Thursday, August 18, 2011

S&P to Wait Until US Budget Finalized Before Leveling the Boom on US Muni's

S&P is reminding President Obama's posse that two can play this game after news broke last night that S&P is being investigated for its muni ratings.
S&P has just released a report stating that they will wait until a final US official budget is in place before deciding on the broad ratings of US municipal agencies.
Perhaps the whole world will discover as soon as December just how similar the finances of the US and Greece are.
Your move Mr. Obama.
  • Federal deficit reduction could complicate state and local government fiscal management
  • Initial cuts under the Budget Control Act appear to be smaller than the revenue losses from the Great Recession
  • Budget management may prove to be integral to maintenance of credit quality

Full report:
State And Local Governments Face Fiscal Challenges Under Federal Debt Deal
Following the Aug. 5, 2011 downgrade of the U.S. sovereign debt rating to 'AA+/Negative', Standard & Poor's Ratings Services said the action would not trigger automatic rating downgrades beyond those that moved in lockstep with the sovereign rating. We reiterated that, pursuant to our criteria, certain state and local government ratings could remain or be assigned at the 'AAA' level (see "State And Local Government Ratings Are Not Directly Constrained By That Of The U.S. Sovereign," published Aug. 8 on RatingsDirect on the Global Credit Portal).
This does not mean there are no credit implications from recent events, however.

The situation, as it is evolving, is similar to "Hypothetical Scenario 2", which we contemplated in "Where U.S. Public Finance Ratings Could Head In the Wake Of The Federal Fiscal Crisis," published July 21. In it we described a scenario in which a federal debt ceiling agreement was reached, avoiding U.S. Treasury defaults but resulting in a U.S. sovereign debt rating downgrade. From the perspective of state and local governments, the credit implications of recent events stem more from potential reductions in federal funding than from the U.S. downgrade itself.
In our opinion, the longer-term deficit reduction framework adopted as part of the Budget Control Act of 2011 (BCA) could undermine the already fragile economic recovery and complicate aspects of state and local government fiscal management. Either of these outcomes could potentially weaken our view of certain individual credit profiles of obligors across the sector. But given the disparate nature of state and local economies, differing levels of reliance on federal funding, and varying management capabilities throughout the U.S., we anticipate the effects on credit quality from the BCA will likely be felt unevenly across the sector.
Initial analysis of the terms of the BCA suggests to us that material reductions in federal funding to state and local governments are unlikely to occur before 2013. According to the BCA, details of potential proposed federal cuts are to be made public by Nov. 23, 2011 with a Congressional vote on the joint special committee's (established under the BCA) proposals by no later than Dec. 23, 2011 (and a final deadline for passage of the legislation by Jan. 15, 2012). Therefore, even if significant cuts were to take effect starting in fiscal 2013, this timeline provides state and local governments advance notice, thereby lessening liquidity risk in our view. Furthermore, should any federal funding reductions represent a budget risk to state and local governments, the cuts and potential cuts scheduled in the BCA provide them with time to implement budget adjustments that, in our view, could prove important in the maintenance of their credit quality.
It is possible the federal government will decrease funding for some programs without commensurate changes in service delivery mandates. Delivering on under- or unfunded mandates could be a source of budget strain. In addition, although we recognize that state and local governments enjoy considerable operating autonomy, we believe that outright withdrawal from participation in any number of federal programs could be politically and administratively difficult. To the extent state and local governments opt to absorb and locally fund services that currently receive federal support, we expect the fiscal effects to vary. In part, this reflects the range of revenue raising flexibility (legal and political) we see among the state and local governments.

Federal Deficit Reduction Framework

According to the Congressional Budget Office, the BCA is projected to reduce the federal deficit in two phases by a total of $2.1 trillion to $2.4 trillion through 2021. In the first phase, deficit reduction of $917 billion would be achieved primarily through caps on discretionary federal spending. In a second phase, which would overlap the first phase, the BCA also establishes the goal of $1.5 trillion in additional deficit reduction over the 10-year horizon (2012-2021). In phase two, specific cuts are to be agreed upon by a 12-member joint special committee of members of Congress and then voted on by Congress and sent to the President. If by Jan. 15, 2012, the joint special committee process does not result in enacted legislation projected to achieve at least $1.2 trillion in deficit reduction by 2021, automatic cuts of this amount would be triggered. The automatic cuts of $1.2 trillion would be across-the-board (except certain specifically exempted programs) and split between security and non-security related spending. Importantly for state governments, Medicaid and the children's health insurance program (CHIP) are among the programs that would be exempted should the across-the-board cuts be triggered. From the standpoint of state and local governments' fiscal positions, the structure of the automatic trigger cuts have potential to be more favorable than cuts that could derive from the joint special committee recommendations. It is possible the joint special committee could recommend approaches to deficit reduction that more directly—and negatively--affect state and local government budgets than would the trigger cuts.

Analytic Implications Of Budget Control Act To States

Cash flow
Following the recent increase to the federal debt limit, we expect federal cash disbursements to flow to payees as scheduled, including those to state and local governments. Thus, we do not anticipate cash flow disruptions for states with regard to their receipt of federal aid. As we understand it, though, states had been actively developing contingency plans in the event an agreement had not been reached and the federal government began prioritizing its disbursements. It was unclear where important state aid, such as that for Medicaid, would have ranked among federal priorities. According to our initial survey, most states had cash flow capacity to continue to fund operations as budgeted for periods ranging from several weeks to months. In our ongoing review of states' creditworthiness, we will consider cash management in advance of any federal spending reductions that we believe could strain states' liquidity.

Tax reform and market liquidity
We do not anticipate material disruption to the market for most municipal bonds as a result of the BCA. However, should the federal tax code be reformed it is possible that the municipal bond market could be affected. Current law includes expiration of the Bush-era reduced marginal tax rates. If the tax cuts (passed in 2001 and 2003) were allowed to expire, marginal federal income tax rates would increase on Jan. 1, 2013. Under such a scenario, the tax exemption on interest income from investments in tax-exempt municipal bonds could increase in value to investors subject to federal income taxes. This could exert downward pressure on interest rates faced by municipal issuers.
Instead of allowing marginal tax rates to increase, some members of Congress have signaled support for reducing tax exemptions and deductions that currently exist in the tax code. One such reform would reduce or eliminate the tax-exempt status of interest earnings on municipal bonds, which in our view would likely increase the interest costs to municipal issuers.
Other potential tax reform proposals that some members of Congress and other public officials have mentioned include eliminating the mortgage interest tax deduction. We believe such a reform could have far-reaching effects on the real estate market, which is already suffering from an overhang of supply built up during the housing boom of the mid 2000s. Elimination of the tax deductibility of mortgage interest would effectively make housing less affordable. Under this scenario, we would anticipate negative effects on home prices—which would translate to lower assessed values, albeit with a lag due to the assessment process. Ultimately, this chain of events could have a negative effect on property and real estate related tax revenues.
Changes to the tax law intended to generate higher federal revenues would, in our view, presumably need to be addressed as part of the joint special committee process or by Congress as distinct tax reform legislation since the automatic deficit reduction provisions of the BCA do not include increased tax revenues (and involve only spending adjustments and interest savings).

Budgetary: Deficit reduction in two phases
Phase one: caps on discretionary spending.  The budgetary implications to the states of the BCA rest to a considerable extent on the outcome of the deficit reduction process undertaken by the joint special committee. The immediate spending caps associated with phase one reduce discretionary outlays by $756 billion and, when coupled with interest savings on debt, are projected to result in $917 billion of deficit reduction over 10 years. But much of the reduced spending for this phase is back-loaded. Of the total discretionary spending subject to the cap, there is $25 billion and $46 billion in reduced spending in fiscal 2012 and 2013, respectively--less than 10% of the total planned reduced spending. These reductions, moreover, are relative to current-law baseline projections, which are scheduled to increase over time. Relative to the prior year, the only outright spending decline ($7 billion) occurs in fiscal 2012—with $2 billion of reductions to non-security spending and $5 billion to security-related spending programs. Hypothetically, even if all of the cuts were imposed on states, the reduction would equal 1.5% of federal funds (and just 0.6% of total revenue) to state governments (at 2009 funding levels). In any event, we expect that state budgets will bear much less than the entire burden of the reduced spending. In fiscal years 2012 and 2013, for example, the BCA specifies the split between reduced security and non-security discretionary spending, but is silent for the years from 2014 to 2021.
Although the loss of any amount of federal funds may impede states' efforts to maintain fiscal balance, particularly in light of the slow economic recovery, states have experienced much larger revenue losses than this in recent years. Total state tax revenues declined 8.6% in 2009 compared to 2008 as a result of the recession. The revenue declines were partially offset by increased federal funding which, especially in the case of certain public welfare programs, functions as an automatic stabilizer to the economy. In addition, during the second quarter of 2009, increased federal funds provided under the American Recovery and Reinvestment Act (ARRA) began to be disbursed to the states. However, although the increased federal funding ($55 billion in 2009) helped, it did not completely make up for the lost state tax revenues ($67 billion). Nonetheless, even as the revenue declines among the states contributed to budget crises for some of them, we differentiated this from outright debt crises among states, even in cases where fiscal strain factored into credit rating downgrades. This was due to the states' taking corrective budget actions—in many instances, in mid-fiscal year.
Phase two: alternative scenarios.  Phase two of the BCA envisions deficit reduction ranging from $1.2 trillion to $1.5 trillion through 2021 achieved via one of two contemplated scenarios. For the states, much depends on the efficacy of the joint special committee, whose goal, pursuant to the BCA, is $1.5 trillion in deficit reduction. Under the BCA, the joint special committee will recommend a deficit reduction plan by Nov. 23, 2011 with a Congressional vote by Dec. 23, 2011. If this process does not materialize in the enactment of deficit reduction legislation, across-the-board cuts, or funding "sequestration," would be triggered automatically. Because the trigger cuts exempt certain programs important to states, this scenario could be more favorable to state and local government finances than potential cuts that could emerge under the joint special committee process.
Phase two: no deficit reduction legislation (automatic trigger cuts).  If the joint special committee process does not result in enacted deficit reduction legislation, the automatic trigger cuts would total $1.2 trillion over 10 years. Compared to the $756 billion in reduced discretionary spending of phase one, these spending reductions are, according to the BCA, more evenly dispersed across the horizon. However, the BCA exempts specific programs, including Medicaid and CHIP, thereby shielding prominent parts of state budgets.
Nonetheless, given the interdependence between the states and the federal government, with federal sources of revenue comprising about 32% of total state revenues (2009 data, U.S. Census Bureau), we expect reduced funds for states to be an unavoidable outcome at least to some degree should the automatic cuts be triggered. In a scenario where the across-the-board cuts were triggered, state grants and pass-through funds could experience large reductions. However, states would know by Jan. 15, 2012 whether the sequestration cuts are triggered, nearly one year before they would be implemented in January 2013. This timeline provides some opportunity for states to accommodate the cuts from a budget management perspective. By and large, this reduced federal funding would not affect states' discretionary revenue. Therefore, if across-the-board cuts were triggered, we believe that the reduced aid to states might not have a commensurately negative effect on states' fiscal positions. In short, we expect that reduced federal funding could be met by states with programmatic cuts in many areas that have been heretofore funded with federal dollars. As we noted earlier, to the extent states decide to continue funding such programs on their own, fiscal tradeoffs will be involved. We understand that some mandates, such as for certain education-related programs, would likely remain in place and represent an increased fiscal responsibility for states. Whether and how states manage any potential federal cuts could play a role in our review of budget management as a part of the larger rating process.
Phase two: deficit reduction legislation.  If the joint special committee process achieves enactment of deficit reduction legislation, in our view state finances could be more vulnerable to potential changes in the federal-state funding relationship. Entitlement programs represent some of the biggest drivers of the federal government's long-term projected fiscal deficit. With wide latitude regarding how to shape deficit reduction, the joint special committee can recommend changes in entitlement programs, with Medicaid representing the most significant from the states' perspective. The federal and state governments jointly finance Medicaid but each state manages it individually. According to the Centers for Medicare and Medicaid Services, total governmental spending on Medicaid was $374 billion in 2009 (2.7% of GDP), of which the federal government funded $247 billion. (Federal funding for public welfare programs, including Medicaid, increased 16.3% in 2009 as a result of the ARRA. In 2008, total Medicaid spending was $343.1 billion with federal funds comprising $202.4 billion of this). If federal funding for Medicaid were converted to block grants or there were changes to the federal medical assistance percentage (the formula upon which federal matching is determined) that lowered federal reimbursements, as long as states continue to participate in the program they could incur greater funding responsibility unless they were also granted increased flexibility regarding service requirements.

Changed budget environment under any scenario
Following adoption of the BCA, we believe that, under any scenario, states can likely expect reduced federal funding, amounting to an impediment to their ability to maintain fiscal balance over the ensuing 10 years. But we note that, in our view, state and local governments have a strong track record of active budget management when it comes to responding to a constrained revenue environment. For example, according to the Bureau of Labor Statistics, as of June 2011, state and local governments had shed 499,000 jobs since June 2008. In the aggregate, payroll reductions are a part of overall spending cuts by state and local governments. Data from the Bureau of Economic Analysis indicate that total state and local consumption expenditures and gross investment declined 3.3% in the first quarter of 2011 after dropping by 2.6% in the fourth quarter of 2010.
These spending cuts and job reductions provide fiscal drag which could negatively impact the nation's economic recovery, but paradoxically they help preserve the credit quality of individual obligors. The workforce reductions represent the difficult choices we have observed and referenced in prior comments, and they are an integral part of most governments' budget-balancing strategies. Pursuant to our rating criteria, in evaluating credit quality, we will continue to consider how effectively state and local governments navigate a new era of reduced federal funding.
Economic.  Federal government spending is important to both the national and state-level economies. Based on 2009 figures, federal spending (including payments to individuals and governments) comprised 25% of state gross domestic product on average, ranging from as little as 13% to as much as 38%, depending upon the state (see table 1). Federal economic stimulus spending associated with the ARRA provided countercyclical support to states during the depths of the recent recession. Whereas total state tax revenues shrank 8.6%, federal grants to states increased 13% from 2008 to 2009. The federal spending cuts contemplated in the BCA are in addition to the phase-out of federal stimulus funding and could have a contractionary effect on the national and state economies. The discretionary spending caps result in relatively modest cuts in the initial years compared to the national GDP. But, according to IHS GlobalInsight, this fiscal contraction could reduce GDP growth by 0.2%. On top of an already fragile recovery, these federal cuts could therefore contribute to even slower economic growth. Two full years after the official end of the 2007 recession, consumer sentiment, after recovering somewhat earlier in 2011, has receded and fell sharply in July to its lowest level since May 1980, according to IHS GlobalInsight. And, 19 states still have unemployment rates above 9.1%. Conversely, this also means 31 states have unemployment rates below the nation's and serves as an example of the disparate state and local economies that comprise the United States. We will therefore continue to evaluate each state and local obligor in its own economic context.

Potential Analytic Implications Of Debt Ceiling Agreement To Local Governments

Cash flow and budgets
Historically, local governments have tended to rely on a combination of locally derived revenues (property or sales taxes) and state aid or state shared revenues. For cash flow planning purposes, fiscal 2012 began favorably for local governments since all but one state had an enacted budget by the start of the fiscal year. Local governments relied on federal funding for less than 4% of total revenues in 2008. And, while local governments receive higher amounts of federal aid indirectly (via their state governments), as mentioned above, we expect federal funds to be disbursed in a timely manner and as scheduled. Future spending cuts associated with the BCA may present budgetary complications, but we do not anticipate unforeseen cash flow disruptions for local governments as a result of the agreement.

We expect any negative economic impact from reduced federal spending to affect local governments by constraining further an already slow recovery, similar to the effect we expect on state economies. Special projects funded by earmarks or discretionary federal appropriations could be jeopardized. We believe that our ratings of obligors with economic exposure to federal military base realignment and closure offer an analytic paradigm. In practice, many communities have successfully redeveloped previous military bases resulting in less economic damage than initial estimates.

Economic And Fiscal Horizon Underscore Importance Of Financial Management

We see a complicated credit landscape on the horizon for state and local governments now that they have weathered several years of difficult economics. The federal debt ceiling increase averted the potential for acute liquidity shortfalls that could have arisen if the federal government had shut off significant amounts of disbursements to state and local governments. However, while enactment of the BCA may have mitigated near-term liquidity risk (associated with federal funds), we believe that medium-term budgetary and economic risks for state and local governments persist. With an already tepid economic recovery, the additional reduction of federal funds could fuel retrenchment among consumers.
This being said, we expect many state and local governments to be better-poised to manage federal cuts to their grant funding than the recessionary-based revenue declines of 2008 and 2009. Compared to the revenue losses from the Great Recession, the initial federal cuts appear to be smaller in magnitude. And, further potential cuts that Congress and the President may approve will be preceded by advance notice based on the timeline laid out in the BCA. But considering that many governments' finances are still in the early stages of fiscal repair from the recession, the BCA offers little respite from further emphasis on budget austerity. In our view, the additional budget strain from the potential federal cuts underscore the importance of the financial management components of our criteria.

Table 1  |  Download Table

Total Federal Spending As % Of State GDP
Fiscal Year 2009; Includes Stimulus Funds
State Rating Outlook Federal spending (mils. $) Nominal state GDP (mils. $) % state GDP
AA Stable 54,674 166,819 32.8
AA+ Stable 14,215 45,861 31.0
AA- Negative 63,029 249,711 25.2
AA Stable 27,302 98,795 27.6
A- Stable 345,970 1,847,048 18.7
AA Stable 47,806 250,664 19.1
AA Stable 42,589 227,550 18.7
AAA Stable 8,137 60,660 13.4
AAA Stable 175,684 732,782 24.0
AAA Stable 83,917 394,117 21.3
AA Stable 24,610 65,428 37.6
AA+ Stable 14,898 53,661 27.8
A+ Negative 116,070 631,970 18.4
AAA Stable 61,149 259,894 23.5
AAA Stable 29,369 136,062 21.6
AA+ Stable 34,705 122,544 28.3
AA- Stable 50,012 155,789 32.1
AA Stable 48,357 205,117 23.6
AA Negative 14,242 50,039 28.5
AAA Stable 92,155 285,116 32.3
AA Positive 83,890 360,538 23.3
AA- Stable 92,003 369,671 24.9
AAA Stable 45,691 258,499 17.7
AA Stable 32,848 94,406 34.8
AAA Stable 67,942 237,955 28.6
AA Stable 10,925 34,999 31.2
AAA Stable 16,526 86,411 19.1
AA Stable 18,894 125,037 15.1
New Hampshire
AA Stable 11,844 59,086 20.0
New Jersey
AA- Stable 80,647 471,946 17.1
New Mexico
AA+ Stable 27,472 76,871 35.7
New York
AA Stable 194,975 1,094,104 17.8
North Carolina
AAA Stable 84,830 407,032 20.8
North Dakota
AA+ Positive 8,618 31,626 27.2
AA+ Stable 107,975 462,015 23.4
AA+ Stable 37,516 142,388 26.3
AA+ Stable 33,594 167,481 20.1
AA Stable 135,687 546,538 24.8
Rhode Island
AA Stable 11,517 47,470 24.3
South Carolina
AA+ Stable 46,904 158,786 29.5
South Dakota
AA+ Stable 9,499 38,255 24.8
AA+ Positive 68,546 243,849 28.1
AA+ Stable 227,108 1,146,647 19.8
AAA Stable 20,702 111,301 18.6
AA+ Stable 7,092 24,625 28.8
AAA Stable 115,554 409,732 28.2
AA+ Stable 66,560 331,639 20.1
West Virginia
AA Stable 19,808 61,043 32.4
AA Stable 61,280 239,613 25.6
AAA Stable 6,278 36,760 17.1



Sources: U.S. Census Bureau, Consolidated Federal Funds Report for Fiscal Year 2009 (table 13); 2009 State GDP - Bureau of Economic Analysis. Ratings as of Aug. 17, 2011.

Table 2  |  Download Table

Total Federal Spending As % Of State GDP
Fiscal Year 2008
State Rating Outlook Federal spending (mils. $) Nominal state GDP (mils. $) % state GDP
Alabama AA Stable 47,966 169,694 28.3
Alaska AA+ Stable 9,423 49,186 19.2
Arizona AA- Negative 54,314 260,454 20.9
Arkansas AA Stable 23,857 99,497 24.0
California A- Stable 299,923 1,911,741 15.7
Colorado AA Stable 38,015 254,218 15.0
Connecticut AA Stable 38,879 225,958 17.2
Delaware AAA Stable 6,623 58,674 11.3
Florida AAA Stable 149,872 747,770 20.0
Georgia AAA Stable 74,165 405,269 18.3
Hawaii AA Stable 15,009 66,119 22.7
Idaho AA+ Stable 11,227 55,212 20.3
Illinois A+ Negative 100,672 637,037 15.8
Indiana AAA Stable 52,813 263,616 20.0
Iowa AAA Stable 23,927 134,959 17.7
Kansas AA+ Stable 25,129 125,333 20.0
Kentucky AA- Stable 52,264 155,592 33.6
Louisiana AA Stable 44,496 213,441 20.8
Maine AA Negative 11,974 49,972 24.0
Maryland AAA Stable 77,905 281,659 27.7
Massachusetts AA Positive 72,115 365,623 19.7
Michigan AA- Stable 82,933 375,436 22.1
Minnesota AAA Stable 38,246 262,758 14.6
Mississippi AA Stable 30,098 96,713 31.1
Missouri AAA Stable 60,829 241,344 25.2
Montana AA Stable 8,843 35,838 24.7
Nebraska AAA Stable 15,739 84,884 18.5
Nevada AA Stable 17,260 132,270 13.0
New Hampshire AA Stable 10,311 58,780 17.5
New Jersey AA- Stable 72,085 483,560 14.9
New Mexico AA+ Stable 23,846 77,168 30.9
New York AA Stable 174,071 1,109,080 15.7
North Carolina AAA Stable 70,203 403,927 17.4
North Dakota AA+ Positive 7,323 31,677 23.1
Ohio AA+ Stable 90,592 470,640 19.2
Oklahoma AA+ Stable 31,758 151,850 20.9
Oregon AA+ Stable 27,530 174,454 15.8
Pennsylvania AA Stable 121,551 545,198 22.3
Rhode Island AA Stable 9,841 47,378 20.8
South Carolina AA+ Stable 38,832 159,500 24.3
South Dakota AA+ Stable 8,552 38,293 22.3
Tennessee AA+ Positive 58,672 247,796 23.7
Texas AA+ Stable 210,005 1,202,104 17.5
Utah AAA Stable 17,117 112,353 15.2
Vermont AA+ Stable 6,080 24,636 24.7
Virginia AAA Stable 118,527 402,853 29.4
Washington AA+ Stable 56,436 334,477 16.9
West Virginia AA Stable 18,002 59,039 30.5
Wisconsin AA Stable 40,137 239,150 16.8
Wyoming AAA Stable 5,969 38,917 15.3



Sources: U.S. Census Bureau, Consolidated Federal Funds Report for Fiscal Year 2009 (table 13); 2009 State GDP-Bureau of Economic Analysis. Ratings as of Aug. 17, 2011.