July 2 (Bloomberg) -- California will pay an interest rate of 3.75 percent on IOUs it will begin using today to pay its bills, a panel decided, as Governor Arnold Schwarzenegger and lawmakers remain deadlocked over how to close a $26 billion budget deficit.

The California Pooled Money Investment Board, made up of the controller, the treasurer and the governor’s finance director, set the rate during an emergency meeting in Sacramento.

Thousands of businesses and individuals will receive a note promising to be paid by October for everything from tax refunds to services and goods. California, a state with the eighth- largest economy in the world, was forced to issue the IOUs after Schwarzenegger and lawmakers failed to produce an agreement before fiscal year began yesterday.

“We don’t have the money to pay our bills because the Legislature has decided that it’s more important to protect their special interests rather than protect the taxpayers,” Schwarzenegger told reporters in Los Angeles before the meeting.

Bank of America Corp., the biggest U.S. bank by assets, said yesterday it would accept the IOUs from its customers through July 10. Wells Fargo & Co., JPMorgan Chase & Co and Citigroup Inc. said today they will accept the so-called registered warrants, also through July 10.

“We are reluctant to take this step, but are doing so to help our customers who are not at fault and with the expectation that the Legislature and governor will complete the budget within days,” Lisa Stevens, head of community banking for Wells Fargo in California, said in a statement.

Legislative Impasse

The first batch of 27,000 IOUs worth $53 million were being mailed today, mostly to residents owed tax refunds, the controller’s office said. By the end of July, Controller John Chiang estimates he will have issued $3.2 billion worth of IOUs, paying as last $20 million of interest that is exempt from federal and state income taxes.

To come up with the interest rate, state officials considered similarly rated short-term corporate and municipal notes, as well as what California has paid over a Thomson Reuters Municipal Market Data AAA rated benchmark on past short- term borrowings plus 250 basis points. A basis point equals 0.01 percentage point.

Budget Gap Debate

The Republican governor and Democrats who control the Legislature are at an impasse over how to eliminate a budget gap that emerged less than five months after the passage of tax increases and spending cuts intended to shore up the state’s finances. California, the most-populous U.S. state, has been battered by a recession that caused its revenue collections to tumble by $13 billion to $73 billion in the 11 months through May from a year earlier, according to the controller’s office.

Schwarzenegger, who has sought spending cuts that would eliminate welfare programs and push nearly 1 million low-income children out of government health insurance, ruled out another round of tax increases, and sought measures to crack down on fraudulent welfare claims and other government waste.

Senate President Pro Tem Darrell Steinberg, a Democrat from Sacramento, told reporters today that meetings with legislative leaders and the governor has yielded “significant progress.”

Making Progress

“The governor and I sat down yesterday, and while it’s clear that we have had, and continue to have, real differences, it is time, it is time to bring this to a close,” Steinberg said. “I think it will take a couple of days, but I think it will be done.”

Steinberg and a core group of lawmakers will remain working on a compromise through the U.S. Independence Day holiday weekend, while others were told to remain within four hours of the Capitol. The Senate will reconvene at 12 p.m. July 6.

Controller Chiang said the warrants can be transferred between individuals, setting up the possibility that a secondary market for the IOUs may develop. Already ads are appearing on Web sites such as Craigslist offering cash for the IOUs at below face value.

In such a transaction, the person who gets the IOU would get most of the cash they were due the state, while the person buying the IOU might then hold onto it until maturity and earn the face value plus the 3.75 percent interest.

At least one person offered to buy an IOU at more than face value as a keepsake.

“I am interested in purchasing a ‘State of California IOU’ as a souvenir,” the ad reads. “I figure it would be an interesting thing to have around when my grandchildren are fighting over my stuff after I’m dead and gone. I will pay two times face value (up to $100, or $50 face value) for a warrant/IOU.”

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

Last Updated: July 2, 2009 18:34 EDT