How to Make Money Off State Budget Crisis
For individual investors who get a chance at some of the IOUs California is issuing during its ongoing budget crisis, there’s only one word: lucky.
Far from a raw deal, these so-called registered warrants, which came to about $1.9 billion Monday, can be pretty appealing. They offer 5% interest, and since individuals get that free of state and federal taxes, the effective yield is higher.
The IOUs are an administrative headache, sure, but apparently they’re no migraine. Los Angeles County, which pays 3% for its money and gets about the same on its parked cash, has already begun buying these warrants at face value, earning a hefty 2% spread relatively risk-free.
But for many businesses, the IOUs aren’t so attractive. Companies must pay state franchise taxes on the interest income, and because the IOUs are really just a mountain of small checks--864,362 so far, for an average of $2,228 each--processing is costly.
Moreover, businesses need cash, and most California banks will stop accepting the paper this week, which means that companies won’t have an easy way to negotiate them. What’s needed, obviously, is a secondary market.
Some IOUs are being bought and sold outside the banking system now. Los Angeles County, for example, is buying from smaller California jurisdictions (entirely altruistically, it claims) and last week held more than $110 million worth. A few factoring firms--which finance accounts receivable for businesses--apparently are accepting Sacramento’s IOUs from their customers.
None of this will suffice once the banks are out of the picture.
“I would expect some form of secondary market will crop up, if it hasn’t already,” says state Controller Gray Davis, whose office is issuing the IOUs. “There will be warrants looking for a place to be redeemed.”
With that in mind, Davis worked to persuade the Internal Revenue Service to exempt the warrants from federal taxes: “I knew in the back of my mind that no secondary market was likely until there was real certainty as to the tax implications.”
The prospects at first seem bullish; in the abstract, the high tax-exempt yield and the state’s strong credit imply that the IOUs should sell at a premium. Depending on the price, big insurance companies and investment houses might be interested.
But Robert Rodriguez, vice president of First Pacific Advisers, a Los Angeles mutual fund concern, notes that these IOUs aren’t securities. That means mutual funds such as First Pacific’s can’t buy them. And all those small checks pose security problems; forged signatures and even fake IOUs could become major headaches. But the banks presumably have screened theirs and might be in a position to bundle them like mortgages.
A bigger difficulty is that the IOUs are so callable. When Gov. Pete Wilson and the Legislature get together on solving the budget problem--California has been without a spending plan since July 1--the state will pay off the warrants. Holding on any longer won’t do any good, because interest will stop accruing.
So anyone who gears up to deal in these things assumes one big risk: that the effort might quickly be for naught. Indeed, the state started calling some of the earliest warrants this week, even while issuing new ones.
All these factors mean that a secondary market in state IOUs will sport some deep discounts, considering that the debts involve almost no credit risk. The market value of these warrants will become evident very quickly if the state doesn’t settle on a budget, because the banks won’t be around to set a floor of 100 cents on the dollar.
The silver lining is that a sharp drop in the value of the state’s IOUs will bring great pressure on California’s elected leaders to reach a settlement. If the IOUs bring only, say, 70 cents on the dollar, state workers and vendors will rise up in fury. At the very least, once people and companies see that the state is paying them only a fraction of the agreed-upon price for goods and services, somebody’s going to have to pay the rest.
“The private sector is not a benevolent entity,” Rodriguez observes dryly. He means that charity isn’t its first consideration, especially when it comes to the state.
In other words, a secondary market that really works would probably contain the seeds of its own destruction. When the IOUs get cheap, the politicians will have to get real. Markets are handy that way.
