NEW TECHNOLOGY

SAN FRANCISCO—For several nail-biting days this month, the credit freeze, after cutting businesses and banks off from lenders, seemed poised to ice over the day-to-day operations of state governments as well. In a remarkably frank letter to Treasury Secretary Henry Paulson on October 2, Arnold Schwarzenegger, the governor of the nation's most populous, wealthiest state, said the slowing economy had left California suddenly short on cash. With no willing lenders emerging, he warned, the state might "be unable to obtain the necessary level of financing to maintain government operations"—and could require an emergency $7 billion loan.

Schwarzenegger was far from the only governor faced with the prospect of turning, hat in hand, to the feds. Citing the frozen credit markets, a handful of other states, including Louisiana, New Mexico, and Oregon, all delayed scheduled bond sales, a critical lifeline for state governments, which use the money to pay for everything from public employee paychecks to K-12 education. Massachusetts, unable to find a willing lender, twice delayed a $750 million sale. Florida, Nevada, and Arizona, three of the states hardest hit by the collapse of the housing market, all have been scrambling to fund state operations. "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, president and CEO of the Public Policy Institute of California. "It's a serious situation."

Bonds for sale. As Washington moved this week to begin shoring up the credit markets, the short-term danger, at least, seemed to pass. Massachusetts finally found a private lender, so the state has enough funds to continue day-to-day operations through November. Schwarzenegger, meanwhile, began appearing in radio advertisements trying to drum up interest in a $4 billion sale of California bonds, which were made available to private investors this week. He sent another letter to Paulson saying he was now "cautiously optimistic" about the state's credit prospects.

Still, experts say, state governments aren't out of the woods yet. Though their short-term financing problems may have been relieved, many states now face an even bigger—and longer-term—threat from the slowing economy. "The damage is just beginning," concludes a new study by the State University of New York's Rockefeller Institute of Government. The problem is that tax revenues, the lifeblood of state governments, are drying up. In September, personal income tax revenues in California were 4.6 percent below estimates; sales taxes brought in 5.7 percent less, and corporate tax receipts were almost 19 percent behind projections. At least 15 state budgets have fallen out of balance since this summer. "Below the surface," says Donald Boyd, a senior fellow at the institute who coauthored the study, "great trouble is brewing."

Many states are trying to find ways to stop the bleeding before it starts. The governor of Georgia, suddenly facing a $2 billion shortfall, ordered a 6 percent cut to every department but education, which will see less severe cutbacks. In New York, facing its highest unemployment levels on Wall Street since after 9/11, the governor asked for a 10 percent cut. Arizona froze all state contracts larger than $50,000. In Utah, more than 19,000 state workers will lose Medicaid benefits. Planned construction of new schools in Connecticut and new pris-ons in Iowa have been put on hold. Because many states do not have year-round legislatures, says Arturo Perez, a fiscal analyst at the National Conference of State Legislatures, more substantial cuts are likely when lawmakers reconvene in January.

In the meantime, some state leaders are looking elsewhere for recourse. Jon Corzine, the governor of New Jersey, has said he may seek legal action against Lehman Brothers, after the state's pension fund bought $200 million of the bank's stock only to see more than half of its investment evaporate when the bank failed. In West Virginia, Gov. Joe Manchin says he may target some of the Wall Street firms the federal government is currently bailing out, like AIG. "I want somebody to pay," he says.

Most states, though, are simply trying to weather the storm. "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."