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California I.O.U.s Implications and Legality
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by tvtayber | July 3, 2009 at 12:55 pm
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As the United States scrambles to recover from the financial crisis, California has decided to issue I.O.Us to tax holders and government vendors in an attempt to relieve some pressure on their unbalanced budget, which has a $28 billion hole in funding.
The controller, John Chiang, issued 28,742 warrants totaling $53.3 million. If state lawmakers fail to reach a budget agreement by the end of August, the amount would grow to $4.8 billion.
California is faced with a dire situation. They do not have enough revenue to pay for their expenditures and in the wake of the most sever recession since the Great Depression they are desperately seeking some way to balance their budget.
Is it legal? The I.O.U.s are also known as warrants. The I.O.U.s are state backed guarantees on debts held by taxpayers and government vendors.
By issuing i.o.u.’s to bridge the budget gap, the state of California is in essence printing money. The state plans to issue $591 million worth of i.o.u.’s to cover its funding needs for July. It also plans to issue $363 million in i.o.u.’s to support nonprofit centers that count on state money.
The IOUs can be redeemed at face value, plus 3.75% interest, by Oct. 2 or earlier if a budget deal is signed and the state has enough cash to cover them.
IOUs are legal because the State can legally issue bonds and warrants against debts, but the real questions is whether banks will honor them:
“In evaluating potential registered warrant acceptance, banks have been advised by regulatory authorities to consider such issues as credit quality, capital requirements and concentration limits,” the bankers’ association president, Rod Brown, said in a statement. “Given the poor credit rating of California, the worst in the nation, banks may be hesitant to extend credit to the state.”
Some banks and at least 25 credit unions have agreed to accept the IOUs. Bank of America, Chase, Citi and Wells Fargo have said they would accept the paper through July 10.
California already has a shaky credit rating and if the state defaults on debts it owes to bondholders it risks devaluing its credit rating even further.
A multinotch downgrade threatens to push the state dangerously close to junk status, which would make it quite expensive for the state to raise cash to finance public works projects in the future and could cause many institutional investors to dump the bonds.
When states require funds to finance infrastructure projects, social programs and other public finance projects they must often borrow money from international investors. They will issue bonds to finance the project. Bonds offer smaller returns than stocks but are considered much safer.
If California’s credit rating worsens it will become more expensive to borrow money because investors will see the bonds as risky and will ask for higher returns on their investment.
In addition, municipalities who have been issued the I.O.Us will be forced to find money in their reserves to balance their own budgets. If the Sate is not able to pay back the I.O.U.s the municipalities may be forced to default on their debts as well.
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Most RecentMost Recommended Comments (4)
at 13:28 on July 3rd, 2009
But, no, you can't pay your income tax with IOUs. Or so I'm told.
at 15:54 on July 3rd, 2009
No, but you can claim bankruptcy, a state can't claim bankruptcy. These I.O.U.s are essentially California declaring bankruptcy to its more personal debtors in an attempt to keep the bigger sharks at bay (while they pray for a miracle... )
at 18:39 on July 4th, 2009
If the state of california issues IOU on july 3,2009.My understanding and what i heard is you cannot cash the california IOU's until October 2009. So everyone has to wait.Its up to the bank to except the IOU's or not.Personally the way the economy is i don't think the banks will except the IOU's at all.You should thank the people of sacramento for this and washington for making the economy being in ruins.The economy will get worsen and i don't think there is a light at the end of the tunnel anytime soon.
People cannot pay there bills and rent on IOU's.If people are renting or making a house payment.Get ready for alot of eviction and foreclosures.Good luck everyone.
Ray
at 14:01 on August 7th, 2009
The banks should accept them at face value now because they will redeem them for the 3.5% in October.
I think that is the incentive for banks to accept them.