Nearly every on financial regulation includes some blanket condemnation of credit-default swaps and other exotic derivatives, which somehow, along with greedy speculators, hedge funds and fat cat bankers, are routinely blamed for causing the world s economic collapse.

But as we wrote last year, credit-default swaps are perfectly legitimate and useful tools for determining how risky the market considers a particular credit to be. You can t dismiss the messenger simply because you don t like the message.

To that end, it s hard to ignore the warnings flashing from California where contracts used to protect against a default in the state s debt have risen 56% since September, veering back toward the crisis levels reached during the height of 2009 s panic. It now costs $310,000 to protect $10 million of the state s bonds against default for five years, up from $185,000 last fall and $61,000 in the summer of 2008.

The Subprime State?

California's Credit Risk

Source: Bloomberg, Rosewood Research

The world s eighth-largest economy, California, faces a $20 billion budget hole and a 12.3% unemployment rate. A glance at the budget indicates the majority of the spending isn t going toward police, fire or the judicial system. Nearly 82% of expenditures go toward health and education entitlements.

Go for Broke

Source: State of California

Higher risks demand higher risk premiums. According to Bloomberg, a taxable California bond maturing in 2039 now yields close to 7.8%, boasting a substantial 3.15% risk premium over 30-year Treasuries. Similarly dated tax-exempt bonds now yield 1.3% more than top-rated muni bonds nearing the distressed levels reached last summer when the state began issuing IOUs.

That s when Moody s and Fitch Ratings downgraded the state s credit rating to just a few steps above non-investment grade, i.e. junk. Now Governor Arnold Schwarzenegger plans to release 6,500 inmates from state prisons in an effort to save cash. No wonder 74% of residents feel as if California is on the wrong course.

Governor Schwarzenegger recently flew to Washington to ask for $7 billion dollars to help plug the budget gap. Already the state will receive $52 billion in stimulus from Washington in 2010 on top of the $32 billion it received in 2009, some of which was used to address last year s budget problems for a few months at least.

We ve written about the inherent fiscal danger of an entitlement state, a reality now being played out in real-time in California. And while it s easy to dismiss the warning signs from the credit-default-swap market as mere machinations of Wall Street speculators, the reality is that California is strapped for cash just as its immense pile of bills are coming due.

Those willing to lend to such a troubled borrower might consider shares of Nuveen California Municipal Value Fund Inc., Morgan Stanley Insured California Municipal Securities and BlackRock California Municipal Income Trust, or other closed-end funds that hold Golden State debt.

Given the state's failing finances and rising credit default swaps, it s unquestionably a risky trade.