Montreal, Canada.

It’s not a pretty site for state finances.

California, the world’s ninth-largest economy -- is bankrupt once again. The state issued its first batch of IOUs yesterday as its coffers ran dry. Though extreme, California is certainly not alone this year as many other states grapple with a bear market in revenues, rising unemployment and increasingly grow dependent on Washington to fund state and municipal operations.

States face a cumulative shortfall of $230 billion dollars from now until 2011 as revenues plunge since 2007. In 2009 alone, the cumulative budget gap for states is $121 billion dollars, according to the National Conference of State Legislatures. Thus far, 42 U.S. states have slashed enacted budgets to cope with rising demand for services and sharply declining revenues, according to the National Governors Association.

State and local sales-tax revenues fell more sharply in Q4 2008 than at any time over the past fifty years. For the first two months of 2009, 41 states that reported tax revenues saw total receipts fall 12.8% compared to 12 months ago.

Of the $787 billion dollars recently legislated by Congress to boost economic growth, about $246 billion has already been deployed to states. In early June, Treasury issued $25 billion dollars in bond authority available to state and local governments under the Recovery Zone Bonds program.

The bad news, however, is that all of this money is now in the process of being spent by states and by next year more government assistance will be required because state revenues are still declining. This has created a dangerous cycle of government interdependence for the most fiscally challenged states – including California, which by all intents and purposes is basically broke in 2009.

I don’t like buying or owning an investment that relies on government support. We all know the rules can change suddenly in uncertain times and depending on government to secure your retirement or long-term investment goals is the wrong way to invest.

If you own a bunch of municipal bonds then I would carefully review your portfolio to ensure the following:

• Is your state solvent without federal aid? You can obtain this information at your state’s budget survey online or at www.sunshinereview.org;

• If not, consider several top-rated national municipal bond funds as ranked by Morningstar to ensure proper diversification and risk allocation;

• Make sure your municipal bonds or bond funds are liquid. If you have to sell your bonds then ensure there’s no liquidity issue. You shouldn’t have to wait more than 24-hours;

• Limit your portfolio duration to a maximum of 5 years. Duration measures interest rate sensitivity. Though rates will stay low for the foreseeable future, make sure you don’t own long-term bonds with maturities extending beyond 2015;

• States with the best balance sheets include Texas and The Dakotas.

Despite the compelling tax savings, I’m very cautious about most municipal bonds because I’m in the camp this economic expansion will be sluggish for the next few years. Consumers are not spending, the unemployment rate is still rising (at 9.5%) and the housing market has not bottomed. This will NOT be a typical post-WW II expansion because bank credit is not expanding and borrowers are largely absent.

Texas is currently only one of six states not facing a budget deficit. The same goes for North and South Dakota and several others.

In Texas, state revenues are projected to decline 10.5% in 2009 compared to 2008, the state has apportioned some money for emergency funding or a Rainy Day Fund. The Rainy Day Fund was established in 1987 following a severe economic downturn and a sharp decline in oil and gas prices. The fund is expected to reach about $9.1 billion in assets by 2011.

Texas, of course, relies heavily on oil and gas revenues to boost its balance sheet. The state continues to benefit from strong oil prices – which have doubled since February – and will shortly receive $11.4 billion from Washington’s Economic Recovery and Reinvestment Act or the $787 billion dollar stimulus bill. That will further cushion Texas’s coffers.

I like the prospects for Texas longer term. That’s because I’m an oil and gas bull and believe she’ll continue to benefit from the trend in rising energy prices and Peak Oil, or a global phenomenon tied to declining oil production coupled by rising consumption mostly in the emerging markets. You could say Texas is in a “sweet spot.”

Also, Texas, though taking federal assistance – like all states – can live without it. The state is one of the few in the Union to balance its books.

If you must own municipal bonds to reduce your effective tax rate, then be especially careful now. These are not normal economic times. The wrong way to invest for the future is to depend on government to bail-out your state -- which means that in the absence of federal aid your state might possibly default on its debt. Though unlikely, this is a growing possibility in the post-2007 credit crisis.

I’m off next week to Spain for a summer break. I’ll be back blogging on Tuesday, July 14 from Tonsberg, Norway. Until then, Happy July 4th and Happy Canada Day!