California set to issue IOUs as fiscal crisis weighs

LOS ANGELES/NEW YORK (Reuters) - California's controller said on Wednesday that he would have to issue IOUs in a week if lawmakers can't quickly solve a $24 billion budget deficit, and the state's treasurer plans to tap a reserve fund to meet debt service costs.

The measures came as a budget crisis deepened in the most populous U.S. state and the gridlocked legislature failed to pass a proposed $11 billion in cuts.

"Next Wednesday we start a fiscal year with a massively unbalanced spending plan and a cash shortfall not seen since the Great Depression," Controller John Chiang said in a statement announcing that he would be forced to use IOUs to pay the state's bills beginning on July 2.

"The state's $2.8 billion cash shortage in July grows to $6.5 billion in September and after that we see a double digit freefall," Chiang said. "Unfortunately, the state's inability to balance its checkbook will now mean short-changing taxpayers, local governments and small businesses."

State Treasurer Bill Lockyer, meanwhile, is planning to draw on reserves for economic recovery sales tax bonds, according to a spokesman.

Rating agency Standard & Poor's warned it may downgrade the bonds, given the problems California is likely to face in replenishing its emergency funds.

The state is expecting to file a material event notice on Thursday to alert bondholders to the move that comes in response to plunging sales tax receipts, said spokesman Tom Dresslar.

"The senior coverage account will be drawn on and debt service on all economic recovery bonds will be paid in full on July 1," Dresslar said.

California has been in crisis since the housing slump and credit crunch caused a severe decline in revenues. The state has seen its unemployment rate climb steadily to 11.5 percent in May from 6.8 percent a year earlier, according to labor department data.

LAWMAKERS REJECT CUTS

The government dipped into the same reserve fund in December to make a principal payment on economic recovery bonds, but was able to top the reserve back up within days.

The California Legislature on Wednesday voted down $11 billion in proposed cuts to state services, sending members seeking a budget deal back to the drawing board.

The vote failed largely along party lines in both houses, with the Republicans saying it falls short of the savings needed and amounted to posturing by Democrats.

Standard & Poor's said it will review its economic recovery bond, or ERB ratings "after further evaluation of state projections as to the size and timing of potential draws on the ERBs' reserves."

The bonds, which were approved by voters in 2004 to help the state through another fiscal crisis, are secured by a sales tax and a general obligation pledge of the state.

California has about $8.6 billion of the bonds outstanding, although some have credit support and will not be affected by any rating change, S&P analyst David Hitchcock said.

S&P rates the bonds at A-plus, or fifth-highest investment grade and six notches above speculative, or "junk" status.

That's one notch above the A rating assigned to California's $57 billion of general obligation debt, the lowest rating of any U.S. state.

S&P has the GO debt on alert for a downgrade.

Moody's also has the state on review and has warned of a potential multi-notch downgrade.

Draws on debt service reserve funds are rare and will likely make waves in the bond market, said Dick Larkin, director of credit analysis at the Iselin, New Jersey, office of broker Herbert J. Sims & Co.

"I am not aware of a situation where an issuer has drawn on a debt reserve for sales tax bonds," he said in emailed comments.

"I am also not aware of a situation where a unit needed to draw on a formal debt reserve fund to pay normal debt service on general obligation bonds," he said.

Larkin said the latest developments reflect the strain on California's cash flow and may signal a situation that leads to a temporary disruption of normal debt service payments.

"In the end, though, I still believe that California debt holders would be paid in full, even if there is a temporary disruption because of this financial crisis," he said.

(Editing by Carol Bishopric)