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 revenue crisis.

The state last week started issuing IOU promissory notes for some bills to conserve cash for priority payments, including payments to investors holding the state's debt.

The 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 could raise California's borrowing costs during a severe cash crunch in Sacramento, the state capital, where talks between Governor Arnold Schwarzenegger and lawmakers to plug a $26.3 billion budget deficit for the fiscal year that began on July 1 are plodding along.

If we're forced to pay tens of millions of dollars, if not hundreds of millions of dollars, in higher interest costs because we have a delayed budget, that's tantamount to lighting money on fire, said H.D. Palmer, a spokesman for the state's Department of Finance. That's money that we could be spending on things like health care or education.

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 due to the state's inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis.

FITCH EYES CALIFORNIA'S CASH

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.

Bass told reporters it was Schwarzenegger who was holding up budget talks by pushing to include overhauls of state government in negotiations: The issue of reforms, I think are critical, but we can begin the reform process the day after the budget revision is signed.

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

The ratings agency said California needs a balanced budget agreement quickly because it will need to sell short-term debt for cash-flow purposes once it has a spending plan.

Fitch analyst Douglas Offerman said the rating agency is keeping a close eye on how California manages its cash, sharply reduced as revenues have plunged amid recession, rising unemployment and a prolonged housing slump.

California is experiencing the worst drop in revenues from personal income taxes since the Great Depression.

The (state) controller having to issue IOUs is one thing, but the controller's own projection is that the state's projected cash position in the fall gets dramatically worse without a resolution to the budget, Offerman told Reuters.

That raises the urgency to developing a budget solution that is going to address the cash-flow problem the state has in a responsible way, he said.

Questions have arisen whether California's tax-exempt IOUs can be bought, sold and traded.

The Securities and Exchange Commission must first determine if the IOUs are securities to regulate them, said Ernesto Lanza, general counsel to the Municipal Securities Rulemaking Board, adding that the board was not working directly with the commission on that decision.

It looks like it has all the hallmarks of a security, Lanza said. If they are securities, I think they're pretty clearly municipal securities.

Fitch's downgrade was seen having little effect Tuesday on the municipal debt market. I don't see any huge negative reaction, it's priced in, said Parker Colvin, head of municipal securities trading at Stone & Youngberg in San Francisco.

(Additional reporting by Marianne Russ in Sacramento, California, and Lisa Lambert in Washington; Editing by Phil Berlowitz)

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