California IOU Values Could Fall 50%

heidi spencer tbi

What are the odds California can maintain the value of its IOUs and solve its budget woes? A reader with extensive history on this sort of thing writes in:

California is following the long tradition of bankrupt states turning to IOUs when the capital market looks less than inviting. States can’t make scrip issues legal tender but they want their
IOUs to be accepted at prices close to par. This is a non-trivial problem for a
state that can’t issue bonds at market yields. The traditional method is to
accept scrip at par for state tax liabilities.

It doesn’t always work. Indiana issued 6% scrip in 1839 but they issued far more
than current tax liabilities and the scrip traded at 40-50 cents on the dollar
During the canal busts of the 1840s Indiana, Michigan, Cook County IL and the
city of Chicago all resorted to scrip IOUs. The IOUs generally traded between
par and 40% discounts depending on perceived credit worthiness and supply
relative to taxes due. These are just a few examples. Between the panics of
free banking era, the gilded age and Great Depression a number of states and
hundreds of counties and cities issued IOUs when the money ran out. In most
cases accepting the scrip for taxes created a market where the IOUs traded near
par with minimal interest payments.

For what it’s worth, that 50 cents on the dollar is what we set our original offer at (just saying).

Meanwhile, the FDIC has weighed in on California IOUs.

This interagency statement offers guidance for financial institutions regarding California registered warrants (warrants). Beginning July 2, 2009, and until a budget is passed, the State of California (State) intends to issue warrants for most general fund payments. The State is issuing these warrants, for example, as payment to individuals for income tax refunds, local governments for social services, and private contractors and state vendors for goods and services provided to the State. State chartered financial institutions should ensure their holdings of warrants are consistent with applicable state laws and regulations.

The State Attorney General has opined that these warrants are valid and binding obligations of the State. Because they share the same expected source of repayment, the warrants generally have the same credit quality characteristics as the State’s other general obligations. For risk-based capital purposes, general obligation claims on a state receive a 20 per cent risk weight. 1 Therefore, these warrants would also receive the same risk weighting.

As with any obligation issued by a jurisdiction, financial institutions should exercise prudent judgment and sound risk management practices with respect to the warrants. Financial institutions are individually responsible for understanding, managing, and controlling the risks and obligations arising from accepting and holding these warrants. Risk management practices should include evaluating the credit quality of the warrants, establishing appropriate concentration limits, and ensuring appropriate liquidity risk management. Supervisors will evaluate financial institutions’ risk management practices as part of the normal supervisory process.

Anyway, tomorrow is ostensibly the last day the big banks will take the IOUs, so we’ll see what happens then. Check Craigslist and eBay to see if the after-market really picks up at a discount to face value. Then things start to get really interesting.

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