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July 7, 2009

What to do with your California IOUs

California is out of money. State leaders need to raise taxes or lower spending so that incoming revenues for the rest of the year are less than outlays. What they have done instead is issue IOUs that pay 3.75% interest. Unfortunately, Big Banks Don't Want California's IOUs, although it seems that many smaller banks will take them. The IOUs act like municipal bonds lasting until October (The state set a redemption date of Oct. 2 for the IOUs, although it said it might redeem them before then if it has the cash.) and paying 3.75% interest. In contrast, the Fidelity California Short-Intermediate Tax-Free Bond Fund (FCSTX) is yielding 2.53%. Assuming they have similar probabilities of being paid out and share tax-exemption with other municipal bonds (Seeking alpha says they are short-term tax-free bills) This is actually a pretty attractive deal in comparison. Converting it to a taxable yield of 6.43% when other short term California debt is trading at a 4.34% equivalent yield. Using those numbers on the Smart Money Bond Calculator suggests that the IOUs should trade at 100.51% of par.

Of course, California may default on their debt (though they cannot actually declare bankruptcy) and Fitch has already downgraded the state's debt to BBB. Roy Kaye LA says in California IOU Online Market: Cashing in on Fear that there is already a speculative market for the IOUs forming on Craig's list. Given the interest rate premium discussed above, perhaps it is a surprise that offers for the bonds are trading at a discount. That may just reflect a liquidity premium. Unlike an ordinary municipal bond you cannot simply buy and sell these using your broker. Taking cash from strangers on Craig's list is riskier and slower. They might also repay the IOUs early, making it difficult for investors to make their money back.

I see two clear ways that California could improve the IOU process to make them more widely excepted. They both stem from the lesson that uncertainty of value is a bad feature of a currency. The first is to make it clear that repaying the bonds early will be optional. Anyone who wants to hold the bonds until October 2nd and collect the full accrued interest will be able to do so. That will allow investors to more clearly understand what they are buying from the state. Second, the banks should make it clear that now and forever, people can repay their California tax debts (of all kinds) with the IOUs. As Dror Goldberg laid out in Famous Myths of “Fiat Money”, there never has been a pure fiat money, and a major way that countries empower their "fiat" currencies is by making them redeemable for tax obligations. Making it clear that California will accept these obligations will clear the way for everyone who expects to pay taxes to accept the IOUs.

Posted by OneEyedMan at July 7, 2009 8:03 AM

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