Credit Crisis Means States May Need Help From Federal Treasury

SAN FRANCISCO—Arnold Schwarzenegger, the governor of the nation's biggest, wealthiest state, began the grim parade last week. In a letter to Treasury Secretary Henry Paulson, Schwarzenegger said the credit crisis and the slowing economy had left his state suddenly short on the cash it needs to pay for its day-to-day operations. If tax revenues continue slowing and no willing lenders emerge in the frozen credit markets, California—a state "so large," Schwarzenegger wrote, "that [its] short-term cash flow needs exceed the entire budget of some states"—would need an emergency $7 billion loan.

Early this week, Massachusetts seemed to inch closer to following California's lead, when it delayed a planned $750 million bond sale for the second time. Bond sales are a critical lifeline for state governments, which often use the money to pay for everyday expenses from public employee paychecks to K-12 education. After several unsuccessful attempts, the state finally found a willing lender yesterday. Without the loan, state officials worried that the $750 million in cash they had in hand—$600 million of it borrowed—would not be enough to continue paying for state services.

Credit-induced anxiety continues to spread to other states. Louisiana and New Mexico have also delayed multimillion-dollar bond sales, citing the uncertain economy. A handful of other states that have been crippled by the collapse of the housing market, including Florida, Nevada, and Arizona, are scrambling to fund state operations. California alone, according to a recent study, accounts for one third of the country's foreclosures—and local governments have watched millions of dollars in property taxes simply evaporate.

The worst, for state and local governments, may be yet to come. "The damage is just beginning," according to a study released this week by the State University of New York's Rockefeller Institute of Government. State governments are always hurt when the economy slows, and the current crisis is no different: Through July, the study finds, revenue from sales taxes, corporate income taxes, and motor fuel taxes was already beginning to dry up. Adjusted for inflation, state tax collections through the summer climbed about 1.5 percent overall—mostly because of strong income tax revenue in 2007—but with a recession looming, those numbers are expected to decline dramatically. "Below the surface," says Donald Boyd, a senior fellow at the institute who coauthored the study, "great trouble is brewing."

On top of the slowing economy, the credit markets are frozen, leaving many states with few good options. "We're at the point where the money most states have in the bank is not that much worse than what we've seen in past recessions," says Boyd. "What's extraordinary is that the world is falling apart around them. There's no place to hide this time." As Schwarzenegger put it in his letter to Paulson, if they can't raise revenues and are unable to borrow, "California and other states may be unable to obtain the necessary level of financing to maintain government operations and may be forced to turn to the federal Treasury for short-term financing."

This, experts say, has hardly ever happened before. "It's very unusual for large states with good credit ratings to be wondering who they are going to be able to borrow from," says Mark Baldassare, executive director of the Public Policy Institute of California. "It's a serious situation."

Some may dismiss state government woes as a problem only for public employees. But particularly in large states, a struggling government can greatly contribute to the vicious cycle dragging down a slowing economy. The state of California, for example, spends close to $150 billion every year. Forty percent of its budget goes to K-12 education, another quarter to health and human services. The state's treasurer warned last week that its cash revenues might disappear completely by the end of October, which could force the state's 5,000 cities, counties, and school districts to lay off thousands of police officers, teachers, and nurses. "It's not money that's just going to the state capital. This is money that is distributed throughout the state," says Baldassare. "It definitely has a huge ripple effect."

So, what can be done? California lawmakers, like their counterparts in many other states, are meeting this week to determine what their options are. The state, after an 85-day impasse, signed its budget only 15 days ago but California is already dropping into the red. According to the state controller, in September alone, personal income taxes were 4.6 percent below estimates, sales taxes were 5.7 percent short, and corporate taxes were almost 19 percent behind projections. One quarter into the fiscal year, the state is already running a $4.6 billion deficit. "We've got to do something," Don Perata, the state's Democratic Senate majority leader said earlier this week. "We're not supporting any additional tax increases," responded Dave Cogdill, the Senate GOP leader.

That may leave borrowing—from the federal government, if necessary. The Federal Reserve's decision this week to start buying up short-term debt could loosen up the credit markets enough that states will be able to get loans from someone other than the feds. With the market in disarray, though, experts aren't sure what to expect. "Like everything else in this that we've experienced in the last few weeks," says Baldassare, "it's hard to say if it's enough, but it's recognizing that there's a problem and that's a start."