Caution is the operative word among Northeast state budget planners.

Anyone who needed a wakeup call got one 10 days ago when Moody’s Investors Service threw a high, hard one at Connecticut, lowering the state’s general obligation bond rating to Aa3 from Aa2, citing budgetary and pension shortfalls, and depleted reserves.

The downgrade came the same week Gov. Dannel Malloy’s administration said projected state revenues are expected to decline by about $95 million, or one-half of 1% of the annual budget, in the fiscal year ending June 30.

Quarterly tax payments from higher-income earners dropped in December, Malloy said.

“What the rating agencies are doing is responsible. They’re telling the states to clean up your act,” said Jonathan Henes, a restructuring partner with law firm Kirkland & Ellis LLP in New York.

Days after the downgrade, Malloy announced a proposal to accelerate payments to Connecticut’s underfunded pension plan, to make it fully funded by 2032. As of mid-January, its pension funding level was only at 48%, according to a report by Cavanaugh Macdonald Consulting LLC of Kennesaw, Ga.

The Pew Center on the States considers 80% an acceptable threshold.

The Moody’s downgrade also prompted a crossfire between Connecticut Democrats and Republicans over spending and borrowing priorities, and even a point-counterpoint about the rating agencies.

Benjamin Barnes, secretary of Connecticut’s office of policy and management, called out Moody’s for “lack of credibility.”

And Treasurer Denise Nappier said her state is in a quandary.

“Moody’s has caught Connecticut in a Catch-22 — we’re being penalized for high long-term liabilities, and yet when we take steps to repay those liabilities more quickly, they criticize our high annual fixed costs for funding debt and pensions,” she said. 

“Moody’s is caught up in a labyrinth of mathematical ratios that loses sight of the essential question: How likely is it that Connecticut would ever default on its debt? The answer is, never in a million years.”

Moody’s analyst Nicole Johnson responded: “We understand that states and other issuers are unhappy when they receive downgrades. Our action was based on the state’s creditworthiness.”

One Connecticut Republican leader defended Moody’s. Sen. L. Scott Frantz of Greenwich, the ranking member on the banking committee, called it a “gift” that Moody’s didn’t downgrade the state further.

Frantz and other Republicans say the state borrows excessively.

“Moody’s did a good job of looking at the state’s fiscal picture objectively and intensively. In addition to getting a gift from Moody’s, this should serve as a wakeup call for a number of people,” Frantz said. “If not, I don’t know what it will take to wake people up.”

Tax and debt issues are on the table in other states as well. In New Hampshire, long an anti-tax bastion, the House of Representatives overwhelmingly approved a constitutional amendment that would ban the state from adopting an income tax.

Opponents say the move could tie the hands of future lawmakers, should a financial crisis occur in the Granite State.

In neighboring Maine, Gov. Paul LePage wants voters to approve all bonds backed by the state’s moral obligation pledge.

Pension funding shortfalls, which forced Rhode Island to overhaul its benefits system for public employees last year and consider similar moves to help its stressed localities to do likewise, will still be an overriding concern.

“Certainly this is not just a Northeast issue. Every state and local government faces these challenges,” Moody’s analyst Robert Kurtter said. “The problem has become more acute with the downturn in asset valuations due to stock market declines. This is a significant pressure point for many states, especially those with large unfunded pension obligation liabilities.”

Standard & Poor’s, in a report last week about state and local governments, called pension underfunding a less formal method of deficit financing. But in the same report, it cited the “fundamental credit strength” of state and local governments.

It said 42% of the 14,000 ratings it issues in the sector are rated AA-minus or higher. S&P also admonished that a credit downgrade does not necessarily equate distress.

“Credit quality could erode and still be considered strong, and in some cases could even remain very strong,” the report said.

Speaking from a national perspective, Standard & Poor’s credit analyst Robin Prunty said state budgets will remain tight.

“Our overall conclusion is that for U.S. state budgets, austerity is here to stay,” she said in an interview. “Economic recovery is under way, but future economic prospects and federal fiscal consolidation present significant uncertainty. We believe this uncertainty will translate into caution.”

Jon Shure, director of state fiscal strategies for the Washington, D.C., think tank Center for Budget and Policy Priorities, said that’s especially so in the Northeast.

“Generally speaking, the Northeast constitutes one of the hardest hit areas in the wake of the recession,” Shure said. “You can’t say the states did anything wrong. There’s been an unpredictable drop in revenue and they’ve been unable to avoid being clobbered. The Northeast has been hit harder because of the markets, the industry, Wall Street.”

Shure sees a multiplier effect.

“It filters down to the local level, too. You see a decline in services. If the state cuts local school aid, you’ll see its effect in the local schools,” he said. “If the state spends less on roads, you’ll see it in the condition of the local roads.”

S&P analysts said a deepening chasm between strong and weaker credits may occur in state and local governments in 2012.

Strengthening credit quality, it said, largely hinges on tackling structural budget imbalances.

“Governments have already wrung most inefficiencies from their budgets, so balancing them will be increasingly difficult. States with a strong base in natural resources are generally in a stronger position than most,” S&P said.

The rating agency also said it will scrutinize the structures of refinancing transactions in the upcoming year.

According to Standard & Poor’s, common short-term relief techniques that could be embedded in refundings include any noneconomic bond refinancing; structures in which a majority of present-value savings is recognized early in the life of the new bonds; proceeds used to cover current-year debt service; a final maturity that occurs much later than the original bonds’ maturity, and one where the final maturity extends well beyond the useful life of the financed asset.

Henes of Kirkland & Ellis added a reference point from afar.

“To me, if you’re the rating agencies, you look across the pond at Europe — Greece, Portugal, Italy, Spain,” he said. “You see too much debt, high unfunded levels and an economic downturn.”

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