Commentaries

Money market funds and California RANs

There’s one group of investors that aren’t likely to jump at the chance to buy California’s short-term RAN notes when they go on sale later this week: money market funds.

The notes are expected to carry a second tier rating of MIG 2, a notch below the top rating of MIG 1. That’s problematic for money market fund managers who are staring at the SEC’s proposal to limit money fund investments to short-term debt rated only the very best.

Higher Credit Quality: The proposal would limit money market funds to investing only in the highest quality securities — that is, not “Second Tier” securities. Currently, most funds are permitted to invest up to 5% of their assets in “Second Tier” securities.

5% may not seem like a lot, but when money market funds hold roughly $3.8 trillion in assets, it’s not chump change.

To be money market eligible, California would have to secure some kind of bank back stop. But given the still uncertain outlook for the state, it could be difficult to get a bank to guarantee up to $10.5 billion.  JP Morgan loaned the state $1.5 billion so it could end the IOU program early, which the state will pay back with RAN proceeds. But I’m not sure if JP Morgan or any other bank is going to want to be on the hook for $10.5 billion into next year when California’s future revenues are still so uncertain.

California debt rush

Talk about a comeback. After a bruising budget fight that forced it to issue IOUs, California plans to sell as much as $10.5 billion in short-term debt later this month.

A reach for yield should trump lingering doubts about the state’s prospects among the small and large investors who are expected to snap up the revenue anticipation notes.

But potential buyers should also be sure to have strong stomachs, as the Golden State remains anything but golden.

The timing for such a sale appears to be good. Confidence in California debt has improved greatly since the state passed its budget, and the minuscule return on most short-term debt means the expected 2.5 to 3 percent yields on the new RANs would give individual investors and mutual funds who invest in such debt a nice bump to their holdings.

RANs essentially borrow against future revenues and are very useful for plugging cash shortfalls, as California well knows — the state raised $5 billion last year and $7 billion in 2007 through these notes that mature in less than a year.

This year, the notes will help bring to an end the IOU saga that brought embarrassing national attention to the state’s fiscal mess, by repaying a loan from JPMorgan Chase that allowed the state to stop issuing the IOUs a month earlier than expected.

But estimating what California’s revenue will be is a tricky business. Just ask the state’s Controller, John Chiang, who is charged with reconciling the state’s estimates with reality on a monthly basis.

California hosts garage sale to raise funds

California Governor Arnold Schwarzenegger is pulling out all the stops with the state’s “garage sale” of unclaimed or unneeded merchandise. The idea came to him via a “tweet,” he’s using his Hollywood cache to juice bidding and it’s all in the name of belt tightening.

The LA Times has the story:

In his latest effort to balance the budget, the governor is cleaning out the state’s storage sheds and holding a garage sale on Craigslist and EBay.

Need a 2001 Ford Focus wagon with 110,059 miles and Schwarzenegger’s autograph on the visor? Someone did, offering the high bid of $1,625.01 for the old state car as of Tuesday afternoon. The governor got the idea to sign the visors from one of nearly 1 million people who follow him on Twitter, and he jumped on it.

“I look forward to selling these signed cars and making some $ for California,” the governor tweeted last week as he autographed the visors….

The state began selling unneeded or unclaimed items online last week and is holding a two-day auction of 6,000 more on Friday and Saturday at a Sacramento warehouse.

If you want to take a look at the stuff on offer, check it out here.

(HT: WSJ’s Real Time Economics)

California IOU’s soon to be DOA

As J.P. Morgan Chase has seemingly been the only rock in the financial storm, it is not surprising that the bank is now helping California, lending it $1.5 billion. The money will enable the state to stop issuing IOU’s a month earlier than planned (on Sept. 4). The loan is essentially a bridge until the state sells $10.5 billion in short-term notes next month. Here’s Reuters’ story.

The Los Angeles Times says:

The risk to JPMorgan is virtually nil: The loan will be repaid by late September, when the state plans to sell $10.5 billion of so-called revenue anticipation notes, or RANs — securities that will mature next spring. Individual investors are expected to flock to the RAN offering as a place to stash cash, because the notes should offer much more lucrative returns than money market funds and other short-term accounts paying next to nothing.

Some muni bond analysts expect the annualized interest yield on the RANs to be between 2% and 3%. For California residents, that interest would be exempt from state and federal income tax.

The loan is something of a about-face: J.P. Morgan was among the banks that refused to accept the state IOU’s after their first week.

California’s topsy-turvy trickle-down

The proposed California budget is looking an awful lot like trickle-down economics. But instead of the classic theory of wealth at the top seeping down to the bottom, the budget would have the state push losses down the pecking order to local governments.

While the full legislature isn’t expected to vote on the proposal until Thursday, the broad outlines of the budget should make the state’s cities and counties shudder, since the proposal would deprive them of already dwindling revenues at a time when borrowing your way out of a jam isn’t much of a fallback plan.

In addition to the proposed $15 billion in spending cuts, the state wants to use roughly $4.35 billion of local funding to plug the yawning $26.3 billion budget gap, according to details that are emerging.

The passage of the budget would be a relief, bringing an end to embarrassing IOUs, and steadying faith in the state’s credit ratings, which had fallen to just a few steps away from junk.

This is crucial for the state, which will need to get back to fund-raising sooner rather than later to make up for time lost during the budget stalemate.

For local governments, however, a bad situation would only get worse.

The budget agreement reached earlier this week proposes to “borrow” $2 billion from property tax revenue that would normally flow to cities, counties and redevelopment agencies. This is coming at a time when these revenues have already taken a big hit from the deeply depressed housing market, double-digit unemployment and a slump in consumer spending.

California IOUs don’t look so hot anymore

Reuters is reporting that California lawmakers are close to inking a deal to close the $26.3 billion budget gap. You know what that means: no more IOUs. So don’t expect to see the IOUs popping up on a trading screen near you.

While a deal will bring the IOU drama to an end, it should create a new one in financial markets: a jump in California muni bonds since an agreement takes the prospect of default – no matter how unlikely it was in the first place – off the table.

From Reuters:

SACRAMENTO, California (Reuters) – California’s top lawmakers told reporters on Monday they were confident an agreement with Governor Arnold Schwarzenegger on a state budget that closes a $26.3 billion deficit would be reached later in the day and voted on by both houses of the legislature on Thursday.

The government of the most populous U.S. state, also the world’s eighth-largest economy, began its fiscal year on July 1 facing the massive shortfall due to a plunge in revenues propelled by the recession and rising unemployment.

Niche broker-dealer ready to trade IOUs

For those eager to buy or sell California IOUs, SecondMarket, a niche broker dealer that specializes in hard to trade assets, will launch its trading platform for the warrants on Wednesday.

But that doesn’t necessarily mean that trading will start tomorrow.

Buyers such as municipal debt portfolio managers, hedge funds and institutional investors are lining up for the service, according to SecondMarket spokesman Mark Murphy, but sellers not so much.

It’s still early days for the IOUS and there’s no guarantee that it will ever turn into a robust market. California could clean up its budget mess, for one.  And SecondMarket doesn’t have a track record of pushing through large trade volumes. In the last 12 months, SecondMarket transactions have totaled only $1 billion.

But it could signal something bigger if the budget stalemate drags on and other broker dealers join in.  California will issue around $3 billion IOUs this month if the status quo in Sacramento holds.

The downside, of course, is it could take the pressure off the state to come up with a solution to sort out its $26.3 billion budget gap. Voters are less likely to gripe if they can get cash for their IOUs. Many commercial banks have stopped accepting them for this reason, though the LA Times reported Bank of the West has agreed to keep depositing the IOUs indefinitely while Citi said it would exchange them for cash until this Friday.

The constitutionality of California IOUs

Matt Yglesias questions here whether California is violating the constitution by issuing IOUs.

First you’d have to determine whether the warrants are debt or currency. States are prohibited from circulating their own version of the greenback.

I’d argue debt since they bear interest and have a maturity date. The SEC’s ruling that they are securities also bolsters the case since it means the rules and regulations governing the municipal debt market would apply to IOUs. Now, if the state passes a proposed bill allowing IOU recipients to pay their taxes in IOUs, I think the distinction gets murkier.

My colleague Felix Salmon forwarded along this from Bureau Crash, which cites two precedent cases, one in 1830 and another in 1900, to argue the point that if looks like currency, walks like currency, it most likely is currency.

If it is unconstitutional though, how come California has been able to issue IOUs twice? I can’t imagine lawyers would let the opportunity slip by if there was a strong case.

Are IOUs securities?

That’s the question lots of folks are asking as they try to figure out how to potentially make money from the billions of dollars in IOUs being sent out by California this month.

If the Securities and Exchange Commission says yes, then two other regulators will be pulled in: the Municipal Securities Rulemaking Board, or MSRB, which would monitor the situation to make sure everyone is playing by the rules, and the Financial Industry Regulatory Authority, or FINRA, which would knock heads if there’s any wrongdoing.

It would also mean that only certified financial professionals could act as the intermediary between buyers and sellers.

If the budget crisis drags on, I imagine the professionals will be clamoring for the SEC to say yes to securities.

Separately, it looks like at least one of the big banks, Bank of America, has no plans to extend its July 10 deadline.

Spokeswoman Britney Sheehan reiterates that based on the bank’s 1992 experience with IOUs, such an extension would be counter productive.

“We do not want our acceptance of registered warrants to deter the state from reaching a budget agreement as soon as possible,” she said.

Paying taxes with California IOUs?

From the AP via the Sacramento Bee, it looks like a lawmaker is proposing that California follow the Argentine model.

From AP:

State vendors and contractors could use their government-issued IOUs to pay state taxes, fees and liens under a bill approved by an Assembly committee.

The Business and Professions Committee unanimously passed the bill by Assemblyman Joel Anderson during its first legislative hearing Tuesday. The bill requires the state to accept its own IOUs as payment for money owed to the government.

This would make the IOUs look and feel much more like currency.  As things stand, the only institutions accepting the IOUs are banks, but the majors like Bank of America, Chase and Wells Fargo have said they will only deposit them for customers until Friday.

It’s doubtful that this bill will gain much traction, though, since it would undermine the governor’s resolve to pressure lawmakers to close the $26.3 billion budget gap.

All of this is academic of course if those promised the IOUs don’t get them. The NYT’s reports that many vendors promised warrants haven’t received them yet.