Get ready for the IOU market

July 2, 2009

agnes1– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Let the trading begin.

California will be mailing out its first batch of IOUs today after the state’s stalemate over how to close the more than $24 billion hole in the budget leaves it with insufficient funds.

The IOU market could swell to $3.36 billion by the end of the month if lawmakers and the governor still can’t find a middle ground.

Big banks, which stepped into the breach 17 years ago when the state last issued IOUs, appear to be reluctant to do the same this time around. Wells Fargo & Co, Chase and Bank of America have so far said they will accept the IOUs from their customers as they would any other check, but only for a very limited period of time. All three banks say they’ll stop accepting them after a week.

For the more entrepreneurial investor, California’s newly introduced debt could be the opportunity of a lifetime, or at least of the summer.

The IOUs are registered warrants with an interest rate of 3.75 percent and a maturity date of October 2. But for the purposes of marketing, let’s just call them Terminators.

They have the potential to become what Wall Street likes to call a liquid market — a large amount of securities with similar characteristics that investors can buy or sell quickly. And given the uncertain legislative landscape, there would be an opportunity to make a buck or two.

First, the Terminators are slated to go out in batches rather than all at once, meaning that those sold in the beginning are likely to be worth more since the interest will be paid over a longer period of time. All the warrants will carry a maturity date of October 2 no matter when they’re sent out. Arbitrage anyone?

Second, the more liquid the market, the easier it is to trade. The longer the budget stalemate endures, the more Terminators will be issued. If you thought the deficit projections for July were big, take a look at August and September.

The controller projects cash shortfalls of $3.7 billion and $6.5 billion in those respective months and “double-digit freefall” after that. That means traders could swap Terminators on a daily basis, with prices fluctuating according to prevailing views on how long the crisis goes on.

That may just mean days. Or it could be for substantially longer. For the October 2 maturity date comes with a big caveat: California will redeem the securities only if it has the cash. If it doesn’t, presumably it will have to issue even more Terminators.

If the crisis does go on and there is a great big pool of these IOUs sloshing around California, what’s to stop someone from collecting, say, $500 million worth and slicing and dicing them into an asset-backed security?

Add general obligation bonds (which the state is required to service with cash) to the mix, and the bond’s triple-A slice should be adequately protected in case the cash doesn’t start flowing on October 2. On a fixed-income desk somewhere on Wall Street, someone is most likely crunching the numbers.

There is also an opportunity to claim altruistic motives. Some of the state’s most vulnerable people are at risk of having key services cut if the IOUs can’t be sold for cash.

The controller estimates that the Department of Social Services is slated to receive roughly $1.2 billion in Terminators during July alone if the impasse continues, while other social service agencies that help people with developmental disabilities and mental health issues will receive more than $400 million in warrants. By buying up these notes, investors can ensure cash will continue to flow to the underserved.

Of course, this market wouldn’t be for the faint-hearted. After all California could emerge quickly from the budget crisis, as the IOUs promise to shame lawmakers to hammer out the compromise. Then investors would most likely be stuck with the notes until October 2, and who would want that?  Certainly not Californians.

(Editing by Martin Langfield)

11 comments

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Well, one must hand it to Arnold Schwartzeneger’s Hollywood Experience coming through in a pinch. One time in Hollywood a couple of guys were confronted with a suitcase full of money and wanting to provide for their needs, yet stay honest with the owner of the cash, proceeded to write IOU’s and place them in the case. Of course the Case ended up empty of Money and Full of worthless IOU’s from two guys who insisted they were ‘just as good as cash’.

Dumb and Dumber, a great movie but not so great in governance of the State of California.

Though we have to hand it to Arnold for having a sense of humor!

The Governator!

I’m going to go try to buy a Loaf of Bread with a Google/Sequoia Capital IOU for the You Tube Business Model they stole in 2004 in the great state of California!

Wasnt’ there a little law about no state shall print its own money?

Well after a slew of emails, I feel confident the US Treasury is aware of the matter in California. You can remind them where the State of California is at OOTPE@do.treas.gov

Thankfully President Barack Obama has stated the Michael Jackson will go down in History as a Great Entertainer and the question of who is better between two basketball players will be answered shortly.

Honestly, I don’t know why Foxnews is so unfavorable to the President, he’s giving them a lot of the type of news they should love as the information we citizens need to make certain our government is running itself in a lawful manner.

I’ll bet a $1.00 IOU that the newsmedia does not cover the legality of the warrants. So funny, no one issued a warrant for madoff in 10 years but when a State needs to bend the law, they get them fed-eral express.

I’m certain a better way will be found over the holiday weekend and I honestly hope I’ve totally ruined 100 bankers fourth of july holiday.

Maybe reading some basic law under the supervission of US Treasury Agents would be a better way for California’s Advisors to spend their weekend.

Maybe they can start with MIRANDA.

In reply to:

July 2nd, 2009 4:41 pm GMT – Posted by James Reginald Harris, Jr
Wasnt’ there a little law about no state shall print its own money?

- Well, yes there is, but since all derivatives are just glamorized IOU’s and banks and all other money managing institutions under the sun have glorified them wrapping them in paper worth more than the signatures in the contracts, I guess a free-for-all has begun.

If the crisis was bad before because of non-existant money that *exists* in the form of IOU’s (or their interests and handling fees, transfer fees and whatnots)… that even the initial fraction cannot be repaid by the original borrowers…wait till Californias IOU’s get those same fees on top of fees for an IOU and they become not worth $0 but instead $0+($-n) (or $0x($-n), which is still $0 but a little more complicated since the value of -n is what matters, right…?)

Of course, I haven’t studied Math in many years, never been too good at it, but someone who is a little more knowlegeable please present the current formula for California IOU’s.
(that’ll be fun)

I’m stamping my own signet on cookie dough and will start trading cookies in exchange for other goods.

Posted by Dan | Report as abusive

Let’s start a internet auction for the califorian state!
I’ll start at 2 dollars ( whatever currency you what) I’m prepared to go to 4 dollars, but after that I’m out!

Posted by gd | Report as abusive

I guess I should be heartened to know some people still have a sense of humor as we watch all our little “Neros” fiddle around as the Capitols burn, albeit figuratively.

Posted by Anubis | Report as abusive

California has to borrow money and pay in cash – not pay in debt in lieu of cash. I just don’t recognize the status of this paper. It should take precedence over any other debt – since it is in lieu of cash. Plus the credit rating of the state has to reflect the issuance of a new type of debt that places existing debt holders at a disadvantage. It’s not right. The correct action is to lay off staff, reduce service and cancel state programs. Or the state can just borrow money at higher rates to reflect the increased risk of delayed payment.

Posted by Don | Report as abusive

Chocolate chip cookies in exchange for sewing the hems in a couple of pieces of clothing!

A whole chicken in exchange of some pork chops!

Posted by Dan | Report as abusive

And by the way, if there is a way to dissolve the California Legislature, this is the time to do it. Dissolve, Suspend it or Freeze it.

Posted by Dan | Report as abusive

one would hope that all state politicians, administrators and appointees would be getting the IOUs instead of checks for their pay.

During the Great Depression Cities issued their own script which was legal tender withing their area. I think this would be a better solution than IOUs.

Posted by B.Free | Report as abusive

California’s Nightmare Will Kill Obamanomics

The “script” that is playing out in California is merely a shadow of DC – “District of Corruptiom” where we have two differnt political parties headed in the same direction.

They only differ in speed; as they both offer expensive government programs for every perceived need voters may have.

After years of playing this charade called “pass the buck” power thirsty politican, instead of paying for what is truly needed, now reap the whirlwind. California politicians have wallowed in an orgy of spending but they are a poor imitation of the porkers in Washington. Yes California’s deficit this year is over of $26 billion and IOU’s are being printed.

This fact pales in comparison however to the U.S. federal deficit which will be nearly 70 times larger. What makes anyone think we can issue printed IOU’s in promise of payment for more “Dirty Paper” !?!?! Tis an Obamanightmare…