The Faculty Lounge: California IOU Update

July 18, 2009

California IOU Update

Click play above to watch interview with SecondMarket's Jeremy Smith on the secondary market in California IOUs. (If video is slow to load, the outlink is here).

A while back, I blogged about the emerging secondary market in California IOUs. At that time, some banks, including Bank of America and Wells Fargo, had agreed to accept the IOUs as deposits, and ads had begun to pop up on Craigslist offering to buy the IOUs at a discount to face value. But I noted that Wall Street seemed prepared to trade the registered warrants (as the state of California terms them) in earnest. Since then, there have been a number of developments.

As of this writing, California has still failed to reach a budget agreement, and even when it does, the prognosis isn’t good: many economists predict further deterioration in the state’s economy -- and revenues – leading to another shortfall in due course. (See here for the Reuters news item). The credit rating agencies also have their eyes on California. Moody's earlier this week cut its rating on about $72 billion of the state's general obligation debt to Baa1, and said the rating may suffer further downgrades.

Which leads us to the part of this story that first piqued my interest: the secondary market in California IOUs. . . .

Although Citibank yesterday announced that it would continue to accept California IOUs until July 24 (an extension from the prior deadline of yesterday), many major banks, including JPMorgan Chase, Bank of America, and Wells Fargo, have already stopped accepting them. (See this California State Treasury document for full lists of banks and credit unions that will and will not accept the IOUs). Moreover, the SEC has declared that the IOUs are municipal securities, meaning that they are subject to the antifraud provisions of the securities laws, but are not required to be registered with the Commission. The IOUs are also subject to the rules issued by the Municipal Securities Rulemaking Board, which include a requirement that the securities sold are suitable for the purchaser. In addition, “persons engaged in the business of buying and selling the IOUs may need to be registered as market intermediaries, such as brokers, dealers, or municipal securities dealers, alternative trading systems, or national securities exchanges.” (See here and here for the SEC releases, and see the bottom of this post for a fuller list of links to relevant state and federal documents and websites).

On Wednesday of last week, SecondMarket, a New York firm that trades illiquid assets -- including whole loans, mortgage-backed securities and bankruptcy claims -- launched a platform for trading the California IOUs. From The Financial Times:

A decision last week by large banks, such as Wells Fargo and Bank of America, to stop accepting the IOUs has paved the way for some initial trading, although volumes are expected to be very thin. . . .

“With several major banks no longer redeeming Californian IOUs, and with some citizens, businesses and municipalities needing liquidity, we felt it was important to launch this market promptly,” said Barry Silbert, SecondMarket chief executive.

Trading is conducted at the firm's Web site, www.secondmarket.com. Because SecondMarket is a registered broker-dealer, it was in a position to quickly step in to this potential market. Although the firm launched its platform on Wednesday, trading is not scheduled to begin until this week, and volume will be determined by a variety of factors, including whether California is able to pre-pay the IOUs and how many other liquidity sources (such as banks and credit unions) continue to accept the IOUs and for how long. The IOUs pay an annual tax-free interest rate of 3.75 percent. Although IOU redemption is scheduled for Oct. 2, Garin Casaleggio, a spokesman for California Controller John Chiang, said the state would like to pay them before that, if the new budget allows. As developments continue, I’ll try to come back here with updates. You do the same.

For those (like lawyers) concerned with the pesky details, links to relevant state and federal information follows, courtesy of SecondMarket:

State of California Treasurer's Office - Redeeming Registered Warrants What You Need to Know

http://www.treasurer.ca.gov/warrants

State of California Controller's Office

http://www.sco.ca.gov/

State of California Controller's Office Information on July 2009 Registered Warrants (IOUs)

http://www.sco.ca.gov/eo_news_registeredwarrants.html

State of California Controller's Office Frequently Asked Questions about Registered Warrants (IOUs)

http://www.sco.ca.gov/5935.html

SEC Staff Statement on California IOUs

http://sec.gov/news/press/2009/2009-154.htm

SEC Investor Alert on State of California IOUs