Clyde, Texas defaulted on its loans after a drought. It’s a warning.

With physical climate risks increasing and FEMA support disappearing, states have an opportunity to push hard for transformative adaptation--but much clearer communication is needed.

Many states are doing great things when it comes to climate adaptation. Take a look at Alabama's fortified roof program (now echoed in many other states) or North Carolina's efforts to provide high-quality flood mapping resources to towns so they can make better infrastructure investments. The problem is that even when states are well intentioned, there is not enough money available for the scale of action needed. We're running out of time to plan, and awareness of what's ahead remains dangerously low—even this week, when over 170 million Americans are suffering under extreme heat made far more likely and more intense by a rapidly changing climate.

We're all just hoping that the storm (in whatever form) won't happen to us. We are nowhere close to doing what needs to be done—because that would require living differently, in different places, in response to risks that remain mostly invisible to many.

All of this is so hopelessly human. It is very hard to persuade anyone, including politicians and voters, to spend money in advance to avoid far greater costs and physical risks in the future. So instead of large-scale public policies actually lowering people's exposure to accelerating climate harms, markets are increasingly stepping in—financializing physical climate risks, tinkering with prediction markets and insurance hedges and exploring converting homeowners into renters.

Usefully, markets are also sending clear, if unsettling, signals about where we're headed. States and cities that are short on resources should take advantage of these signals, communicating clearly about physical climate risk and the urgent need for transformative, if expensive, adaptation. Here's the headline: We are facing disruptive physical climate risk and we need to spend money now to help our cities, our economic engines, adapt. Otherwise, the financial stability and future prospects of our entire state are threatened. Right now, smaller places are struggling, but the contagion will spread.

Last summer, the city of Clyde, Texas (pop. under 4,000) made headlines by defaulting on its municipal bonds as it struggled with water scarcity (H/T Jesse Keenan). A severe drought meant the city's water system couldn't sell enough water to pay its bills and service its debt. At the same time, it had to spend more money buying water from nearby Abilene and patching old water infrastructure.

Although Clyde pointed directly to climate concerns when it disclosed its default, it turned out that questionable fiscal management likely contributed to its problems: The year before it defaulted, Clyde used money earmarked for future construction projects to pay off existing loans and authorized a large, unexplained expansion of its Parks and Recreation budget. At the end of fiscal year 2023, Clyde had about $43 million in outstanding loans—an enormous burden for a small town. Following the default, Clyde raised property taxes and water bills, cut its budget, and took out yet another loan at 9.5% interest—to pay back the bond insurance companies that covered the default and to keep some money around for the city's operations until more tax revenue could be collected.

S&P lowered the city's credit score twice, which will make it very expensive for Clyde to borrow money in future years. Moody's, which does not rate Clyde's bonds, wrote about the city's default in December 2024, saying that if the city had raised property taxes earlier the drought might have been manageable—while also acknowledging that the situation "was somewhat exacerbated by a drought which reduced utility revenues."

Climate stress alone may not have caused Clyde to default on its obligations, but it likely made the city's fragile financial state worse.

Now another amplifying force has arrived: As FEMA considers withdrawing support and shifting greater responsibilities to states, more cities in America that are larger than Clyde—and are already running bare-bones budgets because of steady withdrawal of state aid and heightened resistance to increased property taxes—will buckle under the combined strains they face. Perhaps they'll scramble to raise money through bonds. But it will be expensive, as S&P Global recently warned ("Federal Disaster Relief Funding Proposals Could Elevate Credit Risks for U.S. Governments”), arguing that "a loss of federal disaster relief funds would disproportionately affect state and local governments most vulnerable to disasters and could be material to credit."

The rating agencies, it seems, are finally saying they won't be rolling out the red carpet for local governments facing more significant exposure to disasters that have a limited ability to absorb increased financial stress. As Keenan put it recently, "Expect further delinquencies, defaults, and ultimately municipal bankruptcies on the horizon." A state is not an isolated entity from its cities, and what happened in Clyde will be happening in bigger, better-managed municipalities.

This is an opportunity for states to take charge of their climate adaptation destinies. Without a FEMA backstop automatically kicking in, states will have to develop investment frameworks guided by metrics (EDF) that prioritize particular areas for continued spending, conditioned on adoption of forward-looking building codes and land use practices. We're also in the throes of a nationwide housing crisis. We are not building enough housing to keep up with demand, and we need to—but it needs to be dense, well-served by transit and jobs, and designed to be relatively safe from increasingly extreme physical climate risks. All of this activity could support thoughtful adaptation that keeps climate risks firmly in mind.

Meanwhile, stock market optimism continues. The market seems to shrug off all exogenous shocks. What about a recession prompted by sudden repricing of property values due to physical climate risks? (The FT’s Pilita Clark explored that possibility in a recent piece.) Clyde is still facing repayment of the short-term, high-interest loan (a "tax and revenue anticipation note") the city took out to pay back their insurers. It's hot out there, and getting steadily hotter. More disruption is ahead.

States might as well take advantage of the moment.