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)

California's Comptroller said he would begin handing out IOUs on July 2 and the Treasurer said the state will draw on reserves to service the debt of all economic recovery bonds on July 1. (These bonds were created in 2004, when voters gave the state government the authority to raise $15 billion through bond issuance to plug another budget deficit.)

While a slump in real estate and tax revenue are very real factors behind California's disastrous finances, the San Francisco Chronicle also bullet-points more entrenched problems that have made it difficult if not impossible for the state to surmount extreme dysfunction.

-- Partisanship: California's gerrymandered legislative districts tend to protect incumbents and encourage more political extremes - Republicans on the right and Democrats on the left with less incentive to reach out to the political middle, much less compromise at the Capitol.

-- Term limits: Proposition 140, passed in 1990, limits legislators terms to six years in the Assembly and eight in the state Senate.

-- Ballot-box budgeting: Initiative-loving Californians mandated set-aside funding for all kinds of single-interest issues, from education to stem cell research.

-- Prop. 13: The 1978 landmark law slashed commercial and residential property tax rates, shifting state reliance to other more volatile sources.

-- The two-thirds majority rule: The Golden State is one of just three states that require a two-thirds majority vote from each legislative house to pass budgets.

Fitch Ratings cut California's ratings to A-minus last week from A, and warned that further action could be forthcoming if there's not a budget agreement beyond June 30.

California general obligation bonds have been getting hit as a result of all the uncertainty. In May, the bonds were trading roughly 37 basis points above AAA-rated munis, according to Municipal Market Advisors. Now they stand at 105 basis points. It's also helping to drag down the overall market, though returns for the year are still in the black at 5.2%.

The big fear of course is default, but there are many gradations about what they could mean for bondholders.  The worst case scenario would be repudiation, or simply walking away from its debt obligations, though this seems extremely unlikely given the size of the California economy (eighth in the world if it stood alone) and its dependence on future credit market financing. Then there's defaulting on the debt servicing or paying only part of it.

There's still some hope that the federal government would step in if it came to default, but the Obama Administration has been reluctant to prop up state and local governments, especially when it has its hands full with the auto industry and the financial system. It also would open up the federal government to petitions from a long line of states and municipalities also getting squeezed.

President Obama is in favor of moving towards “energy independence,” but his new 2010 Budget specifically seeks to raise taxes on domestic oil exploration by $31 billion over 10 years, a larger tax increase than on any other industry. In addition, oil and gas producers would bear a disproportionately heavy share of other tax increases on business, more than $320 billion.

Surely a president who desires energy independence would leave oil companies alone so that America could develop greater domestic reserves.  But this is not the case.

The ostensible rationale for the tax increases is that the current tax system “distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent expensing encourages overproduction of oil and gas, it is detrimental to long-term energy security…” This wording, with reference to credits, lower tax rates, special treatment, and accelerated depreciation, is repeated eight times in the Treasury Department’s Green Book, a description of proposed spending and revenue changes in the budget.

President Obama believes that subsidies for renewable energy are acceptable, even though renewable energy is only responsible for 4 percent of America’s supply.  He does not consider expenditures of $60 billion on “clean energy investments” to be distortions.  But oil, which accounts for almost 40 percent of America’s energy usage, is a different matter, apparently deserving of higher taxes to limit overproduction. With fuel prices close to $5 a gallon last summer, we could have used a little overproduction.

If America is to reduce use of imported fuels, it needs to raise domestic production to increase long-term energy security. Every additional barrel of oil produced in America is one barrel fewer that needs to be imported.  The oil and gas industry already employs more than 1.5 million workers, and has the potential to employ many more.

Estimates of American oil and natural gas reserves keep growing, potentially generating more job opportunities.  In 2007, 200 trillion cubic feet of natural gas, equivalent to 33 billion barrels of oil, or about 18 years of U.S. oil production, were found in the Haynesville Shale, a rock formation in northern Louisiana. Discoveries have also been made in Texas, Arkansas, and Pennsylvania. New optimism about U.S. gas reserves and production capacity has been pushing natural gas prices down.  Since the fuel is there, why propose new taxes to discourage production?

President Obama’s new tax proposals, rather than leading towards energy independence, would drive oil and gas production abroad.  New taxes would place American producers at a disadvantage in the global market, punishing domestic American oil and gas companies and benefiting countries with large reserves such as Venezuela, Saudi Arabia, Iran and Russia.  Does President Obama really want these countries, all under fire for their neglect of basic human rights, to get richer at our expense?

Moving towards energy independence is under attack from another quarter—extreme environmentalists. After Tuesday’s failure of California ballot initiatives to cut spending, Californians might take seriously Governor Arnold Schwarzenegger proposal to allow additional offshore drilling from Platform Irene, off the coast of Santa Barbara, which would raise $1.8 billion. But drilling on the Outer Continental Shelf remains unpopular. It’s telling that residents find it preferable to release 40,000 prisoners from jail or fire thousands of teachers—rather than drill offshore, which could bring in a steady stream of revenue to the state capital of Sacramento.

Until the United States has the technology to operate its 250 million motor vehicles without gasoline and natural gas, we need more domestic exploration, not less.  At some point, maybe later this year, maybe in 2010, our economy is going to shift to post-recession recovery, and oil and gas consumption are going to rise.  We don’t want a repeat of $5 gasoline and sky-high home heating bills.

Remember, San Diego has been, along with Phoenix, Las Vegas and parts of Florida, among the most bubbleicious markets in the U.S., and the massive busts there still represent a huge problem for bank balance sheets, for employment and for the U.S. economy generally.

So a bottoming, if that is what we are seeing, would be very significant. Housing is usually among the first sectors to recover in the aftermath of a recession and many economists argue that it actually drives the economic cycle.

Piggington, whose mother knows him as Rich Toscano, is making more modest claims; that prices are reasonable historically, but his arguments have some merit and fair value is a necessary but not sufficient precondition for a bottom and a turn.

He argues that, based on the historical relationship between San Diego county house prices and both incomes and rents, prices are now not so bad. The ratio of home prices to per capita income in December was below eight (remember San Diego housing has always been expensive!) as opposed to a bubble peak above 14. And buying the average single family home now costs the equivalent of just about 200 months of the average rent, as against well over 350 at the peak.

I think it’s fair to say that we are getting ever closer to a bottom in some of the bombed out markets, not just San Diego, but I don’t think we are there yet. On the plus side, in many of these markets transactions are now well above last year’s extremely low levels, driven by banks selling foreclosed properties at aggressive prices. And many of the buyers in places like Florida appear to be investors who are happy to take the quite positive cash flow from renting, a real sign of health, as opposed to 2006’s flippers.

But be cautious: we are in the midst of an awful recession and the employment effects will last long into 2010. Prices also are liable to overshoot on the way down, as they have in the past, including in California.

That means that price measures are now biased to the lower end of the market and don’t give a true picture of affordability. Professor Piggington may have more pain to chronicle as more prime and jumbo foreclosures hit the market.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

In many ways, water policy in the Western United States mirrors the economic policies which created our financial catastrophe. Here in the West we’ve seen a massive development boom fueled by unrealistic expectations of ever-increasing supply.

Water contracts have been issued for many times the amount of water that nature can reliably provide. Wildly optimistic appraisals of water availability are being used to justify long-term, otherwise infeasible projects. Long held cautionary principles are being overlooked or eliminated in the rush to fulfill promises and support dreams that are unsustainable. And the public is being actively encouraged to invest billions more in bonds to subsidize the very system that is driving us to the crisis point.

The result has been escalating conflict, unwieldy demands, environmental collapse and economic disaster. Fortunately, as with the economy, adjustments in expectations, greater efficiency, and implementation of new, smarter ways of doing business can reverse some of the damage we have done, allow the West to come to grips with water limits, and provide reliable water to meet our needs.

The West supported lush post World War II growth in California, Nevada and Arizona by depleting local rivers and creeks and overdrafting groundwater. As these resources dried up, cities reached out with ever deeper wells and with hundreds of miles of aqueducts to grab “surplus” water from areas with less political clout.

But just like Wall Street’s derivatives, underlying water assets were counted many times over.  In startling testimony late last year the California State Water Resources Control Board revealed that they had issued water rights permits for over 8 times the amount of natural water available in an average year. On the Colorado River, seven states cling to unreasonable expectations that they will receive the full allocation promised to them in decades old agreements. (For background information, click here for PDF.)

Over allocation is not limited to surface water. Over pumping of groundwater water is also common in the regions overlying the huge Ogallala aquifer, a major source of water supply for South Dakota, Nebraska, Wyoming, Colorado, Kansas, Oklahoma, New Mexico, and Texas.

At the same time collapsing fisheries in the Sacramento - San Joaquin Delta, caused in large part by the overexploitation of rivers put the fishing industry as well as the fish, on the brink of extinction. The crisis is so bad that the salmon fisheries on the West Coast will be closed for the second year in a row.  Court decisions to prevent loss of multiple California fish control some water projects.

Similar to what happened with the start of the Wall Street collapse; water insiders are encouraging the public to increase investments in business as usual.  Some in California are admitting to supporting more plumbing specifically to allow increased water diversions from the Sacramento – San Joaquin Bay Delta Estuary, the largest estuary on the West Coast and the epicenter of the fisheries’ collapse.

Others are pushing for energy and greenhouse gas intensive desalination of ocean water, despite known impacts to ocean fisheries.  And a few others are trying to get the public to pay billions for more dams, even though there is not enough water to regularly fill the dams that already exist.

Yet, there are emerging solutions to ease these conflicts. Cost effective, climate resilient water development such as water recycling, conservation, groundwater recovery and protection, and stormwater capture all provide opportunities to increase our water reliability while also creating quality jobs.  Policy makers are beginning to see the value of these solutions.

This year State Senator Pavley from Santa Monica is authoring Senate Bill 565 that would pave the way to create at least 2 million acre-feet of new water by 2030 through safe recycled water.  That would be the largest water development program in California since the 1960s.

Another example of smarter water management is AB 1408 authored by California Assembly member Krekorian. This measure establishes a mechanism to allow new housing to be water neutral.  Under the bill, developments would incorporate state-of-the art conservation. The bill further encourages developers to work with water districts to offset all of the demand of the development through conservation in the existing buildings. If implemented, this measure would allow California to accommodate much or our future growth without increasing water demand.

Lastly the public is just beginning to see how the institutions that were supposed to protect them need to be reformed.  Entrenched special interests dominated the decision making in the past.  State and federal water officials for too long ignored their responsibilities to ensure water sustainability and stewardship rather than extraction and exploitation.

Climate change, environmental crisis in the largest estuary on the West coast, and fiscal realities are forcing us to come to grips with limits. Fortunately, we have tools that can allow California and the West to prosper in a sustainable way, but only if we are willing to change our ways.

(For additional information, click here for the Delta Vision Blue Ribbon Task Force Report, from December 2008, in PDF format.)

After eight years of inaction on climate change by the federal government, we can now look forward to the Obama administration tackling global warming head on. With not a minute to lose, Lisa Jackson, the soon-to-be new head of the EPA, should move quickly to capitalize on the momentum of states that have so far been the leaders in fighting global warming. There is no better place to start than by establishing a national greenhouse gas emission standard for automobiles based on California’s landmark clean car law.

California has always been a pioneer in setting tough automobile emission standards. Our regulations paved the way for lead-free gas, the catalytic converter, and many other innovations that were later adopted as the national standard. As a result, we have eliminated 99 percent of harmful pollution pouring out of autos today compared to a 1960s era car, leading to clearer skies and cleaner air in our cities.

In 2002, California continued its track record of pioneering environmental legislation when it passed a law that directly addressed greenhouse gas emissions from cars. Personal vehicles produce 20 percent of the nation’s greenhouse gases, and so are increasingly being addressed by governments that are serious about averting catastrophic climate change. Thirteen other states have formally adopted and three states are considering adoption of California’s cost-effective and technologically doable program.

Indeed, the motivation is not only environmental - owners of these cars will save thousands of dollars over the vehicle’s life because cars that meet the standard are also likely to be more fuel efficient.

Together with California, these 16 states constitute almost half the country’s new vehicle sales, creating a huge market for the best that Detroit has to offer.

Despite these benefits, the EPA blocked California from enforcing its greenhouse gas emission standards for cars. It also delayed responding to the Supreme Court, which required that the EPA consider using the federal Clean Air Act to create a program similar to California’s program to reduce emissions from all the nation’s vehicles. Just last month, the outgoing administration failed to carry through on its promise to publish new CAFE rules – national fuel economy standards – as required by Congress.

The new Obama Administration should use this opportunity to set a new foundation for American energy and climate security. Soon-to-be Administrator Jackson should immediately follow through with President Obama’s promise to allow California’s regulations to come into force. She should also begin the process to create a national greenhouse gas standard for cars based on California’s approach – a 30 percent reduction by model year 2016 - and establishing even greater reductions in the future.

At the same time, the Obama Administration should direct the Department of Transportation to fix its flawed CAFE rules to be compatible with new climate change needs. It also needs to address a regulatory process so distorted that fuel economy standards are based on the technology of the “least capable manufacturer,” holding our nation’s energy security hostage to the lowest common denominator. Instead, Obama should direct DOT to work in concert with EPA to create standards that work for both fuel economy and the reduction of greenhouse gases.

Coordinating these two approaches will also provide automobile manufacturers with THE stable set of national policies they have been calling for. This strong national program will also send a clear signal to Detroit to fire their lawyers who have been wastefully battling California’s regulation and hire the engineers who will build the cars consumers want and that will support the future success of America’s auto industry in a global market.

If we’re going to wring the carbon out of our economy, we will need the coordinated actions of government agencies across all sectors and additional investments for rapid economic recovery under a comprehensive national climate change framework. That will take time to develop, and some careful planning. In the meantime, the EPA can immediately draw upon the experience of states like California and its leadership under Governor Schwarzenegger to use its existing authority under the Clean Air Act and take effective and early action against climate change.

By acting now, the EPA will show the world that the United States is finally taking its place among the community of nations to address the pressing challenge of, in the words of our new president, a planet in peril. California, and many other states, stand ready to help.