California Issues IOUs

California issued IOUs on Wednesday worth just over $26B. The amount is small compared to some of the bank bail-outs or AIG. They also mature in October. The best part of the article below is the history lesson from 1932 in Chicago, just in case you were wondering if our Uncle Sam would eventually guarantee the IOUs. Text in bold is my emphasis. From Market Watch:

More than $300 million in IOUs issued by California will likely be a nice little earner for banks like J.P. Morgan Chase & Co., Wells Fargo & Co. and Bank of America Corp., but the fiscal woes of the Golden State also present a new risk for an already troubled sector.

California, the largest economy in the United States and one of the biggest in the world in its own right, has issued 91,000 IOUs worth $354 million as of late Wednesday as it struggles with a budget deficit of more than $26 billion.

The fiscal crisis deepened Friday when California delayed a $4 billion payment to its Education Department, and the president of the state's university system proposed furloughing tens of thousands of employees.

The IOUs, officially known as registered warrants, are being used by California to pay tax refunds, bills from vendors, financial aid for students and social-service programs run by local governments.

'Banks accepting IOUs from the state of California should get a reasonably strong new earnings asset as we believe the threat of default is very low.'

Banks including J.P. Morgan , Bank of America , Wells Fargo and Citigroup Inc. agreed to accept the IOUs from customers. That helps recipients of the IOUs get cash.

The banks, however, have said that they won't accept the IOUs after Friday, leaving holders of the IOUs with little way to get cash in future. The Securities and Exchange Commission said late Thursday that the warrants are securities, which means they can only be traded by qualified investment professionals and not on Internet sites like eBay and Craigslist.

According to banking analysts at Keefe, Bruyette & Woods, the sector shouldn't be so cautious about accepting the IOUs.

The warrants mature on Oct. 1, when California has said it will pay the cash it owes, plus 3.75% in tax-free interest. That works out to a tax-equivalent yield of 6.5%. Assuming banks can borrow money at roughly 1.5% on average, the sector is making an annualized spread of 5% until the IOUs come due in October, KBW analysts Julianna Balicka and Fred Cannon, wrote to investors on Friday.

"Banks accepting IOUs from the state of California should get a reasonably strong new earnings asset as we believe the threat of default is very low," they said.

While the state faces a $26.3 billion budget deficit, that's peanuts compared with some of the financial holes that the banking sector found itself in last year. That makes a federal government bailout of California more likely, if it comes to that, according to Balicka and Cannon.

The state's $26.3 billion hole is about the same as the $25 billion that the U.S. government pumped into Wells Fargo last year to help that bank survive the financial crisis, the analysts noted.

The Golden State's deficit is about 13% of the $203 billion the government spent bailing out many lenders through its Troubled Asset Relief Program, excluding money some banks have since repaid, the analysts added.

"If the federal government was willing to put $25 billion into Wells Fargo bank to prevent failure, we have to believe that it would put $26.3 billion into the state of California," Balicka and Cannon wrote.

However, California's IOUs are part of a broader fiscal problem that could weigh on banks active in the state over the longer term, the analysts warned.

"Whatever solution does occur will likely entail significant spending cuts and we believe that the budget impasse will be negative for the general economy and for municipalities, impacting the operating markets of local community banks," they wrote. "This will be yet another pressure point contributing to weakness in loan portfolios already suffering from high unemployment and eroding real-estate values."

J.P. Morgan, Wells Fargo, Bank of America and U.S. Bancorp are among the largest national banks active in California, KBW noted.

A Little History

In 1932, Chicago issued similar IOUs, called tax anticipation warrants. Its financial condition continued to get worse, setting off the biggest bank panic of the Great Depression.

Smaller banks with notable exposure to state and municipal securities include Westamerica Bancorp and CVB Financial Corp. , KBW said.

The most damage to California banks may come from loans extended to consumers and businesses that depend on revenue from state projects that could be cut, the analysts said.

However, they said banks' exposure to California's woes is small and the problem won't be a "game changer" for the sector.

"We view this as another data point that underscores our cautious approach to California banks generally," they wrote.

Joseph Mason, an expert on financial crises at Louisiana State University, is more concerned about the potential impact of California's IOUs on banks.

In 1932, in the middle of the Great Depression, Chicago issued similar IOUs, called tax anticipation warrants, Mason explained in a research note earlier this week.

These IOUs were issued to city employees, students and creditors, and by the spring of 1932 the warrants began to circulate as an alternative to cash from Milwaukee to Michigan.

Chicago's financial condition continued to get worse, raising questions about the value of the IOUs. That put pressure on local and regional banks that had accumulated the warrants, Mason said.

By June, Chicago city officials and bankers went to Washington, D.C. for help, but their request for $80 million in aid was rebuffed by Congress.

When the delegation got back and announced Congress' decision on the train platform, the biggest bank panic of the Great Depression ensued, according to Mason and Charles Calomiris, an expert in financial institutions at Columbia Business School.

Lines formed at every bank in Chicago. The president of First Chicago Bank, as Mason described it, shouted from a pillar in the lobby of his institution that the Federal Reserve was sending plenty of cash.

"By June 23, Chicago bank depositors had witnessed, in a matter of two weeks, the collapse of some of the largest businesses in their city," Calomiris and Mason wrote in a 1997 article in the American Economic Review.

The current financial crisis already has produced a modern-day bank run. This time investors in securitizations panicked, rather than bank depositors who are now insured by the FDIC, Mason said.

Both runs were triggered by a lack of information about the quality of assets and who held those assets, he explained.

"Allowing banks -- chief among them Bank of America and Wells Fargo -- to accept new forms of questionably valued assets is therefore probably not prudent at the present time," Mason wrote this week.

"Regulators should be thinking of how to track these IOU concentrations and place limits on undue accumulations," he added. "Alternatively, the Federal Reserve should be thinking about how similar state IOUs fit into their asset repurchase programs in preparation for the next possible stage of the crisis."