DALLAS — State and local governments face their toughest fiscal year since the recession began in 2007, with political polarization and limited market access adding substantial risk, according to Moody’s Investors Service.

In its annual survey of state and local governments, the rating agency placed a negative outlook on both sectors and warned that downgrades will outpace upgrades amid continuing efforts to cut spending.

“Revenue declines have hit bottom, but will remain subdued during a slow and shallow economic recovery,” analysts wrote. “The economic recovery itself is still fragile and could be derailed by risks such as rising gasoline prices or other external shocks.”

With Republicans controlling the House and demanding deep budget cuts, “efforts to reduce large federal deficits likely will mean additional reductions in federal aid and costs pushed down to states,” the report said. “In turn, state budgets will likely include reduced aid to local governments and public universities and other significant cuts.”

The state and local bond issuers “face these hurdles at a time when pension and health care cost pressures are increasing,” the report noted. “Issuers facing severe underfunding of their pensions could see their credit quality deteriorate.”

The loss of federally subsidized Build America Bonds, and investors’ flight from the muni market, have dramatically slowed issuance this year and will mean higher capital costs.

“A protracted interruption in market access could have negative implications for some state ratings,” the report said. “States with large variable rate debt portfolios, greater liquidity facility rollover risk, the need to convert variable rate bonds to fixed rates, weak liquidity or other high fixed costs could be especially affected.”

Federal stimulus funds made up 18% of state budgets in fiscal 2010 and 14% in fiscal 2011, according to the National Association of State Budget Officers. Most of those funds expire in June, forcing states to make fundamental decisions in their fiscal 2012 budgets about whether to raise revenues or cut expenditures, the report said.

Entrenched political positions over raising taxes will mean that budgets that have already been cut deeply will be further reduced, analysts said. Political polarization such as that in Congress that has led to weekly federal budgeting will reduce options for covering costs, they wrote.

Despite the third straight year of negative outlooks for the sectors, Moody’s sees little risk for investors in state and local debt.

“We expect defaults and bankruptcy filings to remain isolated and rare,” analysts said.

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