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

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 |  About: Alliance California Municipal Income Fund (AKP)
by: Vincent Fernando, CFA

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 (NYSE:BAC) says it will accept IOU's and Wells Fargo (NYSE: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.