At the blog Everything Finance, Jonathan Parker breaks down the implications of the State of California issuing IOUs to rollover its debts, essentially creating a new currency whose value is pegged to the US Dollar. He makes a number of interesting points including the observation that since California cannot print Dollars, and cannot issue (conventional) debt, the IOUs place the State in a predicament reminiscent of financially-distressed countries having to defend a pegged exchange rate.
And unfortunately, the history of fixed exchange rates in practice includes lots and lots of these effective defaults. Governments that can issue these i.o.u.’s and have trouble balancing budgets tend to issue a greater value of their currencies than they have the will or ability to maintain. And default follows.
Prior to “maturity” will these IOUs trade at some market price reflecting the probability of default? One question is whether banks will be interested in buying IOUs, offering liquidity in return for the asset and a premium? The strategic issue is whether politically the State will find it more or less attractive to default if the IOUs are still largely held by private citizens, or instead mostly by banks?
My guess is that, in a crisis, a small number of banks would more effectively pressure the State to meet their obligations than if IOU holdings were less concentrated. If so, then I would expect banks to be buying IOUs at a steep discount. But does this create a Grossman-Hart style free-rider problem analogous to tendering shares in takeover bids?
Cheap Talk 
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July 1, 2009 at 2:38 pm
Brett Thomas
This is an interesting insight. However, I disagree with the statement that “a small number of banks would more effectively pressure the State to meet their obligations than if IOU holdings were less concentrated.” Especially if they’d purchased the IOUs on the open market from the original holders. Recall how Chrysler’s bondholders were dismissed by President Obama and many commentators as “speculators.” Dean Baker, for example (at The American Prospect), noted “these were not long-term lenders but speculators who hoped to make a quick buck. (if you buy debt at 30 cents on the dollar and can push to get 33 cents, this is a 10 percent return on an asset that may have only been held for a few months.)”.
If a few banks buy the IOUs at a discount, I think that makes it easier for the government to default on them – since they can claim “Well, we didn’t say we owed *you* this money, and you only paid $.50 on the dollar for them, anyway, so there’s no reason you should get more than that.” I’m not saying this is ethical (or wise) on the state’s part, but I think it undercuts the idea that a few concentrated repurchasers would be more effective at pressuring the state for full payment.
July 1, 2009 at 11:55 pm
jeff
I agree that there are arguments going in both directions. You point out a good one.
July 1, 2009 at 6:02 pm
localcon
California has done this twice before in recent memory. In both cases, there was a lot of political pressure for the banks to take the IOUs at par, though the first time, I recall that they were being accepted at about 95% of face value.
The IOUs are effectively bonds, as the State will pay interest on them, but does not have to redeem them for 3 months. I’m not sure how the banks will treat large customers with IOUs, but I’d bet they’ll honor state employee paychecks and IOUs from other “small” customers at par, then keep the interest when they redeem them.
July 7, 2009 at 12:56 pm
Chris Anschütz
http://online.wsj.com/article/SB124692354575702881.html
“A group of the biggest U.S. banks said they would stop accepting California’s IOUs on Friday… “