California IOUs

An interesting situation is brewing around the IOUs California started issuing last week due to budget gridlock in Sacramento—in the face of tax income for 2008 being greatly below expected. A number of banks agreed to honor these IOUs until today. After today though, many banks, at local and national levels, are voicing resistance about honoring them any further.

California will almost certainly pay them back. They carry an annual rate of 3.75%, which is a better deal then I've gotten on any of my CDs even at promotional rates for a long time, and better than I recall on Treasuries for awhile now. If a holder of an IOU were to sell it for 90 cents on the dollar, that would be the hottest deal in town. Even at 95 cents they would probably fly off the shelves. At 3.75%, even at face value I bet they would sell well.

Which makes it strange that banks are starting to refuse them, particularly with the bad PR and the risk of losing accounts with depositors going elsewhere. It would appear their ongoing liquidity problem, at this point, may be extreme.

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In a humorous turn of events, banks are claiming their refusal to take state IOUs is a public service. Wells Fargo says: "The State of California–just like any household or business–must be responsible for living within its means." Bank of America adds: "We do not want our acceptance of registered warrants to deter the state from reaching a budget agreement as soon as possible." Does Wells Fargo suggest that major banks, being a business, ought to live within their means as well?

Plenty of credit unions see the opportunity here and will be accepting state IOUs.

UPDATE [7/12/09]: It looks like the market rate for California IOUs is emerging between 80-95 cents on the dollar. The cited problem is they are cumbersome to deal with. In a climate of scarce liquidity, I can see it as an issue. Otherwise why couldn't a bank take out a loan from the Fed at under 1% to service these at nearly a 3% markup?