California Misses Budget Deadline, Readies "IOUs"

California's lawmakers failed to agree on a balanced budget by the start of its new fiscal year Wednesday, clearing the way to suspend payments owed to the state's vendors and local agencies, who instead will get "IOU" notes promising payment.

The notes would mark the first time in 17 years the most populous U.S. state's government would have to resort to the unusual and dramatic measure and would follow warnings by Wall Street that the state's credit ratings may be lowered, which would increase its borrowing costs.

While California lawmakers struggle with budget deadlines practically every year, this year's budget fight is taking place amid the state's worst drop in revenues from personal income taxes since the Great Depression as recession and rising unemployment aggravate the damage done to the state's economy from its long housing slump.

Democrats, who control the legislature, could not convince Republicans late Tuesday to either back their plans to tackle a $24.3 billion budget shortfall or make a stopgap effort to ward off the IOUs. The two sides agree on the need for spending cuts, but are split over whether to raise taxes to help fill the gap.

Democrats have pushed for new revenues while Republican lawmakers and Governor Arnold Schwarzenegger, also a Republican, have ruled out tax increases. They want deep spending cuts to balance the budget, but Democrats say that would slash the state's safety net for the needy to the bone.

In the secondary municipal market, California bonds due in 10 to 30 years were trading stronger as the market priced in expectations for a missed budget deadline, said Domenic Vonella, an analyst with Municipal Market Data.

"Not having a budget on time has been par for the course lately," added Parker Colvin, head of municipal securities trading at Stone & Youngberg in San Francisco. "We've seen Cal GO paper widen for the last three weeks or so and it has dragged down local credits in California as well. Today things are a few basis points better."

White House spokesman Robert Gibbs said the Obama administration is keeping a close eye on California's budget woes. State officials have proposed the U.S. government help with financial aid or by vouching for debt California plans to sell. "We continue to watch the situation and we'll see as it develops," Gibbs said.

In Sacramento, California's capital, State Treasurer Bill Lockyer's office is preparing plans to issue short-term debt assuming Washington will not guarantee it.

"We've been operating since May under the assumption that there will be no help forthcoming from the Obama administration," said Lockyer spokesman Tom Dresslar. "We did not ask for a bailout, repeat, we did not ask for a bailout. We wanted the federal government to step in and provide a backstop for our cash-flow borrowing."

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The lack of a budget may trigger action by Wall Street credit ratings agencies, which have warned of further downgrades to the state's ratings.

Fitch last week downgraded its rating on California's general obligation debt by one notch to A-minus, placing it four notches above speculative, or "junk" status, and making it the lowest rating of any U.S. state, and warned of further downgrades.

Standard & Poor's and Moody's have also warned of possible downgrades to California's general obligation debt. Moody's has said the state could see a multinotch downgrade of its A2 rating.

On Wednesday, Moody's Investors Service had no immediate comment on the possibility of issuing IOUs or the state's failure to pass a budget. Analysts at Fitch Ratings and Standard & Poor's were not immediately available to comment.

Back in Sacramento, tempers flared in the state Senate as the midnight start of the new fiscal year neared.

"There is no excuse to hold this whole state hostage," state Senate President Pro Tem Darrell Steinberg told Republicans during a floor debate.

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Senate Republican Leader Dennis Hollingsworth countered that major cuts are urgently needed. Otherwise, "there will be entire programs that will have to be lopped off," he said.

Due to the state's steep decline in revenue, California risks running out of cash later this month to pay all of its bills unless its books are balanced quickly. To conserve cash, State Controller John Chiang plans to issue IOUs by Thursday to the state's vendors, local agencies overseeing health programs and various recipients of state aid -- including the elderly and disabled and college students.

He plans to send $3.36 billion in IOUs this month to help maintain $10.9 billion in other payments, including money owed to investors holding California's general obligation debt.

"The general obligation bonds will be paid," Chiang told Reuters on Tuesday. "California has never defaulted on its debt obligation and we don't plan to do so."

California, which itself had the eighth largest economy in the world in 2006, according it its Legislative Analysts' Office, now needs to reassure Wall Street because state officials see the need to sell $7 billion to $9 billion of short-term debt once there is a budget agreement.

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