(Updated 4:30 p.m. EDT, Sept. 19, 2008)
The turmoil on Wall Street is setting off warning bells in state capitols. The immediate casualty is the loss of millions of dollars in the value of states' pension funds and other investments, but a bigger fear of state officials is a prolonged financial crisis that further reduces already shrinking tax revenue.
Most states diversify their portfolios, which helps cushion the collapse of the investment bank Lehman Brothers Brothers Holdings Inc. and the federal takeover of giant insurer American International Group Inc. Of greater long-term concern to state officials, they say, is how events on Wall Street are tightening credit, threatening to slow down business and consumer spending.
If that continues, state tax revenues could plunge further at a time when more than half of states already are having trouble making ends meet because of the mortgage meltdown that began last year. Because every state but Vermont is constitutionally required to balance its budget, they have little maneuvering room. So at least 29 states have instituted some combination of spending cuts, hiring freezes, tax increases and borrowing to cover shortfalls.
"The impact on tax revenue is likely to be significant and damaging," said Robert Ward, deputy director of the Rockefeller Institute of Government in Albany.
Massachusetts Gov. Deval Patrick (D) said "we are beginning to see some early declines in state (tax) revenues."
New York , which already projects a $22 billion budget gap over the next three years, would be hardest hit because the financial services industry is the largest in the state. According to some estimates, financial workers account for 20 percent of annual state tax revenues. Connecticut and New Jersey are also braced for a hit.
Aware of the need to restore confidence in the financial system, the Bush administration began discussing with Congress on Sept. 19 a rescue plan to insure money market funds and buy bad mortgages from banks and other financial institutions. The stock market shot up about 370 points in response to the news.
Besides suffering the budgetary effects of a national financial crisis, states will also face a regulatory impact. They will be forced to oversee the unwinding of AIG assets as it complies with terms of the $85 billion federal takeover. The nation's largest insurer gradually will sell off its insurance units to repay Uncle Sam over the next two years.
The National Association of Insurance Commissioners is forming a working group of commissioners to oversee the AIG sell-off. The group will be headed by Eric Dinallo, New York 's insurance commissioner. Joel Ario, Pennsylvania 's commissioner, will be vice chairman. The commissioners plan to discuss the sell-off at their annual fall meeting in the Washington area that starts Sept. 22.
AIG is a huge holding company with businesses ranging from car and home insurance to aircraft leasing. But its 71 state-regulated insurance companies are financially strong and are not part of the federal rescue, Kansas insurance commissioner Sandy Praeger said. Preager, who heads the insurance commissioners association, said it is the non-insurance businesses within AIG's financial products unit that caused the problems.
The life and property-casualty insurance companies are among AIG's most profitable, which makes it likely they will be sold to raise cash, said Sujit CanagaRetna, senior fiscal analyst in the southern region office of the Council of State Governments. Any such sales, however, would have to be approved by state insurance officials, who will make the sure the sale price is reasonable and the buyer has adequate assets to cover claims.
State insurance commissioners have been flooded with calls from AIG policyholders this week asking about the safety of their policies. "The basic message is that the (AIG) insurance companies are solvent. That means they can pay their claims," Praeger said.
States can take over troubled insurance companies. In a worst case, policyholders are protected by state guaranty funds, much like the Federal Deposit Insurance Corporation protects bank accounts.
When Lehman Brothers filed for bankruptcy on Sept. 15, state finance officials, who had been monitoring the situation, knew very quickly the extent of their losses. The good news was that the states' investments in Lehman were a fraction of their total holdings.
Lehman stocks and bonds accounted for only 2/10s of 1 percent of Connecticut 's $25 billion pension fund, for example. "As long-term investors with a well-diversified portfolio, we are well-positioned to weather this latest turbulence," said Connecticut treasurer Denise Nappier.
Nearly all state and local governments buy shares in investment banks such as Lehman so no one is completely immune from the financial meltdown. In the last 15 years, many have switched from conservative investments such as Treasury bills to purchasing stock in large financial firms such as Lehman, said CanagaRetna of the Council of State Governments.
States that held stocks and bonds through AIG's institutional investment program stood to lose millions of dollars more in investments if AIG had gone belly up; Wisconsin's public investment board held $139 million of AIG stock out of a fund of $79.4 billion, for example.
Part of the federal government's thinking behind rescuing AIG was that the company was too big to be allowed to go broke. Even before the Federal Reserve Bank acted, New York Gov. David Paterson exercised state power to help the firm. His waiver of state insurance capital requirements would have freed up $20 billion to help AIG meet its obligations.
Scott Pattison, executive director of the National Association of State Budget Officers, said the financial uncertainty over the last few weeks is of grave concern to state officials in part because no one can predict what is going to happen next.
"They're concerned about the condition of the economy and this is another example of how careful they need to be," Pattison said of the week's events. "Is another shoe going to drop?"