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.


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