IOU Blues: California May Have to Issue IOUs to Creditors

The State of California may have to issue IOUs to its creditors Thursday after lawmakers were unable to close a multibillion-dollar budget deficit, setting up an uncomfortable situation between corporate treasurers and banks.

Joseph Tinucci, assistant treasurer for the University of Colorado Treasurer's Office, said banks "hate" IOUs because they are drawn on the issuer and not the bank. "The bank only acts as the agent of the issuer in handling" the IOUs," he said. "(IOUs) are obligations of the issuer and require the issuer to tell the bank whether or not to pay any warrants presented; this can be an inefficient process at best and painful at worst."

Karen Hill, CTP, financial manager with Hines, said her company's "West Coast bank" will forward any IOUs that go to its lockbox as an unprocessed item. "We will hold the IOU until October 1, at which time we should be able to collect our funds," she said. "The bank will not pay the face value and give us the cash. The last time this happened the bank would have paid a discount amount for the items, but then those were 30-day warrants, not 90 day. In the meantime, we have bills to pay and depend on the income from the state to cover our payments."

Paul Dearing of Dearing Consulting offered a historical perspective on the crisis. "California issued IOUs in 1992 that had a five-percent interest rate. Many banks cashed them like checks and took the five percent," he said. "Until the interest rate and terms are published, I'm not seeing any banks commit. Assuming a plan similar to 1992, is the interest on the IOU enough of a gain to make it worth waiting (and hoping) until they can be cashed?"

"It is getting more bizarre by the day," said Anthony Lysenko, CTP, senior treasury analyst with Roper Industries. He added, "California may soon default on its 'official' IOUs, which are their municipal bonds. Where in the chain of bankruptcy claims would the IOU-2 holders stand?"

According to the California State Controller's Office IOUs, officially known as registered warrants, are redeemable on Oct. 1, "assuming there is adequate cash in the treasury." IOUs/registered warrants are negotiable instruments and will go to private businesses, local governments, taxpayers receiving income tax refunds, and owners of unclaimed property. All others receiving payment will receive traditional regular warrants. The state will pay interest on registered warrants presented. The state's Pooled Money Investment Board will set the tax-free interest rate for registered warrants on July 2 and pay interest until they mature. California last issued IOUs in 1992 and, prior to that, the Great Depression. Issuing IOUs would be further proof that the state lacks the cash flow to cover its $24 billion deficit.

What to Do With an IOU

L. Burke Files of Financial Examinations & Evaluations said that California contractors he spoke to intend to offer 90 cents on the dollar, or less, and send them to the State of California, and other municipalities in California, at full face value for the payment of their taxes and other municipal obligations such as water and sewer. "Some have even thought of sending them to the Fed for their tax payments but I am sure that was more fiscal bravado than substance," he said. "There is zero trust in the ability of the government to deal any amount of money; their words, not mine."

Mark O. Conner of Corporate Treasury Investment Consulting said, "I cannot speak to reserve requirements, but as to the discounting factor, that would be essentially the same as what the municipal bond market will be applying in pricing California debt, plus a little more yield spread for the less-liquid nature of the warrants. As a former municipal bond trader, I can tell you without reservation that California paper has long been treated as less desirable than other state issuers, even those carrying identical ratings. And now California is the lowest rated of all 50 states."

Connor relayed a benchmarking idea from a broker friend: Use the credit default swap rate for one-year California G.O., which currently stands at 245 basis points. "That may be a handy discounting rate to apply to California warrants, but keep an eye on the CDS rate—it was over 300 basis points in March, a region my broker source calls 'Lehman Brothers territory!'"

Here are the State of California bond ratings from the major agencies: Moody's (A2), Standard & Poor's (A) and Fitch (A-).

What will banks do?

No one knows what banks will do with the IOUs in part, Conner said, because there is no way to forecast the outcome of the crisis or what prices will be. "In the world of municipal bond prices, there is no such thing as a central quotation system and the reality for all markets is that prices are nothing more than what a buyer has paid," he said.

Connor predicts California may receive Federal bailout money. "California contributes between 10 and 15 percent to the nation's GDP. If a real crisis ensues, California will jump the TARP line at the Fed. The Treasury has already seen fit to subsidize municipal borrowing by rebating to state and local issuers 35 percent of the interest cost associated with Build America Bonds, so there seems to be an inclination to help, despite Constitutional obstacles," he said.