California, which is struggling to close a $24.3 billion budget gap, faces the prospect of a multi-notch downgrade in its credit rating if the state's legislature fails to act quickly to produce a budget, Moody's Investors Service warned on Friday.

Moody's decision to place California's general obligation debt on alert for a possible multi-notch downgrade stunned state officials.

The state's current A2 credit rating is Moody's sixth-highest investment grade and makes California the lowest rated of the 50 states.

The A2 rating is just five notches above speculative status and Moody's raised the potential for the rating to tumble toward junk status if lawmakers fail to quickly produce a budget for Governor Arnold Schwarzenegger to sign.

If the legislature does not take action quickly, the state's cash situation will deteriorate to the point where the controller will have to delay most non-priority payments in July, Moody's said in a statement.

Lack of action could result in a multi-notch downgrade, Moody's added.

I cannot remember reading a ratings note that raised the specter of a multi-notch downgrade, said H.D. Palmer, a spokesman for Schwarzenegger on state finance matters. It's another clear warning from the financial markets that there will be substantial and costly consequences if the legislature does not send the governor a budget that he can sign.

A downgrade could push California's borrowing costs up at time when state officials expect to issue up to $9 billion in revenue anticipation notes as soon as possible after a budget agreement is notched -- a deal whose timing is in doubt.

Moody's said California's leasing debt and other state-related debt are also on review, affecting a total of $72 billion of debt.

STATE FINANCES A MESS

Moody's cited California's expected massive budget gap for fiscal 2010 of more than 20 percent of its general fund budget; warnings by the state controller that without budget solutions the state will not be able to meet all its financial obligations in July; continued political stalemate, and the limited options.

Schwarzenegger and lawmakers face the task of closing a $24.3 billion budget deficit for the state's fiscal year beginning on July 1.

The gap was opened by the state's most severe drop in revenues since the Great Depression, including a steep drop in personal income taxes and sagging retail activity as consumers reined in spending, and the long-running downturn in housing.

Rising joblessness is also weighing on the state. Its unemployment rate jumped to 11.5 percent in May from 6.8 percent a year earlier, state officials reported on Friday.

The UCLA Anderson Forecast unit said earlier this week that the state economy would grow at more normal levels by the beginning of 2011, but will not create enough jobs to push the jobless rate below double digits until the end of that year.

Standard & Poor's on Monday placed California on review for a possible downgrade, also citing concerns about the state's fiscal stress.

Spreads on California general obligation debt have widened as the state's budget crisis has worsened. Since May 1, the yield on the five-year California GO scale is up 92 basis points, compared with a rise of 41 basis points for the five-year benchmark Municipal Market Data triple-A scale.

The warnings by the rating agencies may scare off some investors from holding the state's debt, said Lawrence Glazer, managing partner of Mayflower Advisors in Boston. It appears that California will have some unpleasant decisions ahead of them. ... A scary headline is probably enough to shake some investors out of their positions in the State of California.

On the other hand, California's strained finances may attract investors looking for risk premium. Some investors will look at buying and getting a yield advantage from California, he said.

(Additional reporting by Ciara Linnane and John Parry in New York; Editing by Leslie Adler)

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