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California IOUs to Pay 3.75% Annualized Rate

SAN FRANCISCO - California IOUs will pay a 3.75% annualized interest rate to the creditors who receive them, the state's Pooled Money Investment Board decided last week. The interest is tax-exempt.

The rate was set Thursday morning, hours before IOUs - formally known as registered warrants - were scheduled to begin coming off the printing presses.

The state controller's office scheduled the IOU issuance to commence Thursday, after state lawmakers and the governor deadlocked last week over how to solve the state's massive budget deficit and a related looming liquidity crisis.

To preserve cash for creditors who have standing under the state's constitution - including bondholders - and under court rulings - including most state employees' pay - the IOUs will be issued to those without such standing, including county governments and taxpayers owed refunds.

The controller's office estimates that it will issue $3.2 billion in registered warrants this month.

The board set Oct. 2 as a maturity date, moving its original Oct. 1 recommendation back by one day, to put the warrants' maturity after $885 million in debt service payments due Oct. 1.

The board accepted the interest-rate recommendation of the controller's financial adviser, Timothy Schaefer of Magis Advisors. He recommended the rate after a review of markets that included money funds, consumer and commercial loans, municipal short-term paper, and California paper

"We note that the issuance of a registered warrant amounts to the forced placement of a loan," Schaefer told the investment board. "It is unknown at this point whether or not liquidity will arise spontaneously in the market for these instruments."

The rate and maturity date were approved on a 2-1 vote, with Controller John Chiang and a representative of Treasurer Bill Lockyer overruling Gov. Arnold Schwarzenegger's representative, Thomas L. Sheehy, chief deputy director of the state Department of Finance.

Observing that the market offered very little yield premium for one-year notes compared to three month notes, Sheehy proposed a June 2010 maturity for the warrants, as well as an interest rate below 2%.

"Pushing the date to four months, let alone a year, is entirely too long to deny innocent people money that is owed to them," Chiang said at the meeting. "And a longer maturity date would send an even stronger signal to Wall Street that our governor and Legislature are incapable of balancing the state's checkbook, which is not the case."

After the budget deal failed in the Legislature last week, Standard & Poor's on Wednesday affirmed its A rating for California general obligation bonds, while keeping them on CreditWatch with negative implications.

Issuing registered warrants should allow the state to maintain a positive cash level through late August while meeting its high-priority payments, including debt service, according to Standard & Poor's.

"In our opinion, failure to reach a meaningful budget revision agreement by late August could make the state's financial condition more precarious, with only adequate capacity to service its debt," the rating agency said.

At that point, the state's rating is likely to hinge on its ability to put together a budget resolution that persuades investors to invest in revenue anticipation notes for cash-flow purposes.

"Absent a credible budget revision package, we believe the state may suffer insufficient investor confidence in its finances to successfully place such an offering," said the Standard & Poor's release. "Without market access for its planned Rans, the state's rating will likely face downward pressure."

Analyst Dick Larkin, senior vice president at Herbert J. Sims & Co., said he believes the affirmation is a mistake.

"We are now at a point where serious questions exist over California's cash flow and investors must try to count the days when cash priority payments need to be made," he said in an e-mail. "California right now has to take extraordinary actions to continue making debt payments on time. That is not consistent with a 'strong' ability to pay debts, and a lower bond rating should be considered seriously now."

Fitch Ratings downgraded California to A-minus from A June 25. Moody's Investors Service rated the state A2 on negative watch as of Thursday.

If the state's budget deadlock is resolved, it can redeem the IOUs earlier. Schwarzenegger signed urgency legislation that sped through the Legislature Wednesday, allowing the controller to set an early redemption date for the warrants if there's enough money to do so.

Two banks with large California operations, Wells Fargo and Bank of America, have agreed to accept state IOUs from their customers through July 10, said Tom Dresslar, spokesman for the state treasurer's office, which will ultimately redeem the warrants.

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