UPDATE 3-As California struggles, Fitch cuts debt rating

(Adds background, comments by governor, treasurer's office)

By Jim Christie

SAN FRANCISCO, July 6 (Reuters) - California suffered a new setback in its financial crisis on Monday when Fitch Ratings cut its rating on the state's general obligation debt to just two notches above junk status.

Fitch cut its rating on California's long-term bonds to "BBB," two notches above speculative grade, citing the state's budget and cash crisis. The state last week started issuing "IOU" promissory notes to pay for some bills in order to conserve cash.

The credit rating agency also kept the debt of the most populous U.S. state on watch for additional downgrades. California ranks as the lowest-rated state general obligation credit by Fitch, followed by Louisiana, at "A+."

Tom Dresslar, a spokesman for State Treasurer Bill Lockyer, said the other two main credit rating agencies, Standard & Poor's and Moody's Investors Service, could soon follow Fitch's example. "I'm sure their patience is not deep," he said.

Lower ratings threaten to raise California's borrowing costs during a severe cash crunch in Sacramento, the state capital, one of Fitch's top concerns.

"The folks who are going to end up paying the price are not investors, not the governor, not the legislature, but the taxpayers," Dresslar said.

Standard & Poor's has California's general obligation bonds rated "A" with CreditWatch with negative implications. Moody's has warned of a possible "multi-notch" downgrade in its "A2," sixth-highest investment grade credit rating of California's general obligation debt.

In a statement, Fitch said it cut its "A-" rating "based on the state's continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis."

California faces a $26.3 billion budget deficit for its fiscal year that began on July 1 and talks between Governor Arnold Schwarzenegger and lawmakers to balance the state's books are plodding along.

State finance officials last week began issuing IOUs promising payments to taxpayers owed refunds to preserve the state's dwindling cash for priority bills, including payments to investors holding the state's debt.

Schwarzenegger seized on the Fitch downgrade to criticize state Assembly Speaker Karen Bass for not meeting for budget talks earlier in the day.

"This underscores the urgency to solve our entire deficit," he said in a statement. "This is not the time for boycotting budget meetings -- all sides must come to the table and balance the budget immediately."

FITCH EYES CALIFORNIA'S CASH

Fitch said its "BBB" rating "indicates that expectations of default risk remain low, although the rating is well below that of most other tax supported issuers."