The Evil S&P Empire Strikes Back: Says Broad Muni Downgrade Will Come After Final US Budget
The ridiculous war between Obama and S&P, which escalated last night following disclosure by the NYT that S&P was being investigated for its muni ratings, has just taken another turn for ths surreal after S&P announced that it would most likely downgrade munis as soon as the final US budget is finalized. Granted that could very well mean never. To quote S&P: "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." The sector being the US munis. And from Bloomberg: "The company, which said earlier this month that states and local governments could remain AAA even after the U.S. cut, said in a report today downgrades could come after reductions in federal funding or changed policy. Ratings changes would come based on “differing levels of reliance on federal funding, and varying management capabilities,” and, after the Budget Control Act of 2011, will be felt “unevenly across the sector,” S&P said. "Experience tells me I would expect there to be some downgrades,” said S&P credit analyst Gabriel Petek in a telephone interview. “These cuts are coming in addition to the losses of revenue that already came during the recession."" Bottom line: the longer this downgrade over up to 7000 issues is deferred, and it is very much overdue right now, the bigger it will be when it finally arrives, and the greater the gloating by Meredith Whitney will be when it finally arrives.
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.
- 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
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
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|
|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|
|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.|