July 20 (Bloomberg) -- Governor Arnold Schwarzenegger and lawmakers in California, which has paid bills with IOUs for three weeks, say they may be one negotiating session away from an agreement to close the state’s $26 billion deficit.

The legislative leaders are scheduled to meet today behind closed doors in Schwarzenegger’s Sacramento office, after senior Democrats announced July 17 that they thought they might announce an agreement last evening. That meeting was scrapped because of scheduling problems, they said.

“Staff continues to work through issues, and we remain in a position to close on an agreement very quickly,” Schwarzenegger’s Press Secretary Aaron McLear said.

Schwarzenegger and lawmakers have been at an impasse since May over how to fill the hole in the $100 billion annual budget caused by the longest recession since the 1930s. The clash forced California to begin paying some bills with IOUs on July 2 to avoid running out of cash, and prompted Fitch Ratings and Moody’s Investors Service to cut the state’s credit rating to a few grades above so-called high-yield, high-risk junk ratings.

California’s finances have deteriorated more quickly than elected officials have responded. In February, Schwarzenegger approved tax increases and spending cuts meant to eliminate what was then a $42 billion budget deficit through June 2010 only to see the gap re-emerge as the recession battered tax collections.

Since the budget was approved in February, finance officials found that tax revenue was likely to decline another $13 billion between then and the conclusion of the current fiscal year, June 30, 2010. Voters rejected a package of tax and fee measures in May that would have narrowed the gap.

Progress Noted

Speaker of the Assembly Karen Bass of Los Angeles and Senate President Pro Tem Darrell Steinberg of Sacramento, both Democrats, emerged from a late-night meeting with Schwarzenegger and top Republican lawmakers July 17 and said they believed they were close to an agreement.

Legislative staff and lawyers spent the last two days reviewing a method to cut school funding and how to best repay the money when the economy rebounds. Disagreement over that issue stalled negotiations July 16.

If an agreement is announced, it would still require lawmaker approval in both chambers of the Legislature. While Democrats control both the Senate and the Assembly, they are six votes shy of a two-thirds supermajority needed to pass the measures. Bass and Steinberg told rank-and-file lawmakers that a vote might come by July 22 or July 23.

The rating cuts by Fitch and Moody’s put California’s creditworthiness where it was in December 2003, when Schwarzenegger tightened the state’s fiscal bind by honoring a campaign pledge to slash a car tax. By comparison, before the end of the Cold War, which battered military contractors in California, the state had the top credit grade from all three bond rating companies.

To contact the reporters on this story: Michael B. Marois in Sacramento at mmarois@bloomberg.net;

Last Updated: July 20, 2009 00:00 EDT