From Bloomberg:

Standard & Poor's, the credit rating company that cut the U.S. to AA+, said the federal budget deal may lead to downgrades on municipal credits.

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."

The initial budget cuts would be smaller than the revenue losses during the recession that ended June 2009, he said. States lost $67 billion in aggregate during the 18-month contraction, the report said. The federal government has planned $7 billion in cuts, most of which won't be implemented until 2013, giving states some time to prepare, Petek said.

S&P will begin evaluating states and local governments starting Nov. 23, when a panel of 12 members of Congress, split evenly between Republicans and Democrats, is supposed to come up with recommendations, Petek said.
Federal Funding

In 2009, when the U.S. introduced economic stimulus, federal spending on average was 24.6 percent of state gross domestic product, the report said. States that had federal funds representing more than 30 percent of GDP included Alabama, Alaska, Hawaii, Kentucky, Maryland, Montana, Mississippi, New Mexico and West Virginia. The state with the lowest percentage was Delaware.

"We do not have immediate concerns at the state and local levels," said Natalie Cohen, managing director and senior municipal-bond analyst for Wells Fargo Securities, in an Aug. 16 report.

The 11,500 municipal bonds already downgraded from AAA in lockstep with the U.S. were a "logical extension," and "not a symptom of a meltdown in the municipal-bond market," she wrote. The debt was directly dependent on federal funding.

S&P mentioned possible changes to the municipal market if tax policy is altered. If tax cuts enacted during George W. Bush's presidency are allowed to expire, federal taxes would increase and the tax exemption on municipal bonds would be more attractive to investors and drive yields on municipal bonds lower, S&P said.

Alternatively, Congress could limit some of the tax exemptions on municipal bonds to raise more government revenue, which would likely increase interest costs, S&P said.

To contact the reporter on this story: Sarah Frier in New York at sfrier1@bloomberg.net

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net

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