Cambio de California

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Cambio de California

Q and A  on California and the IOUs, or Much ado about what to do with an IOU

The State of California intends to issue IOUs.

This really is an interesting event. In theory only the US Treasury can issue currency. The issuance of exchangeable or negotiable IOUs is monetizing the debt and creating a defacto currency. A second problem is that under state laws “due bills” can be issued – but only by banks. So is California breaking Federal Law, or it now required to become a licensed and regulated bank, or most it now be licensed as a money service business? We can see the marquee: Cambio de California.

However, this current “IOU” plan is not without precedent. In 1992 California issued interest-bearing warrants, which are not currency but a temporary debt form that is accepted by participating bank and other financial institutions, usually at a discounted price to their maturity value. The current California plan describes warrants that will mature on October 1, 2009. What is interesting is that they have gone from a 30 day maturity to the limit of maturities for commercial paper at 90 days. Just short of running afoul of the Securities Laws and the MSRB (Municipal Securities Regulatory Board).

If California is like most other governments, they will be issuing warrants. Warrants are payable upon presentment items, where the first person in line to present their warrant for payment has first claim upon any funds available in the account, and are drawn on the government itself rather than on their bank. If the first person in line to be paid has a warrant for more than is available in the account to pay them, all others in line behind have to wait until the first person is paid before they can present their claim for payment –even if their warrant is for less and there is enough in the account to satisfy their claim. FIFP (First In First Paid). This is a historic hangover from the West’s mining days when a local city continued operating even though the treasury didn’t have sufficient funds to pay all the bills. People would literally line up at the city hall (or bank) and wait to be paid based in accordance of preference denoted by their place in line. What’s old is new again…

More than $1 billion of the so-called warrants will be issued to the elderly, to the 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.

How do you deal with a warrant? According to one California bank if an IOU/warrant is received in a lockbox, the bank will send it to you as an unprocessed item. The recipient gets to hold the IOU until October 1st, at which time they should be able to collect funds. Banks will not pay the face value or give cash. The last time this happened the bank would have paid a discount amount for the items, but those were 30 day warrants, not 90 day warrants.

Banks handle warrants just as they handle checks, but hate them because they are drawn on the issuer and not a bank. The bank only acts as the agent of the issuer in the handling of the warrants. Warrants are obligations of the issuer and require the issuer to tell the bank whether or not to pay any warrants presented; this is an inefficient process at best and painful at worst. According to most banks we have spoken to, they will not be accepting them. Those that are willing to accept them are looking at discounting them.

It will be very interesting to watch how this plays out. If California does sufficient damage to the reputation of warrants it might motivate state legislatures to update their laws.

It is unprecedented, considering California may soon default on its “official” IOUs, which are their municipal bonds. Where in the chain of bankruptcy claims would the IOU-2 holders stand? It is getting more bizarre by the day…

What are the warrants worth and what do they mean to the financial institutions? Will banks accept the warrants based upon the debt grade of California? What discount would they need to apply to the debt not to suffer a haircut on reserves parked in these instruments? And would the warrants have to be written down to zero, (our friend mark to market) if the State defaults on it bonds, or begins to pay the interest on the bonds with warrants?

As for the banks, we cannot speak to reserve requirements. But as to the discounting factor, that would be essentially the same as what the municipal bond market will be applying in pricing California debt, plus a little more yield spread for the less-liquid nature of the warrants. For those of you who have access to a Bloomberg terminal, you can compare California yields to other states and general market rates to see what risk premium is being assigned to California debt. We can tell you that California paper has long been treated as less desirable than that of other state issuers, even those carrying identical ratings. And now,California is the lowest rated of all fifty states and will probably be rated even lower soon.

Some banks may elect to traffic in warrants while others may not. We would like to emphasize here that there is no empirical or even statistical way of forecasting the outcome of all this or what prices will be. In the world of municipal bond prices, there is no such thing as a central quotation system, and the reality for all markets is that prices are nothing more than what a buyer has paid.

As for the question of default and its impact on the warrants, we can only say that the ratings agencies seem to believe that the State has adequate capital and resources to pay its debt, since it is not currently rated as junk, though more downgrades could be in the offing if the State doesn’t reach a legislative compromise. Warrants maturing October 1 buy some negotiation time. California contributes between 10 and 15% to the nation’s GDP. If a real crisis ensues, California will jump the TARP line at the Fed. The Treasury has already seen fit to subsidize municipal borrowing by rebating to state and local issuers 35% of the interest cost associated with Build America Bonds, so there seems to be an inclination to help.

So what will they be worth?

In the discussions we have had with managers in California, it is their intent to offer no more than ninety cents on the dollar, and send them to the State or municipalities in California, at full face value, for the payment of their taxes and other municipal obligations such as water and sewer. There could develop a brisk market in state warrants with buyers who have to pay state taxes and invoices buying warrants at a discount and delivering them to the State at full face value. Some have even thought of sending them to the Fed for their tax payments, but we are sure that was more fiscal bravado than substance.

The following are a few useful ways to benchmark how the warrants will be discounted.

The first useful idea for benchmarking California warrants is the Credit Default Swap rate for one year California G.O. bonds, currently at 245 basis points. So, that may be a handy discounting rate to apply to Cal warrants, but keep an eye on the CDS rate – it was over 300 bps in March, a region one source calls “Lehman Brothers territory!” Since virtually nobody buying or selling CDSs, the reliability of this is roughly what you would expect. The second is to look at the market price for California G.O. bonds due this year. At 3.2% they are about 2.5 above treasury and are selling at 98 cents on the dollar. This implies a discount to cash of about 4.5% for a liquid instrument.

The reality is that some expect the discount that will be offered will be more like 9% to 12% by reputable financial institutions.

We also expect the state to become indignant about how the incredible script is being treated, and discounted and sue those who are providing the cash for excessive discounting.

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