What's the deal with IOUs?

SACRAMENTO — For just the second time since the Great Depression, California began paying some of its bills with IOUs on Thursday, as this year's version of the state's annual budget battle dragged on.

The IOUs began going out a few hours after state financial officials set a 3.75 percent interest rate on them, along with a redemption date of Oct. 2.

Several of the state's leading banks, meanwhile, said they would accept the IOUs, formally known as registered warrants, but only until July 10. Others had not decided.

"Given the poor credit rating of California — the worst in the nation — banks may be hesitant to extend credit to the state," Rod Brown, president and chief executive officer of the California Bankers Association, said in a news release.

While legislative leaders and their number crunchers scurried between closed-door meetings Thursday, and Gov. Schwarzenegger held news conferences in Los Angeles and Fresno to demand quick action, the state controller's printing presses began churning out 28,742 warrants, worth $53.3 million, which will be mailed to people awaiting tax refunds.

Instead of a check, they'll get an IOU and a letter of explanation.

For Californians not getting a letter of explanation, here are answers to questions they might have:

Q: Why can't a state with the eighth-largest economy on Earth pay its bills?

A: The short answer is that state government doesn't have enough money on hand. Even in good times, the state faces a cash shortage at the start of fiscal years because tax revenues come in later. And these are really bad times. Controller John Chiang has determined that he won't have enough money to meet a constitutional mandate to pay education bills and money due state bondholders and pay other bills. So the other bills will get IOUs.

Q: Who gets stuck with them?

A: People and companies that do business with the state, cities and counties, and those awaiting tax refunds are the main victims.

Thanks to a 1993 federal court ruling, state employees won't get them. Nor will the state pension funds or recipients of health and social service programs.

The federal Social Security Administration has notified the state it will pick up the state's share of SSI-SSP payments for July and August, and officials are working to extend that arrangement, if necessary.

Q: How many IOUs are there likely to be?

A: That depends on how soon the governor and legislators can settle on a solution to the budget deficit. Assuming it's a reasonable plan, and not smoke and mirrors, that would allow state Treasurer Bill Lockyer to borrow money from private investors to ease the cash flow crunch.

Absent a budget deal soon, Chiang has estimated that it might take $3.2 billion worth of IOUs this month, and $1.65 billion in August. After that, you don't want to know, but it's huge.

Q: What are these puppies going to cost taxpayers?

A: Assuming the 3.75 percent rate, Oct. 2 date and a need for $4.85 billion through July and August, about $45.5 million in interest, according to the Department of Finance.

Q: What's a registered warrant look like, anyway?

A: Like a regular state check, only it has "registered" stamped on the front and an endorsement box on the back full of legalese.

Chiang said they are as safe and secure from counterfeiting as regular state checks.

Q: If I get stuck with one, what can I do with it?

A: If you don't need the money now, you might hang onto the IOU until the state redeems it. At 3.75 percent, the annualized interest rate is pretty sweet by today's investment standards. The interest is exempt from state and federal taxes.

Q: When will they be redeemed?

A: That depends. The Pooled Money Investment Board (the state controller, state treasurer and state finance director) voted 2-1 on Thursday to set Oct. 2 as the redemption date. But there's some wiggle room there.

For one thing, the Department of Finance, which is part of the governor's administration, wants a redemption date of June 16, in case the state still doesn't have enough dough to pay off the IOUs.

After losing that pitch at Thursday's meeting (along with a proposal to set the interest rate at 1.5 percent), Thomas Sheehy, chief deputy director for policy in the finance department, got the board to agree to reconsider the rate and date next week.

In addition, the Legislature passed and the governor signed an emergency bill this week that would allow the state to call in the IOUs before the current redemption date of Oct. 2, and pay interest only from Thursday to the date they are called.

Q: Suppose I'm not in an investing mood. How else can I get rid of an IOU?

A: Check with your bank. Bank of America, Wells Fargo, Tri-Counties and Chase have said they will accept state IOUs through July 10, mostly as "a courtesy" to their customers.

Central Valley Community Bank said it will accept them through July 31. Golden One Credit Union and 30 other credit unions say they will take them, and they didn't set an end date.

Banks are leery about accepting IOUs because they pose difficulties in handling and electronically redeeming them.

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