With California set to run out of cash by September, the state is finding it increasingly difficult to borrow its way out of trouble.

Lenders are rattled by California's $38.2 billion budget deficit and the prospect that the all-but-certain recall election against Gov. Gray Davis will only prolong the stalemate. Wall Street warned recently that it might downgrade the state's credit rating, which would trigger higher borrowing costs. Meanwhile, some big investment firms that usually purchase state government bonds have stopped buying.

It's a vicious circle: The more desperate California gets, the harder and more expensive it becomes to obtain loans that would ease the state's financial crisis.

Consider that California needs to sell $3 billion worth of securities by early September or it will be penniless, according to state officials. Yet legislative deadlock makes it more and more unlikely that the deal can be put together quickly enough.

State Treasurer Phil Angelides said a budget must pass by Tuesday or the $3 billion won't be available. That's because it takes at least six weeks to complete the transaction -- preparing the cash-flow estimates demanded by Wall Street, marketing the securities and so on -- and the process cannot start without a budget.

Given the enormity of California's fiscal mess, Angelides said Friday that investors might insist on extra time to scrutinize the offering. "Six weeks is what I'd consider an aggressive timeline," he said.

What's more, Wall Street won't swallow the $3 billion in securities if it thinks the budget is fishy, Angelides said. "It needs to be truly balanced, not speculatively balanced."

There's another complication.

A bond sale completed in June, which did not require that a budget be in place, came with some costly strings attached that could scare off potential buyers of the new $3 billion offering.

To complete the June sale, which raised a sorely needed $11 billion, California offered special enticements to the investment funds, insurance companies and other big bond buyers. These little-publicized incentives prevent the state from selling any new bonds that would be repaid before the $11 billion is paid off. That restriction will make the $3 billion sale a tough one, Wall Street analysts said.

"You're going to have a hard time finding people stepping up for that," said public-finance analyst David Hitchcock of Standard & Poor's, one of the leading Wall Street credit-rating firms.

Angelides said he believes the state can alleviate investors' concerns about the soundness of the $3 billion offering.

If the $3 billion doesn't arrive in time, however, state officials will start trimming expenses to stretch out their fast-dwindling reserves. But it's not clear what would happen if the state ran completely out of cash.

"We don't exactly know," said Sandy Harrison, a spokesman for Controller Steve Westly.

But even if the $3 billion deal is done by September, state officials and others say Wall Street's hunger for California bonds may be reaching its limits.

"You never know when the appetite's going to end, 'til it ends," said analyst Claire Cohen of Fitch Ratings, a Wall Street bond-rating firm.

As if to underscore that sentiment, state lawmakers agreed in May to shelve proposals to issue billions of dollars of new bonds to finance public works projects.

California has routinely borrowed on Wall Street, in good times and bad, to pay for roads, schools and the like -- and to bridge temporary cash shortages. Tax revenue tends to dry up in the fall and the $3 billion securities sale needed by early September would cover a typical seasonal cash shortage that will occur even with a budget in place.

But as the fiscal and political crisis in Sacramento intensifies, investors are getting nervous.

On July 2, S&P and Moody's Investors Service announced they might lower California's general bond rating, the grade assigned to most long-term borrowings.

Analysts at both firms said they're worried about California's perilous financial picture and the possibility that a bitterly fought gubernatorial recall campaign could drag out the budget process. Moody's cited the "increased risk that the state may not be able to reach consensus on a budget prior to exhausting its cash resources."

As it is, California's ratings are the lowest of any state. S&P gives California an A rating. Moody's, using a different system, gives an A2 rating to California, New York and Louisiana.

A decline in the state's credit rating would force California to pay higher interest expense on the $24.6 billion in bonds that have been authorized but not yet sold. Angelides estimated it would cost California between $400 million and $850 million in extra interest over the 30-year life of those bonds.

A downgrade wouldn't change the interest California pays on the billions of bonds already sold.

Similarly, S&P's Hitchcock said a lower rating probably wouldn't affect the proposed $10.7 billion multiyear bond that Democrats and Republicans have informally agreed should be part of the budget solution. But that's only true as long as there's "dedicated" revenue -- such as the governor's proposed sales tax hike -- earmarked to pay off the bonds.

In any event, Wall Street experts said California will have to pass a "credible budget" to get back in investors' good graces. That means a budget based on believable cash-flow estimates and not accounting gimmicks or false promises, analysts said.

"We pass a bogus budget that Wall Street doesn't believe in, that will be problematic for (future borrowings)," said Mark Battey, the state's chief deputy controller.

Battey said the state's reputation on Wall Street is tenuous. That point was driven home last month, when Westly, Battey's boss, completed the sale of $11 billion worth of securities known as revenue anticipation warrants. He needed the money to help pay off $12.5 billion in bonds California sold earlier to keep the state going.

Wall Street, however, balked at buying the $11 billion in new securities. Credit rating agencies planned to assign the securities such a low score that many insurance companies, money market funds and other typical investors would have walked away from the offering, said Battey and Wall Street analysts.

So the state added a sweetener -- a series of "credit enhancement" agreements with giant investment firms such as Merrill Lynch & Co. and Bank of America. Under the terms of the deal, those firms, in effect, guaranteed the notes. The credit agencies then raised their ratings on the securities, making them more marketable.

Naturally, the guarantees came with a price. Right off the bat, the firms charged the state $84 million. More importantly, the firms attached covenants to the securities that have limited California's options when it comes to future borrowings.

Specifically, the state can't issue additional bonds that would come due before the $11 billion is paid off next June.

That's an important restriction in the often-bewildering world of public finance. Here's why: Potential investors might resist buying a bond that gets repaid after the $11 billion is paid because they'll fear there won't be enough money to satisfy the newer debt, S&P's Hitchcock said.

Battey acknowledged that by agreeing to the covenants, "you're tying your hands." But he and Wall Street experts said the state had little choice.

With the guarantee of the big investment firms, the securities won a top-drawer rating and a low interest rate of 1.13 percent.

Yet Battey said it was troubling that some of the big firms that usually buy California bonds -- Fidelity Investments, Vanguard Group and others -- didn't purchase any of the securities. A Fidelity spokesman had no comment, and a Vanguard official couldn't be reached.

"They didn't show up to play," Battey said. "The budget risk may have been too high for some of the buyers to stomach."

What California's credit ratings mean

Wall Street's credit-rating firms are considering downgrading California's credit rating, citing uncertainty about the state's fiscal health. A lower rating translates into higher borrowing costs. Here's how the two leading credit rating firms currently assess California's long-term bonds:

* Moody's Investors Service rates California as A2, tying it with New York and Louisiana for the lowest designation of any state. An A2 rating is defined as having "above-average creditworthiness relative to other U.S. municipal or tax-exempt issuers or issues."

* Standard & Poor's rates California as A, the lowest of any state. It's defined as having "strong capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions."