States Feeling Credit Crunch Pain

The combination of declining revenues, increasing expenses, and insufficient access to capital is a deadly one for local municipalities.

"Houston, we have a problem," said the Apollo 13 astronauts when faced with a compounding set of issues during a failed lunar mission. Finance managers of local municipalities around the country can relate to that scenario; they're currently dealing with their own set of snowballing problems.

Tornado of bad news

The economy is producing a rare confluence of bad circumstances for local governments: declining revenues, increasing expenses, and insufficient access to capital. The situation is so dire that huge budget cuts are on the horizon for many state, county, and city coffers.  

Local municipalities generate revenue primarily from taxes on sales, properties, and income, as well as on interest and investment earnings. All of these sources are currently experiencing varying degrees of downward pressure:

• Sales taxes are declining as consumers reign in their spending.
• Property taxes are heading south as home values weaken.
• Income taxes have been impacted by rising unemployment.
• Interest and investment earnings are taking a beating as governments transition out of risky investments.

Some local municipalities, including the city of Long Beach, California, got stuck holding commercial paper issued by the now-bankrupt Lehman Brothers. Situations like this cause two problems. First, the money invested in the impaired security may not be recovered-which means a loss of city funds. Second, the municipality must reduce its investment earnings projections going forward. That creates a revenue shortfall.

Meanwhile, more people are in need of government services, and the cost of providing them continues to rise. Increasing foreclosures are causing problems, too-since those houses require more inspections by city staffers.

Credit crunch blues

Local governments generally have two options for raising capital: increase tax rates or sell bonds. Increasing tax rates is always an unpopular choice, but selling bonds may be downright impossible. With the country in the midst of a credit crunch, the marketability of municipal bonds is questionable.

States cut services, get creative

California, Maine, Nevada, and Rhode Island have already begun slashing budgets. Specific actions range from hiring freezes to layoffs, and complete program cancellations. Massachusetts is raising taxes. California Governor Arnold Schwarzenegger has dropped a few hints about asking Treasury Secretary Paulson to loan his state $7 billion until the credit markets recover. And local politicians in Long Beach recently passed a measure allowing the city to sell corporate logo placements on city-owned buildings and property.

Paulson, we have a problem

In the face of all this uncertainty, it's likely that Governor Schwarzenegger won't be the only one asking Secretary Paulson for help. As banks and financial firms fail at record rates, some local governments might be at risk of failure, too.