Do California IOUs Carry an Implicit Guarantee from the Federal Government?

By now almost everybody probably has heard of how California will issue IOU's to pay its bills and how these will yield 3.75%. As Joe Weisenthal at Clusterstock pointed out, this puts and end to the key difference between the Federal Government and California - that California couldn't print money when in a pinch. Because soon thousands of companies and individuals will be receiving California funny money in lieu of greenbacks.

Thousands of businesses and individuals will now get issued a note promising to be paid by October for everything from tax refunds to services and goods. California, a state with the eighth-largest economy in the world, was forced to issue the IOUs after Schwarzenegger and lawmakers failed to produce an agreement before the state’s fiscal year began yesterday.

Joe even had some fun at Clusterstock and offered $500 in real dollars for $1000 in face value of California IOU.

We think $.50 on the dollar is a fair price, and we'd love to buy more, but we don't want to be overwhelmed by you desperate Californians looking to unload your worthless paper for our valuable paper

But are California IOU's really worth anything as low as only 50 cents on the dollar? We realize Clusterstock was just having fun, but stay with me for a moment... Might IOU's actually be worth something pretty close to 100 cents on the dollar? Banks are already on board. Bank of America (BAC) says it will accept IOU's and Wells Fargo (WFC) too. I bet most other banks probably will too, if they haven't already made a statement. Great... so now California could potentially take down Bank of America... and thousands of Californians... no wait that's impossible.

Let's think about what if California really couldn't honor these IOU's. Would the federal government allow such a thing to happen when thousands of ordinary people were pretty much forced to receive them? Or can we assume that there is actually an implicit guarantee of this paper. I mean look who is receiving these things... (hat tip Mr. Salmon)... the aged, the blind, disabled persons, people needing basic family needs, people with development disabilities, in mental health treatment... will these people be left with worthless paper? What about the too-big-to-fail banks?

Look these things only carry a 3.75% yield, big banks are accepting them, and these IOU's are being pretty much forced upon some of the more challenged segments of the population (what are they going to do, refuse their checks?). Thus unless you see people refusing these IOU's in droves, the market/the street is telling us something... these IOU's carry an implicit federal guarantee in some shape or form. Whether it's honoring them directly or providing a loan to California, or whatever shape can get around directly acknowledging a potential California bailout, let's face it, the federal government just went on the hook for California's bills.

Comments

[Mad Hedge F...:]

Not a chance. Implicent doesn't exist anymore. Perhaps it was deliberate that AMC Channel featured an Arnold Schwarzenegger film festival this weekend. Was the gratuitous violence of Terminators, Judgment Day, and the End of the World intended to drive us all to the negotiating table (“speak to the hand”)? We now have a new currency in circulation, Golden State script, which is thoughtfully being printed in green as I write this. Of course the banks haven’t said they will accept this past July 10, so many spent the July 4th weekend at Big Five Sporting Goods stockpiling ammo and drinking water (everyone here already owns guns), possibly inspired by the Arnold movies. Many schools have already cancelled summer school, so of course, the malls are full of jobless kids lounging around and smoking cigarettes, with nothing to do. Towns are going without fireworks celebrations, and worried citizens are bracing themselves for a complete cessation of state services by the fall. Obama has wisely turned a blind eye to all of this, leaving we non taxing big spenders to stew in our own manure. With everyone of all parties thoroughly disgusted with our leaders, I’m surprised that the grass roots campaign for a state initiative to dump the two thirds majority required to pass a budget, hasn’t welled up yet. Does France still have that guillotine thing? Is it available for rent?

Jul 05 09:02 AM

[morph366:]

I think you're right - there is an implicit US guarantee on these IOU's

Under a truly federal system like the US it is hard to imagine that the central government will let the state go down and the systemic inter-connections would be more fearsome than even those for a major Wall Street bank.

If you want to contemplate a less secure scenario i.e. one not part of a federal system think about what would happen if a Eurozone economy started issuing IOS's - would the ECB honor those?
That's less straightforward.

Jul 05 11:48 AM

[Alan von Al...:]

As a matter of constitutional law, the United States guarantees to each state a Republican form of government controlled by Democrats. California's scrip is probably illegal, because Congress has preemptive power to coin money and the 'full faith and credit' clause could conceivably compel other states to honor California's IOUs -- implicit if BoA and Wells are accepting script as money. Huge mess getting worse by the second.

Jul 05 12:45 PM

[Bruce Vande...:]

If California has set a precedent of paying bills with IOU's what is stopping other states from doing the same? I don't mean to contribute to the mayhem but such are the times.

Jul 05 02:08 PM

[J. D. Swampfox:]

While whatever banks choose to invest in does not have an implicit guarantee, the banks themselves ARE implicitly guaranteed. I suspect that, since it's not politically acceptable for the government to directly guarantee California IOU's, the government has already directed its captive banks to invest aggressively in those IOU's. The banks will do exactly as they are told-just as they did in the Chrysler and GM bankruptcies. If the banks take losses on those "investments", it doesn't cost the banks anything...only the US taxpayer.

Jul 05 02:42 PM

[nova:]

Will or will not the Federal government bail out California?

The answer is no brainer: the fed government is broke and cannot bail out anybody including itself.

American political elite and its people are living in a "fantasy land" foolishly thinking that the world will come and save America being unable to see us impoverished. It appears that America is "high" on something, and a hangover will be terribly painful.

Jul 05 04:15 PM

[Steven Hansen:]

hello......

if bofa and wells are accepting script, this is the governments face saving way of backing california. after all both bofa and wells are too big to fail - and i suspect there has been some winks, handshakes and kisses in washington.

hope somebody recorded the conversations this time.

Jul 06 12:24 AM

[Gregman2:]

It's a great legal question you raise. A couple of months back Arnold was in D.C. asking about federal guarantees for new bond issues. This is slightly different, but I think you are right about an implicit guarantee to the extent a state operates like a territory or protectorate
of the federated union. I'm wondering what the case law on this would suggest?

Jul 06 03:51 PM

[a. palmer jr.:]

Maybe the Mexican government should be asked to help back the California IOUs....it's their people that helped CA get in the shape it's in.

Jul 06 10:27 PM

[Old Trader:]

Interestingly enough, FT had a front article about Wall St. firms and people gearing up to trade CA. IOUs. People evidently have started advertising on Craigslist, offering to buy the scrip. It pointed out that because the IOUs will be repaid in a reltively few months, and as mentioned, pay 3.75% interest, even paying $.99 to the dollar would result in an annual yield in excess of 7%.

Second-Market, a firm that trades illiquid securities like private company stocks, bankruptcy claims, and hedge fund partnership units is also getting ready to jump in on the action.

Jul 07 12:10 AM