July 10 (Bloomberg) -- California’s government-issued IOUs have put community banks in a no-win situation. Either they add the state’s debt to their balance sheets, or they face the prospect of losing depositors.

“It’s an unfair position to put banks in where we’re allowing the state Legislature to go on and we’re financing it,” said Kevin McPhaill, executive vice president of Porterville-based Sierra Bancorp, which has 23 branches in California. “If you don’t take the warrants then you have the risk of losing customers.”

Sierra is among more than two dozen California banks that agreed to accept IOUs at least through today as Governor Arnold Schwarzenegger wrestles with a $26 billion annual budget deficit. While the biggest U.S. banks, including Wells Fargo & Co. and Bank of America Corp., announced plans to stop exchanging the registered warrants for cash after today, smaller banks with offices only in California can’t afford to cut off depositors and risk losing business.

Refusing IOUs would also slash funding for Californians already mired in a housing crisis and facing a surge in job losses. The state had the nation’s second-highest foreclosure rate in May, according to RealtyTrac Inc., and its unemployment rate of 11.5 percent ranked fifth in the country.

The IOUs, which the state government started paying to businesses and individuals on July 2, carry an annual interest rate of 3.75 percent. The Controller’s office estimates the state will send $3 billion in IOUs this month to pay for social services, state vendors, tax refunds and other expenses.

Monitoring Warrants

Sierra is accepting the registered warrants from existing customers for an indefinite period and is monitoring the overall amount, McPhaill said in a phone interview yesterday. Sierra had $1.2 billion in deposits at the end of the first quarter, compared with almost $953.5 billion at Charlotte, North Carolina-based Bank of America.

Sierra shares fell 24 cents, or 1.9 percent, to $12.52 at 4 p.m. New York time on the Nasdaq Stock Market and have dropped 40 percent this year.

Golden Valley Bank, which has two locations in Northern California, is evaluating the process every Friday to determine if it will continue taking the warrants, said Chief Executive Officer Mark Francis. The Chico-based lender had $64.6 million in deposits.

“I don’t like the fact that this is getting jammed down our throats and we’re financing the incompetence” of the government, Francis said in an interview. “It would be very difficult since we’re a small bank not to take one from a customer.”

Payback Schedule

The state said it plans to pay back the IOUs in October. In terms of seniority, debt servicing is second only to education spending under California law, which means the bonds should be secure, according to a report today from KBW Inc. analysts Julianna Balicka and Frederick Cannon.

“In our view, the risk of state default is low, and the worse case is a federal bailout,” the analysts wrote.

California, the world’s eighth-largest economy, had its credit rating cut on July 6 for the second time in two weeks by Fitch Ratings as Schwarzenegger and lawmakers remained deadlocked over how to fill the hole in the $100 billion annual budget. Fitch lowered state bonds to BBB, or two levels above so-called high-yield, high-risk junk ratings.

“The state’s known for months that the budget is out of balance, so there’s some frustration among our industry that we’re put in this position,” said Beth Mills, spokeswoman for the California Bankers Association, which represents more than 200 of the state’s 300 banks.

Bigger Banks

Bank of America spokeswoman Julie Westermann has said the lender, the biggest in the U.S., will stick by its deadline while easing credit terms to help some customers on a case-by- case basis. Wells Fargo’s Mary Trigg said the deadline won’t be prolonged, though the bank, the largest based in California, is willing to extend credit lines.

Wes Schaefer, vice chairman of American Business Bank in Los Angeles, said his company is following the lead of Bank of America and San Francisco-based Wells Fargo and will stop accepting IOUs if and when they do. The lender, which provides services mostly to businesses in Southern California, is more concerned about the state’s deteriorating economy than the risk of holding the warrants, said Schaefer.

“If all the banks just accept, there’s no reason for any pressure to be on the legislators to get the problem fixed,” he said.

To contact the reporter on this story: Ari Levy in San Francisco at alevy5@bloomberg.net

Last Updated: July 10, 2009 16:11 EDT