Banks Turn the Screws on California

Governor Arnold Schwarzenegger and state legislators are slugging it out over how to fix California's $26.3 billion budget gap. Now, some of the nation's biggest banks are sending them a message: You're on your own.

The Republican governor and Democrat-controlled statehouse have been at an impasse for weeks, after the state's runaway spending collided spectacularly this year with its falling property, sales, and income tax revenues. Legislators have offered up a tonic of steep spending cuts, new taxes, and fee hikes. Schwarzenegger says he wants more long-lasting reforms—such as cutting the length of time the jobless can collect welfare from five years to two. It's gotten so bad that even the press secretaries for the governor and state Assembly Speaker Karen Bass have taken verbal shots at each other.

California missed its June 30 deadline to sign off on the new fiscal-year budget. On July 6 Fitch Ratings downgraded the state's general obligation bonds to a BBB rating, the lowest among the 50 states. "California's situation is a concern to everybody," says Maud Daudon, chief executive of Seattle-Northwest Securities, a municipal bond broker. "It's a bellwether of the market, and if they don't find a way through this it has the potential for a tidal wave of change."

Banks Say No More

Already, state Controller John Chiang's office has begun issuing IOU paper to thousands of state agencies, contractors, and municipal governments. The controller began issuing the IOUs on July 2. Some 92,000 of them have gone out since, totaling more than $350 million. Estimates are that $3 billion will be issued by the end of July. That flurry of paper, however, may just be the tool that forces politicians to reach an agreement.

Many of the state's banks and credit unions have been cashing the IOUs like checks. They have some incentive to do so, as the IOUs carry a 3.75% annual interest rate. But the interest and principal amounts aren't due to be paid until Oct. 2—and that's only if the cash-strapped state has the money.

So after initially agreeing to cash the IOUs, some of the state's biggest banks are now saying no more. Bank of America (BAC), JPMorgan Chase (JPM), and Wells Fargo (WFC) all say they won't accept the IOUs after July 10. Banks have balance-sheet issues of their own these days. And the big lenders do not want to be perceived as an enabler of the Golden State's dysfunctional government. "The state of California, just like any household or business, must live within its means," says Julia Tunis Bernard, a spokeswoman for San Francisco-based Wells Fargo. "Banks can't be the solution to the budget problems."

Offers for 85¢ on the Dollar

With the big banks refusing to cash the state's paper, fears are that desperate IOU recipients will turn to other more expensive outlets such as check-cashing stores and third parties who offer to buy the paper at steep discounts. Already dozens of offers to purchase IOUs for 85¢ on the dollar are popping up on "If a bank will not honor an IOU then someone may need to rely on a third party," says Hallye Jordan, a spokeswoman for the state controller. She says federal regulators may step in "to prevent people from being gouged."

J.J. Feldman, an investment advisor in Los Angeles, says he posted an ad on offering to buy IOUs at 85¢ on the dollar after hearing about them on the radio. He put the ad up on July 9 but so far hasn't had any offers. "I figure if someone needed the money fast I could buy $10,000 worth of a state tax refund," he says. Feldman says he made good money earlier in the year buying the bonds of distressed companies such as General Growth Properties and Hertz (HTZ). California, he says, is just another distressed issuer. "They've had their ratings lowered but they're not junk status, yet," he says.

The Securities and Exchange Commission has declared that the IOUs are municipal securities, meaning that only dealers authorized to trade in such paper can do so. In a statement, the agency also warned that "broker-dealers, as well as any potential secondary markets, should be aware that the requirements of the securities laws and the rules of the Municipal Securities Rulemaking Board apply to the IOUs." Other security steps may be taken. The controller's office is expected to require a bill of sale for all who try to redeem an IOU that was not issued in their name. "It's going to be more painful for people who are trying to sell them for money," says Matt Fabian of Municipal Market Advisors, a research firm devoted to municipal bonds. "There are additional hoops to jump through to sell municipal securities. It would really be unfortunate for the people of California, and increase pressure on the state to get something done."

This is only the second time that California has had to issue IOUs since the Great Depression. The last time, in 1992, a budget compromise was reached, in part because banks refused to cash the paper.

Market on eBay

IOU recipients may not all be on the hook, however. One IOU being offered for sale on eBay (EBAY) already appears to have appreciated in value. Bidding on the $2 check—issued to cover a state tax refund—has already risen to $21. The auction ends July 16. "Hopefully this will never happen again," the eBay listing says. "This is a piece of history right here."

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