California Misses Deadline to Avoid the Need for IOUs

California Misses Deadline to Avoid the Need for IOUs

By Michael B. Marois and Ryan Flinn

(Corrects date in sixth paragraph.)

July 1 (Bloomberg) -- California is poised to issue more than $3 billion in IOUs to pay some bills after lawmakers failed to reach an agreement to close a $24 billion budget deficit facing the most-populous U.S. state.

Last-minute negotiations between Governor Arnold Schwarzenegger, fellow Republicans, and Democrats who control the Legislature failed to produce a compromise before the state’s fiscal year began at midnight. Without budget revisions to account for a recession-driven 20 percent drop in revenue, California doesn’t have enough money to meet its debts and will issue IOUs beginning tomorrow, Controller John Chiang said.

It would be only the second time since the Great Depression that California, a state with the eighth-largest economy in the world, has issued IOUs instead of paying its bills. The state’s bond investors and credit rating companies are watching closely. California has the lowest debt rating of all U.S. states.

“It’s an embarrassment that you have to issue IOUs,” said Paul Brennan, who manages $12 billion of municipal bonds for Nuveen Asset Management in Chicago. “This continues to fuel investors’ nervousness.”

The two sides have been at an impasse since April over Schwarzenegger’s insistence on spending cuts that would eliminate welfare programs and push nearly 1 million low-income children out of government health insurance. Democrats want fewer reductions and some tax increases to make up the difference.

Lower Ratings

The impasse combined with the severity of the economic decline prompted Fitch Ratings on June 25 to lower California’s credit rating to A- from A. The state’s $59 billion of debt is rated A2 by Moody’s Investors Service, five steps above non- investment grade, and a comparable A by Standard & Poor’s. Both companies have warned of reductions.

Brennan said the state’s credit rating may be cut further and California might need to borrow more money as part of a budget fix, which would further pressure debt prices.

“We don’t think debt service will be interrupted,” he said. “But that doesn’t mean we won’t see more downward pressure if the state doesn’t come up with a credible budget solution.”

A California bond maturing in 2037 traded for as little as 83.35 cents on the dollar yesterday to yield 6.27 percent. The price is down from as much as 97.25 cents on May 12.

Treasurer Bill Lockyer has repeatedly said that California won’t default on any of its bonds, which have a claim on payments second only to schools. Schwarzenegger’s administration forecasts that the state will spend $4.5 billion on debt service this year; only $16 million is due this month.

Economic Effect

The IOUs may damp the economy of California, the home of Silicon Valley and the U.S. movie industry, said Jerry Nickelsburg, an economist with the UCLA Anderson Forecast in Los Angeles. The step may force some businesses to fire workers and strain people dependent on state aid, such as welfare recipients.

“This is a worse outcome than just biting the bullet and getting the job done,” Nickelsburg said.

The controller will begin issuing the IOUs tomorrow after a meeting of the State Pooled Money Investment Board, which will set the interest-rate that the state will pay on the promissory notes until they mature in October.

More than $1 billion of the so-called warrants will be issued to the elderly, disabled and to welfare recipients that are due checks, according to the controller. Another $565 million will be sent to businesses that hold contracts with the state, while $159 million will be given to students.

Hallye Jordan, a spokeswoman for Chiang, said the step may be called off -- or halted soon after it begins -- if the Legislature reaches agreement before the State Pooled Money Investment Board meets.

“We don’t want to do these IOUs,” she said.

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