California IOUs: This Year's October Surprise?

Short of cash, the State of California has started to issue IOUs called "registered warrants" to pay some of its obligations. While the state hasn't entirely run out of cash, it will pay out some $3.36 billions in IOUs in July, and probably more than that in August if the state still hasn't solved its fiscal crisis. The IOUs will be due on October 2, 2009 and bear interest at an annual rate of 3.75%. However, they won't be paid unless the state has obtained enough money to cover them.

Some banks are cashing the warrants at face value, at least through July 10, 2009. These include Bank of America, Wells Fargo and J.P. Morgan Chase. After that, IOU holders may have to turn to smaller banks, credit unions and check cashing stores if they want to convert the registered warrants into cash on the barrelhead. The smaller banks, credit unions, and especially the check cashing stores, are likely to charge fees that will result in IOU holders receiving less than face value. The check cashing stores could really clean up if banks and credit unions get nervous and step back.

The July 10 deadline was set by the big banks apparently as an incentive to the state to resolve its fiscal mess. But California is famous for being ungovernable. Since the 1970s, California voters have wanted Cadillac quality state and local government services with a Chevrolet tax burden. Municipalities have given extremely generous pay and benefits to their employees. The California electorate has avoided fiscal responsibility the way teenagers avoid homework. What are the chances California will put together the cash to pay the IOUs on October 2? Both voters and state legislators have seemingly done their best to preclude any solution.

The problem could extend to bond defaults, and the "borrowing" of tax monies from municipalities (that would otherwise receive these tax revenues). A lowered credit rating and straitened municipalities would only exacerbate the Golden State's difficulties. The governor has already made a variety of cuts in state spending, and more cuts are on the way. But there is only a modest chance a solution will be found before the registered warrants become due.

By October, California may have issued something like $10 billion or so in registered warrants. Most likely they will largely be held by banks, which will either have accepted them from customers or received them as collateral for loans to check cashing stores. If California defaults on the IOUs, the financial system wouldn't collapse. The Federal Reserve would simply print some more money and throw it at the banks. Moreover, the state and its government would get by, albeit more spasmodically.

But there is something about October and the stock market. In 1929, 1987, 1989 and 2008, October did nasty things to investor portfolios. No one knows why it's so bearish. But even bold investors tread carefully when the fall foliage reaches the height of color in the Blue Ridge Mountains. California's failure to pay the IOUs in October would add to the general shakiness of the market. We've already seen the market drop close to 8% in the last four weeks. Prospects for this summer seem clouded. The fiscal meltdown of the largest state would lower investor confidence when it is already ebbing.

Government is the only thing we have going for us in the current economic crisis. The federal government has responded reasonably well, although at the expense of an ominous boost to the federal deficit and potentially inflationary measures by the central bank. The federal government is close to being tapped out. If the government of the largest state, which has the 8th largest economy in the world, can't get it together, we may run out of cards to play.

It's always something unexpected that leads to October surprises in the stock market. Last year, it was the collapse of Lehman Brothers, followed by the panicky no questions asked bailout of AIG (in which AIG's creditors got a pass from responsibility for the risks they took). California has repeatedly dodged the bullet on its fiscal messes. But if the real estate collapse of 2007 to 2009 (and into the future) teaches anything, it's that chickens eventually come home to roost and recklessness and irresponsibility aren't free. The Obama administration hasn't shown any interest in bailing out financially troubled states, nor should it. See http://blogger.uncleleosden.com/2009/06/bailout-for-states.html. California's fiscal dysfunction can be expected to continue--there's no reason why the state should suddenly ascend to adulthood when it's spent the last 30 years in adolescence. And its likely default might be just the thing to tip the stock markets downward, renewing October's reputation as the cruelest month for investors.