California’s IOUs may be difficult to cash in

July 1, 2009

With the California controller getting ready to send out the first batch of IOUs on Thursday, banks in the state are still trying to figure out if they want to buy the warrants from depositors. If they decide not to, get ready for crunch time and most likely the emergence of some kind of distressed debt market that will scoop up the IOUs – at a price – from those desperate for cash.

Just because the IOUs are sent to a specific person, business or local government doesn’t mean that they can’t be traded in or simply just traded. Whoever ends up holding them by their maturity date can redeem them with the state. And there’s certainly enough IOUs coming down the pipeline to make for a nice liquid market.

The controller expects to send out $3.36 billion IOUs this month alone, if the state can’t fix its finances. And there will be plenty more to come in August and September, when the cash shortfall is projected at $3.7 billion and $6.5 billion, respectively.

But there is a catch. California will stamp an Oct. 1 maturity date on the IOUs, but will only redeem them if there is sufficient cash available.

That adds another layer of risk given the gridlock over the budget and the more than $24 billion gap that needs to be closed by lawmakers and a governor who can’t agree on where the pain should be felt most. It also means a logistical headache for those holding the IOUs since presumably they would have to send in the old IOUs to get new ones if the state coffers are still empty.

The last time California paid out IOUs in the early 1990s, some banks stepped up to the plate and paid cash for the warrants, profiting from the interest paid by the state when they were redeemed.

Beth Mills, spokeswoman for the California Bankers Association, said bankers are still struggling to sort out how they’ll protect themselves against possible fraud and the impact of a redemption extension beyond Oct. 1. Banks are also waiting to see what kind of interest rates will be attached to the IOUs. Rates will be set Thursday. Mills, though, notes that the rate can’t be more than 5% due to statutory guidelines.

7 comments

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Credit unions will honor the IOUs. They put their members first. It’s a hundred year-old belief. Learn more about credit union philosophy at findacreditunion.com

Ridiculous.
What’s next – paying in produce?
This reminds me so much of the cooperatives in Eastern Europe – members got paid in grapes, wine, flour and other items. More and more this country begins to look like a socialist country, I am sorry to say.

Posted by Lou | Report as abusive

Fitch downgraded California general obligation bonds to A- a few days ago and placed them on Rating Watch Negative. If the credit rating agencies were to make additional cuts in their estimate of California’s credit quality, then it would be unlikely that California banks would be permitted under banking regulations to purchase California warrants, since such instruments would be deemed “speculative.”

It is more likely that a secondary over-the-counter market would have to handle any trading of warrants. Prices would be well below par, perhaps 80% to 90% if the crisis is contained, but I would not rule out street prices of 25 cents to 50 cents on the dollar, depending on the neighborhood.

Another problem with hoping that banks will buy the warrants is that even if regulators overlook the risk, the bank itself is probably taking on more risk than the 5% interest rate limit compensates for. Buying warrants would be a loss-making service performed more as a promotion to increase customer loyalty than to make money.

Posted by civilator | Report as abusive

Jct: There’s nothing wrong with small denomination California State IOUs if I or anyone else can pay their taxes with them. When Argentina’s government workers were faced with cuts, their unions talked 6 state governments into paying them with small-denomination state bonds which could be used to pay for state services and taxes and which everyone accepted as useful currency. Best of all, when the local currency is pegged to the Time Standard of Money (how many dollars per unskilled hour child labor) Hours earned locally can be intertraded with other timebanks globally! In 1999, I paid for 39/40 nights in Europe with an IOU for a night back in Canada worth 5 Hours.
U.N. Millennium Declaration UNILETS Resolution C6 to governments is for a time-based currency to restructure the global financial architecture. See my banking systems engineering analysis at http://youtube.com/kingofthepaupers
Too bad California State IOUs won’t be accepted in payment for state taxes and services like state bonds were in Argentina. Too bad California State IOUs will be denominated too big to use as local currency. Too bad Argentina people were smart enough to avoid the tent-cities catastrophe and California people are too stupid to follow their example.

As the oldest California bank owned by, operated by and serving the Latino communities of Los Angeles and Santa Ana, Pan American Bank decided yesterday to fully honor its customer’s presentation of warrants (IOUs). Like the comment above regarding credit unions, Pan American Bank for over 40 years has supported the working class Latino. We have a duty to meet the needs of our communities which have given us the opportunity to thrive for four decades.

Jesse Torres
President and CEO
Pan American Bank
3625 East First Street
Los Angeles, CA 90063
(323) 264-3310

http://www.earthtimes.org/articles/show/ los-angeles-bank-to-honor-california-iou s,880116.shtml

It sounds like the Government of California is adopting Social Credit policies.

Posted by Jimmy | Report as abusive

Matt,

Credit Unions are putting their members first by cashing the warrants? How’s that? They’re loaning other members’ money to those presenting the warrants for payment and hoping the California government will honor the IOU…how is that “putting the member first”? It seems more like it is “putting the credit union at risk” in my view through risky loan practices.

Posted by Ken | Report as abusive