by Calculated Risk on 7/06/2009 03:57:00 PM

Fitch's analysis suggests that issuing IOUs will only work until October, at which point the cash shortfall will start impacting priority spending.

Note: "GO" General Obligation.

Press Release: Fitch Downgrades State of California GOs to 'BBB'; Maintains Rating Watch Negative

The downgrade to 'BBB' is based on the state's continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis. Since no agreement was reached by the June 30, 2009 fiscal year (FY) end, the state's controller has now begun issuing registered warrants (IOUs) for certain non-priority payments to preserve cash, and the budget gap to be addressed has increased to $26.3 billion from $24.3 billion. The use of IOUs for non-priority payments would offset cash shortfalls into September 2009 as now currently projected.

The Rating Watch Negative reflects the short-term risk, in Fitch's view, that institutional gridlock could persist, further aggravating the state's already severe economic, revenue and liquidity challenges and weighing on the state's credit. Resolution of the Negative Watch will depend on actions taken to address the cash flow imbalance. The 'BBB' rating indicates that expectations of default risk remain low, although the rating is well below that of most other tax supported issuers. GO debt in California has a constitutional prior claim on revenues, although after education; appropriation debt has a lesser legal claim, but the controller prioritizes payment directly after GO debt service, ahead of other mandatory payments.

With issuance of IOUs for non-priority payments, margins for meeting constitutional and court-required contractual commitments are narrowing. After September 2009, absent any proposed budget and payment adjustments, cash deficits will expand dramatically. Cash flow solutions, including the ability to access short-term borrowing, are inextricably tied to reaching timely agreement on effective and credible budget solutions.
...
The inability of the state to reach agreement has prompted the controller to begin issuing IOUs for non-priority payments, primarily disbursements to vendors, for certain social services, and for tax refunds, in order to ensure payment of priority payments, including GO and lease debt service. The controller's office estimates that $3 billion in IOUs will be issued during July 2009; priority payments of $10.8 billion will be made for education, debt service, Medicaid, payroll, pensions and other mandatory contractual obligations. Projections will be revised to reflect June revenue performance and other changes but as currently estimated, cumulative cash deficits of $3.7 billion are projected through August, offset by $4.5 billion in non-priority payments that could be covered with IOUS, excluding tax refunds. However, by the end of October, the projected cash deficit expands to $16.1 billion, well beyond non-priority spending of only $10.6 billion, excluding tax refunds.
emphasis added

Fitch downgraded California from A to A-minus just 10 days ago.