LOS ANGELES -- Some market participants have overreacted to California's problems and possibly created an attractive opportunity by driving yields higher than necessary on the state's general obligation bonds, according to a report by Sanford C. Bernstein & Co.

The report, which came out this week and updates a 1991 analysis that correctly predicted a round of downgradings for the state, concludes that California's fundamental strength supports a double-A general obligation rating.

The Bernstein report argues that the last rating change by Standard & Poor's Corp. to A-plus "and the recent high yield on California bonds represented an overreaction to ongoing cyclical factors."

The report says it is unlikely Standard & Poor's "will change its rating in the near future, [but] we expect that within the next two to three years the AA rating will be restored."

In the meantime, however, "recent increases in the yields on California's bonds have represented a tremendous opportunity," the report says.

Specifically, yields higher than those consistent with a double-A rating, or yields higher than those consistent with a single-A for the state's lease obligations, "represent an attractive opportunity," the report concludes.

A Standard & Poor's official declined to respond to the report. The official reiterated, however, that his firm's last downgrading of California reflected specific reasons, including concern over the state's lack of timely corrective action to address recent serious budget problems.

Moody's Investors Service and Fitch Investors Service rate the state's GOs double-A, and the report calls this level appropriate.

"Given the weakness of its economy, the size of the budget gap, and the outlook for continued fiscal pressure, it is easy to overlook California's basis credit strengths and overreact to the current conditions affecting the state's credit position," the report says.

"It is the state's vast economic resources, high wealth levels, still quite manageable debt burden, and recent positive budget actions that we continue to see as contributing to high-quality bond security," the report adds.

Joseph Rosenblum, director of municipal credit research at Bernstein, prepared the report along with Fred Cohen, a municipal credit analyst. Rosenblum worked at Moody's for over nine years before joining Bernstein in 1990.

In an interview yesterday, Rosenblum said he believes "people fall into a trap" by overemphasizing California's recent problems. He cautioned that "some analysts get too caught in it" and allow themselves to be swayed by extensive bad publicity focused on California.

The state "is not alone in terms of having budget problems," Rosenblum noted, adding that a comparison with other states still shows California with many fundamental strengths.

Rosenblum stressed he is not downplaying the state's fiscal pressures. For example, his report notes that California's recession ranks among the worst since World War II.

But the Bernstein report concludes that cyclical economic factors especially weakness in defense and residential and commercial real estate, are the main causes of California's credit problems.

"This confluence of negative factors has led some commentators to suggest that the sun is setting on California's golden era," the report says. "We come to a different conclusion."

Indeed, the report argues that the cyclical weakness California is experiencing "is likely to prove to be a very positive influence on its longer-term creditworthiness."

Last year's Bernstein report on California, which was also released in October, expressed concern over the structural imbalance in the state's budget as expenditure growth continued to outstrip revenue increases.

But "the budget just adopted, while it includes a number of one-shot revenue items and will not totally prevent further budget stress, represents a major first step in realigning resources with commitments," this week's report says.

By using historical comparisons, the Bernstein report also observes that the state's overall economic performance resembles past downturns.

"Despite arguments sometimes made to the contrary, the state's economy has always been sensitive to national business cycle developments," according to the report.

The report says it would be wrong to compare the state to less-diversified ones that suffered downturns in the 1980s. Rather, "because California's economy so closely resembles that of the nation in terms of diversity and cyclicality, the state's economic rebound will largely depend on the national recovery," the report says.

The report forecasts an eventual real estate rebound, partly because California's rising population will likely spur housing starts.

Although the report acknowledges that defense spending "seems sure to remain in decline," it also notes that this spending now represents a much smaller component of the state's economy than 25 years ago.

The state will continue to face budget imbalances through fiscal 1994, though it "has probably seen the worst of its revenue declines," the report adds.

California's increased borrowing in recent years also is an issue, the report notes. The state's debt ratios now are close to state medians (see table). But even though the state's debt position is relatively weaker than in the past, it "remains manageable," according to the report.

Before the state's recent $1.3 billion GO bond sale, portfolio managers at municipal bond funds expressed varying opinions relating to California's credit worthiness.

Some managers generally agree with Bernstein's double-A assessment. But some consider the state a strong single-A, with room for improvement.

At times in recent months, yields on some California GOs traded upwards of 45 basis points over triple-A levels. Bernstein considers such differentials a buying opportunity. Rosenblum said, because that wide of a rate spread is more consistent with a single-A than a double-A credit.

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