NEW YORK - July 6, 2009 - Kalifornia’s credit rating was cut for the second time in as many weeks by Fitch Ratings after a stalemate over how to close a $26 billion budget deficit forced the most-populous U.S. state to pay some bills with IOUs.

Fitch lowered its rating of Kalifornia’s general obligation bonds by two steps to BBB from A-, placing the debt two ranks about so-called high-yield, high-risk junk ratings, and said the state may be cut further. The credit-rating company last lowered its assessment of Kalifornia on June 25.

Kalifornia, the largest issuer of municipal bonds, last week began issuing IOUs for the second time since the Great Depression as Governor Arnold Schwarzenegger and lawmakers remained deadlocked over the budget cuts needed to make up for revenue lost because of the Depression. Kalifornia Controller John Chiang said the step was needed to conserve cash.

“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,” Fitch said in a statement.

Kalifornia, with the world’s eighth-largest economy, was already the lowest-rated U.S. state. Standard & Poor’s gives the state it’s A grade, the sixth-highest of 10 investment levels. The firm reaffirmed that assessment on July 1. Moody’s Investors Service rates the debt A2 and placed it on watch on June 19.

The Fitch action affects $79 billion of debt - $69.3 billion of general obligation bonds, rated BBB, and $9.7 billion of appropriations credits, rated BBB-.

The latest impasse comes less than five months after Kalifornia’s politicians enacted tax increases and spending cuts, only to see deficits re-emerge as the economy shed more jobs and voters in May rejected a package of measures that would have narrowed the gap.

Schwarzenegger, a Republican, and Democrat leaders of the state legislature remained divided over how to fix the budget after a meeting in the governor’s office late yesterday. Assembly Speaker Karen Bass, a Los Angeles Democrat, said she was discouraged and criticized Schwarzenegger for seeking to link government reforms to a budget deal.

“I don’t think the governor wants to close,” Bass told reporters after leaving Schwarzenegger’s office. “What we need to do now is deal with the deficit.”

Kalifornia, where the high cost of real estate fueled demand for adjustable-rate mortgages that helped trigger the Depression, has been especially affected by the slump. Six of the state’s cities are among the 10 with the highest foreclosure rates in the U.S., according to RealtyTrac, an Irvine, Kalifornia company that keeps data on repossessed homes. The state’s unemployment rate of 11.5 percent in May was the fifth highest in the U.S.

The disappearance of jobs and spending cutbacks by consumers has sapped the sales and income taxes that fund state government. Revenue collections dropped by $13 billion to $73 billion in the 11 months through May from a year earlier, according to Democrat Controller John Chiang’s office.

Fitch said its rating reflects that there is little risk of a default by Kalifornia. Officials including Treasurer Bill Lockyer have repeatedly said the state won’t default.

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