Aug. 13 (Bloomberg) -- California will stop using IOUs to pay its bills in early September, lifting a burden on businesses, taxpayers and municipalities that received $2 billion of the registered warrants instead of cash as the recession pushed the most-populous U.S. state toward insolvency.

Controller John Chiang said the use of IOUs will stop on Sept. 4, pending approval by a panel of state finance officials, and the state would begin redemptions a month ahead of schedule. State Treasurer Bill Lockyer said he plans to sell $1.5 billion of notes by Aug. 28 to meet cash needs, followed by $10.5 billion of such short-term loans in mid-September.

Lawmakers enacted a revised budget last month that closed California’s $24 billion deficit and paved the way for the state to borrow money.

“Along with short-term loans that are routinely obtained in the fall, this spending plan should provide sufficient cash to meet all of California’s payment obligations through the fiscal year,” Chiang said in a statement.

California, with the world’s eighth largest economy, issued IOUs for the past six weeks to pay for everything from tax refunds to health-care clinics and to avoid missing payments on items, such as bonds, deemed a priority under state law. California’s largest banks, including Bank of America Corp. and JPMorgan Chase & Co., stopped accepting the IOUs last month, straining businesses in a state that’s among the hardest hit by the nearly two-year-long recession.

‘Bankrupt Vendor’

Gloria Freeman, president of a medical staffing company, Staff USA Inc., said before Chiang’s announcement that the end of the IOUs will have little immediate effect on her business. Based in Rocklin, California, the company fired five of its 12 administrative employees because of the IOUs, she said, and anticipates that her payments will be delayed by backlogs, as they were after prior budget battles.

“I’m stuck with the warrants and the fact that they’re not going to pay for a long period of time even once they do get this straightened out,” she said. “You’re basically dealing with a bankrupt vendor.”

The use of IOUs drew speculators who offered to buy them at a discount on Internet sites before they even arrived in the mail. The U.S. Securities and Exchange Commission moved to halt such trading by advising that the IOUs were securities akin to bonds, confining the market to registered brokers.

Reluctant to Sell

SecondMarket Inc., a New York brokerage that arranges trading in hard-to-sell assets such as auction-rate securities, tried to foster trading in IOUs. None were ever executed because sellers didn’t want to take less than face value, in part because of the chance that California could redeem them early, as the state is now planning to do, said Mark Murphy, a company spokesman.

“Sellers are, with good reason, reluctant to sell for less than par -- or 100 cents on the $1 -- if the state turns around and says ‘we’ll redeem them now,’” he said.

California began issuing the securities on July 2 as politicians remained deadlocked over revising the budget through June 2010 to compensate for a plunge in tax collections. The stalemate was resolved on July 28, when Republican Governor Arnold Schwarzenegger signed a package of bills that cut spending to schools, prisons and welfare programs -- and imposed accounting maneuvers and other one-time changes -- to balance the books.

Borrowing Costs Narrow

The scope of the deficit and funding crisis rattled investors, as credit-rating companies downgraded California’s bonds and investors demanded higher returns to compensate for the risk of holding them.

With passage of the revised budget, the premium demanded by investors has eased and officials are reviving plans for the short-term note sale -- needed to pave over temporary mismatches between spending and revenue -- that they previously said would be too costly.

The difference between a 10-year California bond and a top- rated municipal security was as high as 1.71 percentage points on July 1. The spread slipped to 1.16 percentage points yesterday, the lowest since April 24.

The controller has issued about 327,000 IOUs worth $1.95 billion since July 2. The registered warrants were set to mature in October and pay an annualized interest rate of 3.75 percent.

Marketing Plans

Lockyer said he plans to borrow the $10.5 billion in mid- September. Proceeds will be used to repay the $1.5 billion initial loan. No decision has been made on what investment banks would manage the sale, treasury spokesman Tom Dresslar said.

When the state sought a cash-flow loan last October, Lockyer lowered the yield range on the debt by a quarter- percentage point and boosted the size of the offering by 25 percent to $5 billion after a marketing campaign targeting individual investors helped draw more than $3.9 billion of orders, an all-time high.

California still paid a yield of 4.25 percent on the notes due June 22, 2009, the most on record at the time relative to Treasuries.

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

Last Updated: August 13, 2009 17:43 EDT