California's IOUs: Unintended Consequences of TARP Mentality

It's hard not to get a bit disgusted by the lack of political will to resolve the California budget crisis within its own borders. It has been apparent for months that California tax revenues would be substantially lower than projected and that the budget would be impacted accordingly.

What did Governor Schwarzenegger and the California legislators do to prepare for and respond to this crisis? Nothing, nada, zilch. Instead of developing of plan to stem mounting costs, to issue municipal bonds to fund a portion of the shortfall and to temporarily increase tax revenues (with an automatic sunset), the bickering continued and the June 30 fiscal year ended without a budget in place for next fiscal year.

Since then, California has been operating in never-never land with no concrete plan yet on the table. But now that the state has bills to pay and no money to do so they've decided to issue paper IOU's to pay their liabilities bearing a 3.50% interest rate with an October 2, 2009 payment date. Problem is a paper IOU is of questionable value. Its value depends on whether California will ultimately get its act together and figure out a way to fund its obligations, something that is far from assured.

Bank of America (BAC) set the tone for dealing with the IOU's which was quickly adopted by other California banks. BAC stated that it would accept them as cash equivalents but only through Thursday, July 10, 2009. Why not through October 2, 2009? Because BAC concluded that leaving the IOU's commitment open for several months would not exert the necessary pressure on the State of California to resolve its budget/fiscal problems.

Let's think about the irony of BAC's position. Just last year, Ken Lewis, CEO of BAC, entered into an ill-conceived and ill thought-out merger with Merrill Lynch. He basically decided to pay $50 billion for Merrill over a weekend without understanding the nature of potential losses and by paying a premium for a company whose stock price would have surely fallen to a fraction of the cost paid in just a couple days after Lewis acted. To add insult to injury, after he found out the extent of the Merrill losses, Lewis didn't even bother to tell BAC shareholders so that they could decide if the deal made sense. But that is not the point of this blog post.

I mention the BAC-Merrill deal only because at the same time as Lewis was gallivanting around trying to satiate his ego as opposed to working on behalf of shareholders, BAC was also in a financial crisis exacerbated by the Merrill deal. In fact, BAC became one of the largest TARP recipients receiving a total of $45 billion of taxpayer funds.

But BAC was not alone as all of the large banks were required to take TARP funds whether they needed them or not, and most of them did. Stately more starkly, BAC and the other TARP financial institutions were bailed out by the U.S. government via the American taxpayer.

Fast forward. California doesn't solve its budget crisis and the longer it doesn't do so, the more call there is for some sort of bailout or assistance from the federal government. To date, the Obama Administration's, to its credit, has rejected those pleas due to the consequences of the dangerous precedent it would set, to wit: that virtually every other state would then also seek federal government assistance -- something this country cannot afford on top of the already trillions of dollars of debt racked up in the past year.

Having been turned down by the U.S., did California change its ways and get down to business? No, instead it continues to engage in a game of chicken with the American taxpayer, whether by design or sheer lack of leadership and discipline. Where does that leave us? Either the taxpayer bails out California or BAC and the other TARP banks in California will have to accept the IOU's past their current self-stated deadline of tomorrow. If the banks do stand firm on their threat, California will essentially be bankrupt from a liquidity perspective and hundreds of thousands of government employees will not receive paychecks and government services will grind to a halt in a matter of days.

On the other hand, if BAC and the other TARP banks do accept the IOU's for the next several months and the budget crisis in California is still not solved, we could have the unintended consequence of a TARP bank taking huge losses or write-downs on the IOU's they are then-holding. So either the TARP recipients bail out California indirectly (with implicit U.S. backing) or the U.S. government is likely going to end up bailing out California and a longer list of states that come calling thereafter.

Perhaps the most long-lasting problem with the TARP is that, even after TARP funds are repaid, there will not be an end to the mentality it created. It basically told irresponsible banks that they didn't have to pay the ultimate price of insolvency, even though they were insolvent, because they were "too big too fail". Now, the federal government is in the same position vís-a-vís California as it was with the TARP banks. Essentially, the question now becomes whether California is too big too fail and, if it is, the federal government will have no choice to come to its rescue. And so goes the TARP.

Disclosures: No position

Comments

[Chris Newfield:]

thanks - this is one of the best overviews of the Calif problem I've seen, and you do a great job of linking it to larger national issues.

Jul 09 08:04 AM

[TracingError:]

Only problem with your title is California has done this twice before.

Jul 09 08:20 AM

[Jimbo:]

We get the government we deserve. How do we educate the average citizen who goes to the polls to vote?

Jul 09 09:55 AM

[ejhickey:]

Perhaps another reason for BAC's reluctance give owners of IOUs cash past 7/10/09, is that the State Treasurer said the IOUs would be paid by October 2, 2009 IF California had the money. Also it is unclear that interest will be paid on the IOUs after the due date. If BAC did not limit their exposure to this toxic paper, they could wind up holding large amounts of illiquid paper on which no interest would be paid until redemption. Giving out cash for this potentially bad paper may violate the terms of TARP . Also since the US Government is a partner with BAC and other TARP Bank, turning this paper into US Currency may constitute de facto currency creation which is the exclusive power of the Federal Government. Turning these warrants into cash would in effect monetize California's debt.

Jul 09 10:27 AM

[WS1835:]

I would correct only one statement in the article. California is not playing chicken with the American taxpayer. California is playing chicken with the federal government. The states got restricted bail-out money in the stimulus package. Now California (and others) are simply returning to the trough for more. Pure Pavlov.......

To say they are playing chicken with the taxpayer suggests that the taxpayer has some kind of power to object to or stop the madness. In reality, the insiders are firmly in control and all the taxpayers can do is watch as their children's future is sold out from under them.

is just a pantsy in the whole thing.

Jul 09 12:46 PM

[Mad Hedge F...:]

They should really be issuing Michael Jackson tickets. 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. For more on this see my earlier piece . With everyone of all parties thoroughly disgusted with their 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? Will they take California "script"?

Jul 09 04:09 PM

[Boxed Merlot:]

If you’re asking how do we currently educate the average citizen who goes to the polls to vote the answer is simple. We do it be using government paid union members since most of us attended public schools. If on the other hand, you are asking how should we educate the average citizen who goes to the polls to vote, I’d say the answer should lie somewhere other than where it has been and where it is now including the pseudo news shows sprinkled between the government sponsored PBS interpretations of events, coupled with public frenzy. Perhaps a return to thoughtful, rational reasoning beginning in the home between the oldest members of our families and the youngest would be a logical place to start.


On Jul 09 09:55 AM Jimbo wrote:

> We get the government we deserve. How do we educate the average citizen
> who goes to the polls to vote?

Jul 09 05:47 PM

[Northstar10000:]

You don't educate the fools who go to the poles. The stock market sends them a message, then the bond market will rock their boat and finally the currency markets will finish the fools off.

Jul 09 09:39 PM

[KingofthePa...:]

Jct: There’s nothing wrong with small denomination California State IOUs if anyone can pay their taxes with them. When Argentina’s government workers were faced with cuts, their unions talked 6 state governments into paying them with small-denomination state bonds which could be used to pay for state services and taxes by everyone.
When the local currency is pegged to the Time Standard of Money (how many dollars per unskilled hour child labor) Hours earned locally can be intertraded with other timebanks globally! In 1999, I paid for 39/40 nights in Europe with an IOU for a night back in Canada worth 5 Hours. U.N. Millennium Declaration UNILETS Resolution C6 to governments is for a time-based currency to restructure the global financial architecture.
See youtube.com/kingofthep...
Too bad California IOUs won’t be accepted in payment for state taxes and services like state bonds were in Argentina. Too bad California IOUs will be denominated too big to use as local currency. Too bad Argentina people were smart enough to avoid the tent-cities catastrophe and California people are too stupid to follow their example.
If they make IOUs legal tender, I take it all back.

Jul 12 10:50 PM