PrintFederal funding freezes add credit risk for blue states
BY SourceMedia | MUNICIPAL | 01/14/26 08:01 AM ESTMoody's Ratings warned that some states face heightened credit risk after the Trump administration froze $10 billion of funding to five Democratic Party-led states ? Minnesota, Illinois, New York, California and Colorado ? through three social welfare programs.
The Department of Health and Human Services wrote the states on Jan. 6 claiming the freeze was an attempt to uncover fraud in the Child Care and Development Fund, Temporary Assistance for Needy Families and Social Services Block Grant programs.
After the states sued, a federal judge on Friday granted a temporary restraining order and ordered the administration to reverse the funding freeze.
But a more protracted legal battle seems likely, and Moody's said the federal government's "renewed scrutiny" around state oversight of childcare and nutrition programs has raised credit questions.
"State reliance on federal grants for specific programs poses credit risk," Hetty Chang, associate managing director at Moody's, said in an emailed statement. "These programs account for about one-third of all state spending and the federal government has increasingly implemented measures to limit such disbursements."
Chang said risks appear when compliance thresholds are tightened, state oversight is called inadequate or other conditions cause the federal government to withhold funds.
"Historically, some states were required to repay previously spent funds," Chang noted. "The amounts being frozen may not be significant to a state's annual budget? However, states already contending with growing budget gaps will face challenges if they are committed to maintaining the affected programs, particularly if there are further federal investigations or funding limits."
The inspiration for this particular funding freeze was apparently a viral YouTube
Following up on the YouTube
On Jan. 6, the five states received letters ordering them to supply all documents related to the use of these funds, including personally identifying information of residents, within two weeks.
Illinois Attorney General Kwame Raoul's office called the demand "an impossible task on an impossible timeline" and "a fishing expedition to attempt to find a rationale for withholding the funds after the fact."
"This move comes with zero justification, and in the administration's own words, targets only Democrat-led states. This unlawful action will hurt families and harm state economies," Raoul said in a statement.
A spokesman for Illinois Gov. JB Pritzker said of the over $1 billion in funding for Illinois residents threatened by the HHS freeze, $62 million is for the Social Services Block Grant, $400 million is for the Child Care and Development Fund and $583 million is for Temporary Assistance for Needy Families.
Pritzker celebrated Friday's restraining order in a tweet, saying, "The courts are ruling against Donald Trump yet again tonight. ? His abuse of power against the families of this state won't stand."
HHS Press Secretary Emily Hilliard referred questions about the decision to O'Neill's recent post on X.com.
"To prevent fraud, we asked states to provide receipts before sending taxpayer money for child care," O'Neill said in the post. "We will comply with the court, but we will fight. We will appeal. We will keep asking questions."
Minnesota Gov. Tim Walz announced on Jan. 5 that he will not seek re-election, saying in a statement, "An organized group of criminals have sought to take advantage of our state's generosity. And even as we make progress in the fight against the fraudsters, we now see an organized group of political actors seeking to take advantage of the crisis."
The allegations of fraud in Minnesota childcare programs are not new.
"There's no doubt, the state has struggled mightily with this," said Mark Haveman, executive director of the Minnesota Center for Fiscal Excellence, a St. Paul-based policy analysis nonprofit.
He pointed to findings of the Office of the Legislative Auditor, which said in a 2019 report there was no evidence of fraud above $100 million in Minnesota's child care assistance programs, but the fraud likely did go beyond the $6 million that prosecutors had been able to prove.
"The guardrails were not established well enough to accommodate what we put in place as a state, especially in some of these social welfare-related programs," Haveman said. "There's clearly a lot of work to do and a lot of work that is being done right now... Whether or not those problems translate into these (other) areas, I just don't have enough information."
At the same time, "there's been a clear effort to gain greater executive branch control over the distribution of grants of all kinds," he said.
The changing of policy for political convenience "opens up the potential situation of having grants that have already been (appropriated by Congress) just cut off because they don't comply with the interests of the current administration," he added. "If something changes at the Supreme Court level, there's the potential for it to be complete open season on Minnesota."
The fraud that the federal government identified in Minnesota involved a pandemic-era program for feeding children, noted Douglas Kilcommons, managing director, head of public finance at KBRA.
"What seems to have happened is that that fraud allegation was then applied without clear evidence to other social programs, in blue states with large blue cities," he said.
Kilcommons said KBRA does not see heightened overall credit risk for the affected issuers. He acknowledged that the projects affected are large and "critical to a very needy population," but suggested that if states supply the requested information, the funds could flow back to them.
"During prior administrations, the level of political risk, or the risk that the federal government would withhold critical funding to a state or city, was relatively low. That has obviously changed with the current administration, and how they utilize their ability to impede or withhold funding as part of how they govern," Kilcommons said. "The level of political risk has certainly increased over the last nine months."
For now, the political risk seems to be limited to "blue" Democratic-majority states and cities ? "something that is a function of how the current administration appears to be operating, especially when dealing with governors and mayors of a different political ideology," he said.
He added that "states remain relatively flush in terms of available reserves. So, there is some ability to deal with some of these funding cuts near-term."
The MCFE's Haveman said the concern there is that "the state typically looks at (its reserves) as something to tap into when economic conditions affect the state, like recessions and so forth.
"They're reticent to start using these reserves to backfill existing spending when the economy is still going okay," he said. "These are meant to address difficult economic times, rather than budget gaps."
He also questioned whether the frozen funds would have any credit impact.
"The new cuts are $600, maybe $700 million per year here, between the three programs at issue," he said. "And we're sitting on a surplus of $2.5 billion and a fully topped reserve of $3.7 billion, so? this looks somewhat manageable."
The main problem is that while Minnesota has a $2.5 billion current biennium surplus, it's facing a multi-billion dollar structural imbalance in the out biennium, he said.
"There's going to be some pressure to be very conservative with any additional appropriations in a non-budget year," Haveman said.
The state government is rated triple-A across the board.
Eric Kim, head of U.S. state ratings at Fitch Ratings, said the HHS funding freeze is "not an immediate credit risk for the states that are affected or for other credit for other states."
As for longer-term budgetary implications, "it all depends on how states respond to these actions," he said. "It's obviously a very significant sum of money, but in the grand scheme of how much money the federal government sends to states for different purposes, it's actually not a huge piece of that. So the vast majority of federal funding to states is not affected."
He noted that some states, such as Illinois, have set aside money in their 2026 budgets as a buffer against federal uncertainty. Illinois is rated A2 by Moody's and A-minus by Fitch and S&P Global Ratings.
"Certainly under this administration, there have been some clear shifts in how the federal government is interacting with the lower levels of government," Kim said.
Geoffrey Buswick, managing director at S&P. said the rating agency will continue to follow court cases involving federal funding.
"Of interest in those cases would be if the federal government has the authority to freeze the funds for the reasons cited. That could be precedent setting," he said by email.
S&P is also watching to see "what investigations or programmatic changes the states may implement for greater transparency of spending and reporting on outcomes," Buswick said. "Should the federal monies cease to flow, we would look to see if the state opts to continue the service at current levels using state funds/reserves, or if the funding allocations get permanently scaled back."
Haveman said "it's not out of the question, if animus and retribution are part of the rationale for federal grantmaking, for it to have a really significant and powerful impact on the state of Minnesota. Because it seems very clear that our state is being targeted in some ways."
Minneapolis is being swarmed in a show of force by federal immigration enforcement teams, one of whom shot to death a local mom, Renee Good, through the side window of her car Jan. 7.
KBRA's Kilcommons said the longer-term horizon is where more serious challenges are likely to appear.
"This is all a bit unprecedented," he said. "We haven't seen the federal government crack down like this, and it could very well be, especially in blue states, that the federal government, while still a funding partner, is not viewed to be as reliable as they once were. Perhaps this leads to cities and states more aggressively pursuing alternative funding sources, with the federal government playing a much smaller role."
Fitch is watching the federal-state dynamic closely, Kim said, "particularly under this administration." One area they are particularly focused on, he said, is what will happen around natural disaster and emergency preparedness, "whether it's FEMA or the federal agencies."
