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Moody’s Calms Waters Over State, Local Debt

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In a new report, Moodys Investors Service has moved to calm the waters over whether the credit ratings agency was about to drop the ratings for a widespread number of state and local governments.

In its report, entitled Most Munis Well Insulated from Volatility; Some May Have Exposure, the ratings agency said that while increased downgrades may occur in an environment of diminished market access, we do not expect to see widespread multi-notch downgrades, downgrades below investment grade, or defaults.

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It added that although most municipal issuers are well insulated from shock, some could face diminished market access and higher funding costs in the event of significant capital market volatility.

A downgrade is bad for taxpayers. When a downgrade happens, it means that a municipality's debt is more risky. So that means a state or city downgraded has to offer higher yield, or interest rates, on their bonds to investors. To pay for that higher yield, municipalities either have to, say, raise property taxes, or cut spending.

Moodys new report comes on the heels of Standard & Poor's indicating earlier this week that it will be assessing the ratings of U.S. states and local governments in the context of its downgrade of the U.S. to AA+ status from Triple-A.

Standard & Poor's said that it may be possible for some U.S. state and local governments to maintain Triple-A ratings, despite its downgrade of long-term U.S. federal government debt to double A-plus.

S&P has already dropped ratings for an estimated 11,500 muni bonds worth $120 billion that are generally tied to federal government financing, such as Fannie Mae and Freddie Mac debt, or bond derivatives backed by U.S. Treasuries. Thirteen states are rated Triple-A by S&P.

S&P noted that municipalities can raise taxes and cut deficits to curtail budget deficits.

S&P's Steven Murphy, who runs S&P's U.S. state and local ratings, said his company would meet later this year to decide whether to downgrade U.S. municipalities, using a similar assessment of their budget deficits that it used for federal debt.

Moodys added in its new report that a small number of municipal issuers may face acute stress in the face of hostile market conditions.

Moodys has already warned that it is worried about a handful of states, which it says it could downgrade. The 5 states are Maryland, South Carolina, New Mexico, Tennessee and Virginia, which remain under review.

Maryland, Virginia and New Mexico have comparatively high percentages of federal employees and contracts, the ratings company said.

New Mexico, South Carolina and Tennessee depend more on Medicaid money versus the national average, Moodys said.

Moodys also indicated some states are safer than others and are less vulnerable to a downgrade.

The 10 top-rated states are Alaska, Delaware, Georgia, Indiana, Iowa, Missouri, North Carolina, Texas, Utah and Vermont. They would be cut only in the event that the federal rating is dropped by more than one level, Moodys said.

However, Moodys indicated that most municipal debt is used to finance capital projects, and governments have the ability to defer projects if they cannot finance them at rates that make sense. It added: Even many issuers of short-term cash flow notes for operating purposes could draw down their available cash reserves, if necessary, to handle seasonal cash flow imbalances.

Moodys offered a reminder of what happened in the 2008 and 2009 crisis, where muni issuers deployed a number of strategies during this period of market volatility, including issuing debt on less favorable terms, drawing down their own internal funds, securing direct bank loans, or seeking other alternatives to market financing.

But Moodys did say that an exact repetition of these tactics will be unlikely because tax revenues and balanced sheets have still not fully recovered to 2007 levels, leaving most municipal issuers somewhat weaker today than they were prior to the last major market disruption.

It also said even in the deteriorated economic environment of the past three years, a small minority of municipal issuers have issued long-term debt to fund current operations.

These include even some of the most battered states with poor finances, including California, Illinois, Arizona, Connecticut, Ohio and New Jersey. But Moodys said even those states still carry the highest profile in terms of ratings in the municipal market.

S&P said in its new report released this past Tuesday that the key for state or local government's ability to keep stronger credit characteristics than the federal government is a predictable institutional framework; a high degree of fiscal flexibility; and independent treasury management.

Only a handful of state and local governments carry S&P's highest rating, but the ratings agency said "we expect that many of these obligors, particularly those with relatively low levels of funding interdependencies with the federal government or those that, in our view, are likely to manage declines in federal funding without weakening their credit profile, should be able to retain ratings above the U.S. sovereign rating.