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?