Unintended Consequences of TARP Mentality: California IOU's

It's hard not to get a bit disgusted by the lack of political will to resolve the California budget crisis within its own borders. It has been apparent for months that California tax revenues would be substantially lower than projected and that the budget would be impacted accordingly.

What did Governor Schwarzenegger and the California legislators do to prepare for and respond to this crisis? Nothing, nada, zilch. Instead of developing of plan to stem mounting costs, to issue municipal bonds to fund a portion of the shortfall and to temporarily increase tax revenues (with an automatic sunset), the bickering continued and the June 30 fiscal year ended without a budget in place for next fiscal year.

Since then, California has been operating in never-never land with no concrete plan yet on the table. But now that the state has bills to pay and no money to do so they've decided to issue paper IOU's to pay their liabilities bearing a 3.50% interest rate with an October 2, 2009 payment date. Problem is a paper IOU is of questionable value. Its value depends on whether California will ultimately get its act together and figure out a way to fund its obligations, something that is far from assured.

Bank of America set the tone for dealing with the IOU's which was quickly adopted by other California banks. BAC stated that it would accept them as cash equivalents but only through Thursday, July 10, 2009. Why not through October 2, 2009? Because BAC concluded that leaving the IOU's commitment open for several months would not exert the necessary pressure on the State of California to resolve its budget/fiscal problems.

Let's think about the irony of BAC's position. Just last year, Ken Lewis, CEO of BAC, entered into an ill-conceived and ill thought-out merger with Merrill Lynch. He basically decided to pay $50 billion for Merrill over a weekend without understanding the nature of potential losses and by paying a premium for a company whose stock price would have surely fallen to a fraction of the cost paid in just a couple days after Lewis acted. To add insult to injury, after he found out the extent of the Merrill losses, Lewis didn't even bother to tell BAC shareholders so that they could decide if the deal made sense. But that is not the point of this blog post.

I mention the BAC-Merrill deal only because at the same time as Lewis was galavanting around trying to satiate his ego as opposed to working on behalf of shareholders, BAC was also in a financial crisis exacerbated by the Merrill deal. In fact, BAC became one of the largest TARP recipients receiving a total of $45 billion of taxpayer funds.

But BAC was not alone as all of the large banks were required to take TARP funds whether they needed them or not, and most of them did. Stately more starkly, BAC and the other TARP financial institutions were bailed out by the U.S. government via the American taxpayer.

Fast forward. California doesn't solve its budget crisis and the longer it doesn't do so, the more call there is for some sort of bailout or assistance from the federal government. To date, the Obama Administration's, to its credit, has rejected those pleas due to the consequences of the dangerous precedent it would set, to wit: that virtually every other state would then also seek federal government assistance -- something this country cannot afford on top of the already trillions of dollars of debt racked up in the past year.

Having been turned down by the U.S., did California change its ways and get down to business?No, instead it continues to engage in a game of chicken with the American taxpayer, whether by design or sheer lack of leadership and discipline. Where does that leave us? Either the taxpayer bails out California or BAC and the other TARP banks in California will have to accept the IOU's past their current self-stated deadline of tomorrow. If the banks do stand firm on their threat, California will essentially be bankrupt from a liquidity perspective and hundreds of thousands of government employees will not receive paychecks and government services will grind to a halt in a matter of days.

On the other hand, if BAC and the other TARP banks do accept the IOU's for the next several months and the budget crisis in California is still not solved, we could have the unintended consequence of a TARP bank taking huge losses or write-downs on the IOU's they are then-holding. So either the TARP recipients bail out California indirectly (with implicit U.S. backing) or the U.S. government is likely going to end up bailing out California and a longer list of states that come calling thereafter.

Perhaps the most long-lasting problem with the TARP is that, even after TARP funds are repaid, there will not be an end to the mentality it created. It basically told irresponsible banks that they didn't have to pay the ultimate price of insolvency, even though they were insolvent, because they were "too big too fail". Now, the federal government is in the same position vís-a-vís California as it was with the TARP banks. Essentially, the question now becomes whether California is too big too fail and, if it is, the federal government will have no choice to come to its rescue. And so goes the TARP.