IOU. . . More?

There was a fun bit of news out last night regarding the latest in California's IOU (I-Owe-You) fiasco. You might have heard that banks didn't want IOUs. Consequently, the Securities and Exchange Commission has ruled that the IOUs can be treated as securities and sold in the market. So how are those IOUs different than usual state-issued municipal debt? They're not really, except in some of the details. Here's an excerpt from an Associated Press article:

Therefore, the Securities and Exchange Commission recommended Thursday that the IOUs, which carry an annual interest rate of 3.75 percent, be regulated by the Municipal Securities Rulemaking Board as a form of municipal debt. As of Wednesday, the state had issued more than 90,000 IOUs worth $354 million.

A regulated market for the IOUs would make it easier for individuals holding them to sell them at a fair price, analysts said.

In other words, if banks or others don't like IOUs, they can trade them in the market for cash. So banks should be thrilled, right? Not exactly. AP says:

A spokesman for JPMorgan Chase & Co. left open the possibility Thursday of a change in that bank's policy, but spokesmen for Bank of America and Wells Fargo said those banks still planned to cease honoring the notes. Citigroup had no immediate comment.

It wasn't long ago that I can still remember those very same banks running to the government, hat in hand, begging for a bailout. Now when a state government comes to them, asking for some flexibility, banks don't seem eager to return the favor. Why wouldn't they accept these IOUs -- especially now that they can just be traded in the secondary market for the cash they'd prefer?

I can't speak on behalf of banks, but I can offer up a theory. As one of the article's sources explains:

The price (IOU sellers) receive may be discounted in accordance with the market's perception of the risk of the state repaying the notes, but it would be an orderly market price.

And the SEC, via AP, adds:

As with any new securities, the robustness of the trading market that will develop "cannot be predicted with certainty."

These two concerns are risks. The first is California's default risk -- the likelihood that the state will declare bankruptcy and welsh on its debt. The second is liquidity risk -- the potential difficulty IOU-holders might have in selling them in the market. Each of those risks reduces the market value of the IOUs. For example, if default risk reduces the price by 15 cents on a dollar, and liquidity risk reduces the price an additional 5 cents on the dollar, then the market value of an IOU is only 80 cents on the dollar. (To be clear, these are just fictional risk estimates. I have no intimate knowledge of IOU market pricing.)

So what's the point? If California writes a $10 million IOU to Citigroup, and the market value is only 80 cents on the dollar for that IOU, then Citigroup will only be able to get $8 million for it in the market. That's a 20% loss in this scenario. Suddenly, the banks' side seems a little more sympathetic.

Of course, California should be able to get around this problem, at least partially. They should write IOUs for amounts that cover the discount for market value of the IOUs. Using the 80 cents on a dollar example, instead of providing Citigroup with $10 million of IOUs worth $8 million, California could provide $12.5 million of IOUs worth $10 million in the market -- what Citigroup is actually owed.

The real math involved is a little more complicated than this, and liquidity risk might be difficult to determine. But I think the point I'm making seems sensible. If California agreed to pay IOU recipients the debt they owe them based on what the market value of those IOUs ended up being, there'd really be no reason to complain.

Sure, that value could change eventually, but the value of cash fluctuates too. At that point, it's up to the IOU holders to sell the IOUs as quickly as possible to obtain the cash value promised. Alternatively, they could hold onto the IOUs and risk the price changing over time -- just like the risk associated with holding any other asset.

In any case, this should be an option on the table for California to attempt to further satisfy its creditors. Sure, it would further increase their debt, by having to issue more in IOUs than they currently owe, but that might be better than the alternative. Nobody wants to see California default.