California’s ongoing struggle to close its budget gap may cause headaches for those collecting IOUs from the state. But investors holding California’s $59 billion in general obligation bonds shouldn’t worry, say some municipal market participants. The state may stiff everybody else, but it’s unlikely to bilk bondholders.
Issuing IOUs may seem like a warning of worse to come, and even if California closes its $26 billion gap soon, declining revenues mean another shortfall is likely to hit later in the year. Bondholders may be safe for now, but what about then? The federal government, apparently willing to let the CIT Group fail, may be less likely to support California than many think (see, "CIT: Too Big To Fail?").
The state’s financial mess has some predicting a default. One of the more prominent voices in this crowd, Martin Weiss, president of Weiss Research, correctly warned of troubles at Bear Stearns, Lehman Brothers and Citigroup. Weiss sees spending cuts to balance California’s budget leading to declining tax receipts in the near future, a series of downgrades from rating agencies, a refusal from the Obama Administration to bail out the state and then a default. If California can use IOUs to pay other creditors, Weiss says, it can pull the same trick with bond payments.
But there’s another way of looking at the IOUs: Handing them out should reassure bondholders. It conserves cash to make interest payments at the expense of nearly everyone else, says Robin Prunty, a director of Standard & Poor’s public finance group. It would be a different story if the state paid interest on its bonds with IOUs, she said. The state’s constitution, after all, puts education first in line for claims on revenue and bonds second. All other spending ranks lower (see "Municipal Bonds: Armageddon or Opportunity?").
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