Q: Meredith Whitney, a Wall Street analyst, claimed last year there would be “hundreds of billions of dollars’ worth” of municipal-bond (muni bond) defaults in 2011. Why was there such concern?
A: At the start of the year we were certainly receiving a lot of enquiries on the muni bond market. There was definitely a fair amount of fiscal and budget stress and because it involves politicians it tends to be played out in a very public way.
State and local credit quality withstood an extremely difficult budget period following the Great Recession. Most governments have transitioned to a post-federal stimulus environment by making what we consider to be very difficult spending and revenue adjustments.
In our view, fiscal conditions for the sector remain strained, and reserves are significantly depleted across the sector, which somewhat limits flexibility.
To the extent that state and local governments are unable or unwilling to adjust to any additional economic and revenue contraction related to fiscal consolidation at the federal level, there is potential for lower ratings and revised outlooks.
In our view, the additional budget strain from the potential federal funding changes underscores the importance of the financial management components of our criteria.
Q: Given these concerns how have muni bonds fared this year?
A: State and local governments are required by law to balance their budgets so they had to make tough choices.
It’s not as if they were able to continue to build up debt piles. They made some public statements about the difficulties they were facing but that didn’t mean they couldn’t manage their debt.
We don’t think there has been a lot of change in our outlook since the start of the year. In our outlook piece we suggested it was going to be a tough year for local governments with some credit deterioration but we though widespread defaults were highly unlikely.
We have seen some credit downgrades, as we expected, but only three rated defaults [Jefferson County, Alabama; Harrisburg, Pennsylvania; Central Falls, Rhode Island]. That’s a fairly small number when compared with the 17,000 ratings we cover. (Q&A continues below)
Q: Do you think that the major challenges for local government funding have been confronted or is there room for further weakness in the sector?
A: There are still a lot of budget adjustments going on. Our outlook heading into next year is for a slow recovery where there is one.
Until the housing recovery gets underway I don’t think local government revenues will recover. The Federal Reserve has estimated that the housing crisis reduced tax revenues by $22 billion from 2006 to 2009, which is about 3% of total state own-source revenues in 2006.
The assessments tend to lag what the market is doing but as long as housing continues to put pressure on local government revenues it will remain difficult to improve credit conditions for local governments.
That said, it used to be the case that a lot of the muni bond market used some kind of credit enhancement, but that’s no longer the case. There’s still the potential for credit deterioration but not on a widespread basis.
Q: What are the longer-term problems that local governments still have to address?
A: Beyond the federal funding and tax policies that could directly affect state and local governments, we believe that near-term fiscal consolidation efforts could undermine the already fragile economic recovery. 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) constituted 25% of state gross domestic product on average, ranging from as little as 13% to as much as 38%, depending upon the state.
We will evaluate the fiscal effects of any changes to transfer payments, as well as to federal government employment and procurement levels, and any associated economic contraction, on a state-by-state basis.
A longer-term issue that we will continue to assess is the level of fiscal interaction between federal and state and local governments during recessionary periods.
Despite the magnitude and duration of the recent recession, credit quality of state and local governments was insulated to some degree by federal stimulus funds.
These resources have typically flowed to state and, to a lesser extent, local governments during recessionary periods to offset their revenue deterioration.
The problem is that these resources are discretionary, and the outlook for federal resource allocation for this purpose is uncertain in our view, given the general focus on fiscal consolidation at the federal level.
We believe that a decline or elimination of such funding during a recession could present significant challenges for many state and local governments as they are generally required to align revenues and expenditures annually.
Q: As we approach 2012 there are plenty of uncertainties for investors to worry about from the eurozone crisis to the American budget impasse. Should muni bonds be added to the list?
A: Despite the defaults, it is probably a slightly improved environment [for local governments] than we had at the start of the year.
There are still doubts on the federal level, however, and it is possible that we will see further deterioration in credit conditions.
Given that numerous state and local governments have yet to recover from the recent recession, additional fiscal pressure could result in rating downgrades in some cases. Yet we believe that direct funding reductions are less likely to instigate liquidity problems since we anticipate that any such changes to federal funding arrangements would be known well in advance.
In short, for the majority of state and local governments we believe there would be sufficient time to make adjustments.
Robin Prunty is a senior director in the public finance ratings group at Standard and Poor’s.