As a result, the State of California has run out of cash and its paying its obligations with IOUs instead. This strategy does not appear to be working. Starting Friday, the leading banks in the state will stop accepting State of California IOUs.
While the United States can always issue more debt to pay for its obligations, and so far, there have always been buyers for that debt, state and local governments cannot. State and local goverments do business in a currency, the U.S. dollar, over which they have no control, just like private businesses. Typically, state and local governments must balance their budgets and need either supermajority approval or a vote of the people to issue additional debt. As California is the biggest governmental entity in the country other than the United States government itself, its inability to balance its budget and complete lack of liquid funds is a big problem.
It isn't inconceivable that the State of California would have to resort to bankruptcy. Governmental bankruptcies are normally handled under the little known Chapter 9 of the bankruptcy code, but it isn't clear if this applies to states. No state has ever filed for bankruptcy in U.S. history, to the best of my knowledge, and Section 109(c) of the Title 11 of the United States Code (the Bankruptcy Code) provides that:
An entity may be a debtor under chapter 9 of this title if and only if such entity -
(1) is a municipality;
(2) is specifically authorized, in its capacity as a municipality or by name, to be a debtor under such chapter by State law, or by a governmental officer or organization empowered by State law to authorize such entity to be a debtor under such chapter;
(3) is insolvent;
(4) desires to effect a plan to adjust such debts; and
(5)(A) has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter;
(B) has negotiated in good faith with creditors and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter;
(C) is unable to negotiate with creditors because such negotiation is impracticable; or
(D) reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under section 547 of this title.
It isn't clear that a state can be a municipality within the sense of Section 109(c), and there is little precedent to guide this determination. Special federal bailout legislation might be required if California can't manage to work out its problems on its own.
Orange County, California filed for bankruptcy under Chapter 9 in December, 2004 in the largest bankruptcy filing under Chapter 9 ever, when it was burned to the tune of $1.7 billion of losses in financial derviatives transactions not directly related to county business.