Are states next in line for federal bailout?

How California fares with a $4 billion short-term bond sale this week will help answer a key question looming over the current US financial crisis: are traditional credit markets so frozen that states won't be able to raise revenues to tide them over their cash crunch?

The practice of selling short-term bonds is used regularly by at least a dozen US states, and occasionally by several more, to keep state programs and services running smoothly year round.

Because tax income is not steady throughout the year – far more revenue comes in from September through December than January through March – California and others (including Massachusetts, New Jersey, Nevada, Rhode Island, Arizona, Delaware, New York, Florida, and Alabama) borrow short-term to pay their bills when revenues are temporarily insufficient.

Now, with states facing the same problem faced by millions of businesses – tightening credit markets – at the same time that revenues are sinking, many budget officials are worried that they may not be able to borrow when they need to.

Will states turn to Washington?

Some, including California, have notified US Treasury Secretary Henry Paulson that if the credit markets don't come through, they may be knocking on his door.

There is currently no formal mechanism in place for the federal government to provide loans to states unless the need is generated by a natural disaster, say experts.

By law, states have to balance their budgets each year. If several go to the federal government and line up all at once, who will decide which states gets the limited – and dwindling – funds?

"This is an unprecedented situation because of the scope of the lending needs," says Alan Rubin, director of federal government relations for Buchanan Ingersoll & Rooney, which has decades of experience in state financing. "If these states can't get their funds the usual way and start asking the federal government, there is no clear-cut way for Washington to respond."

The federal government is best prepared to come through with funding after disasters – such as Katrina or 9/11 – says Mr. Rubin and others.

"This could pit states against each other in very uncomfortable ways," says Rubin.

"If the federal government has to determine who gets $6 billion and who gets $10 billion, there's likely to be a lot of finger-pointing. People will be very angry if politics becomes the methodology – there are real issues that are critical to determine. We've never been there before."

Scott Pattison, executive director for the National Association of State Budget Officers, says "about 10 to 12 states in the next few months might have to go on market for a RAN [short-term bonds called Revenue Anticipatory Notes]."

Most states have rainy day funds they are dipping into during the current revenue crisis. Other states may be forced to raise taxes, cut services, or do both, he says.

Optimism after Massachusetts' sale

California needs to make up a $7 billion shortfall. But state Finance Department spokesman H.D. Palmer says this week's bond sale will attempt to collect only $4 billion.

"Given the market conditions, we concluded it was best to go only for $4 billion immediately and try for $3 billion more in a few weeks," he says.

Because Massachusetts successfully marketed $700 million in bonds last week, Palmer says Governor Schwarzenegger is "cautiously optimistic."

The state sent a letter to Henry Paulson last week saying that if the bond sale doesn't work, officials hope to borrow from the US Treasury under the recently signed Troubled Asset Relief Program (TARP).

"The Treasury hasn't answered yet," says Nick Johnson, director of the state fiscal project for the Center for Budget Planning and Priorities. "There's some discussion on whether or not they have legal authority to do so."

The issue to watch, say several state fiscal analysts, will be whether the credit markets will be able to loan money to California and other states. If not, it sends a dire signal to the rest of the country's businesses.

"States are the safest loans out there with the exception of a loan to the US federal government," says Donald Boyd, a state fiscal analyst with the Rockefeller Institute of Government, the public policy research arm of the State University of New York.

"They have very diverse economies, have the power to tax, and cannot go bankrupt. How can General Motors get a loan, if the state of Massachusetts cannot?"