserves the benefit of the doubt for now. But the unintended consequences of mistakes - and even of giving mistaken impressions - merit early consideration, too. 

A new road and 25 jobs from stimulus cash

NEW YORK (CNNMoney.com) -- When the first stimulus-funded infrastructure contract from the Rhode Island Department of Transportation went up for bid in February, Michael D'Ambra jumped at the opportunity to score a job for his shrinking company.

The staff of D'Ambra Construction, a family-run company in Warwick, R.I., dropped from 150 workers to 75 last year. "It was dismal," D'Ambra says of his firm's workload. "In the winter, it's normal for the [number of employees] to go down, but this spring, we couldn't call back very many."

D'Ambra Construction started landing Department of Transportation (DOT) contracts 20 years ago, and typically derives more than half of its annual sales from the work. Drawing on his decades of experience with the contracting process, D'Ambra placed a bid for the stimulus job. Moving quickly, the DOT awarded his firm the deal for $2.5 million.

On March 12, at a ceremony held by Governor Donald Carcieri, D'Ambra signed the contract. Less than two weeks later, his company broke ground, hiring back 25 of the workers it had let go.

The project calls for resurfacing and improving curbing, sidewalks and guardrails along 2.3 miles of Route 138, a major road that runs through the town of Tiverton, near the Massachusetts border. D'Ambra Construction has already finished half the job and expects to wrap it up by August.

Paul Durand, owner of Durand's Auto Gallery in Tiverton, calls the construction "a big mess in front of my shop" but is happy it's happening. "It needed to be done," he says. "There were potholes everywhere."

The Route 138 project was one of many that the DOT had on a list of federally approved jobs that were ready to be awarded, but it sat stagnant until the state knew it would have money to finance it. When the stimulus money became available, officials pounced.

"When there was the first inkling of a stimulus in September, we started to put together a list of projects that could be shovel-ready before inauguration," says DOT Director Michael Lewis.

The DOT has 53 projects it plans to fund with stimulus money, more than a dozen of which have been awarded so far. The department expects the projects to create 1,500 direct jobs in the construction industry and at least 3,000 indirect jobs. Much of Rhode Island's economy is made up of small business, and, particularly in the construction sector, government contract work is the bread and butter of their business.

"In September, Rhode Island was going neck-and-neck with Michigan in terms of unemployment," Lewis says. "It's crucial to their survival that they have predictable work."

D'Ambra will get to keep the workers he hired for the Route 138 resurfacing job. One month after being awarded that project, D'Ambra bid on and won a second DOT contract. The $5 million job, which will take place a few miles south of Tiverton on West Main Road, will be similar to the first contract but will also include the installation of new traffic signals and pavement-sensor equipment. D'Ambra anticipates hiring 30 people to work the job, which will start this year and finish by October 2010.

"We're continuing to bid for other projects," he says. "I'm hopeful that the 50 we're bringing back for these projects will stay on. We'll have a backlog, so everyone can stay on payroll next year."