Default, Cali Style Part 2

Martin Weiss of Weiss Research says that California defaulting on its $59 billion in debt is "unavoidable".

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.

In other words, should California miss a payment, the muni market turns into a chum factory during Shark Week, not to mention California's credit would be through, leaving the state unable to float more bonds without a heavy cost. Everyone out there who invested in California bonds would be holding increasingly worthless paper, and that $24 billion gap would end up growing as tax revenues are eaten up by credit costs.

In other words, California would no longer be a going concern without a bailout. It's not a question of if anymore, but when. One seventh of the population of America and 55 electoral votes will have long memories of internal state politics, but the national reponse to Cali's current disaster may have a much larger impact on everyone.

Even Republicans aren't going to write off California. They may not want to bailout, but you'd better believe they'll have to give one out.