WASHINGTON — The economy is improving at the national level but state and local governments face further revenue declines and dismal financial conditions that pose a risk of lowered credit ratings, market participants warned in their outlooks for this year.
State and local finances lag the national economy’s recovery by one to two years, according to economists. Most municipal governments cannot run deficits and therefore must cut budgets or raise taxes to avoid them.
While the federal government has bankrolled fiscal and monetary programs to reverse the recession and taken on a lot of debt, state and local governments have been forced to slash spending while continuing to provide services like education, health care and transportation. Meanwhile, tax revenues have continued to decline as unemployment remains in double digits and home values drop.
“The snapshot at this moment is awful,” said Scott Pattison, executive director of the National Association of State Budget Officers. “We’re seeing a real slow, incremental recovery.”
The recession has drawn investors toward municipal debt just as state and local government budgets are hurting the most, he said. The threat of higher taxes, competition from Build America Bonds, and low inflation rates have all made munis attractive and have pushed yields to near-record lows this year.
Municipal Market Data’s triple-A yield curve scale was 3.07% on Dec. 18, below its 10-year average of 3.96%.
Credit concerns are among the biggest fears investors have next year. State and local credit risk “is the major performance downside” in the municipal market as “fears of credit trouble cause institutional investors not to buy,” said Matt Fabian, managing director at Municipal Market Advisors.
“I think we’re going to see some additional downgrades on municipal issuers,” said Mary Talbutt-Glassberg, vice president of fixed-income portfolio management at Davidson Trust Co. “Municipalities are taking on more debt than they can handle because of the BAB program and because the federal government says they can raise their debt ceilings” by offering stimulus funds, she said.
“The struggle in credit valuation is going to be the most important aspect of 2010,” said Dominick Mondi senior managing director at Mesirow Financial Inc. “If unemployment remains high and the economy continues to struggle, you are going to have stress on the state and local level,” he said.
Credit is an “exchangeable currency right now,” Mondi said. “Everything is ultimately going to center on credit.”
How municipalities handle their budget issues “is still uncharted territory,” he added. “I think that will be a strong theme for the first six months of 2010.”
Lower-rated credits cannot expect to buy out of their ratings with insurance, sources noted. Assured Guaranty Ltd., the only monoline insurer writing new business, could insure 15% of the market next year, sources said.
When many state legislatures convene this month to begin writing their fiscal 2011 budgets, they will find themselves without the federal stimulus support provided by the American Recovery and Reinvestment Act. If the ARRA aid is not extended, the stimulus funds will dry up before revenues return, sources said.
States’ Medicaid relief expires at the end of 2010 along with the Build America Bond program. The $53.6 billion the state fiscal stabilization fund provided to the states, mostly for education, must be appropriated by Sept. 30, 2011.
“Fiscal 2012 is going to be worse than 2011 because a lot of the stimulus money will still be in effect in 2010,” said Donald J. Boyd, a senior fellow at the Rockefeller Institute of Government.
States face at least $21.9 billion in budget gaps for fiscal 2011, according to both a national survey conducted by the National Governor’s Association and NASBO that was published in December, and a separate study by the Pew Center on States.
Even with stimulus aid, enacted budgets for fiscal 2010 show a 5.4% decrease in general fund expenditures, the NGA survey found. The drop follows a 3.4% decline in general fund expenditures in fiscal 2009, the survey’s first spending decline since 1983.
“If you look at the history of past recessions the states were raising taxes a good two to three years even as the economy was recovering,” Boyd said.
“A lot of the tax revenue does lag the economy,” he said as employment returns are expected to rebound only after broader measures of the economy recover.
And unemployment remains high. In November, 36 states and the District of Columbia reported decreases in unemployment, while eight showed increases and six reported no change, the Labor Department said earlier this month.
As a result of the high unemployment, income taxes “are likely to be slower to recover than the economy as a whole,” Boyd said.
Sales tax revenues are expected to bounce back first among taxes collected, according to Pattison. A strong holiday shopping season could mean states would see better returns early next year. Income taxes, — particularly from capital gains taxes — take longer to revive, he said.
Most states “do not anticipate the revenues to make up for [stimulus funds]” until fiscal 2011, Pattison said.
COUNTIES AND CITIES
At the county level, an October survey conducted by the National Association of Counties found that 82% of respondents said they expect a shortfall in fiscal 2011. Half of the survey respondents said they started fiscal 2010 with up to a $10 million budget shortfall and about half of them said the shortfall has increased.
Only 11 counties said their bond ratings have changed since the start of the economic crisis.
The survey also reveals that the full effect of federal stimulus funds have not hit counties. More than a third of respondents said they have not received any federal funds from ARRA and only 9% have received more than half of their expected stimulus funds.
The funds are delayed because of the layers of approval needed to get the money to work, said Edwin Rosado, NACO’s legislative director.
Some of the stimulus funds go to the states first and are then allocated to counties, he said. Transportation funds, for example, may have to be allocated through metropolitan planning organizations.
“Not all of the funds are getting back down to us,” Rosado said.
Timothy Firestine, the chief administrative officer of Montgomery County, Md., and former vice chair of the Government Finance Officer’s Association’s debt committee said that, like many local governments, the county revisited its fiscal 2010 budget to make additional cuts as revenues declined. The county faces a $600 million budget deficit for fiscal 2011, having already closed $1.2 billion of gaps.
First, the county rescheduled its other post-employment benefit payments to an eight-year time frame. That helped free up about $30 million, which was comparable to what Montgomery lost in aid from the state. Then the county eliminated its OPEB payment for this fiscal year altogether.
“The first year was tough, it was difficult, but we had a lot of low-hanging fruit like everybody else,” Firestine said.
The federal stimulus aid for local governments primarily targeted education jobs. While that was enough to make funds available to save other positions, those funds will expire next year.
“Our toughest year, we’re hoping, is [fiscal] 2011 and then 2012 will start to see some improvement,” Firestine said.
As the “doers” of the government system, counties face particularly difficult decisions next year because they are locked into labor agreements with unions, Boyd noted
Cities have not been spared either. Ninety percent of city budget officials reported trouble meeting their fiscal needs in 2009 and will be less able to meet them in 2010, according to Lars Etzkorn, principal legislative counsel at the National League of Cities.
“While the nation’s economy may be in the late stages of the worst economic downturn, the consequences of the recession are going to be playing out in America’s cities for some time,” he said.
Legislators this year will continue to face decisions on the use of dwindling funds that are needed to preserve credit ratings while they are needed for services simultaneously.
Moody’s Investors Service warned in September that state and local governments “will face more negative pressure” on their ratings if governments are forced to honor union contracts and pay workers.
The NGA report said 16 states implemented furloughs for fiscal 2010. In August, workers in Prince George’s County, Md., won an initial ruling by a federal judge that a furlough decision violated the Constitution. The workers argued that they were furloughed so that the county could preserve a triple-A rating and that it had reserve funds to pay them.
More state and local governments next year will face a tradeoff between their credit rating and services, Boyd said.
“Fiscally, unless they are coming to market with a lot of new debt, it is not a big near-term fiscal issue,” he said of a municipality’s credit rating. “That does not mean it is not an important thing for them to worry about.”
Alternatively, governments may consider issuing IOUs as an option to protect their credit rating. California issued IOUs to some creditors earlier this year when it could not issue revenue anticipation notes.
“The IOUs helped California issue revenue anticipation notes, which received high short-term ratings from Standard & Poor’s and Moody’s.” Despite the negative headlines, the IOUs “protect bondholders” and do not “necessarily affect the ratings,” according to MMA’s Fabian.
California, the largest tax-exempt issuer by dollar amount, faces a $6.3 billion deficit for fiscal 2010 and a $14.4 billion shortfall for fiscal 2011, according to Standard & Poor’s.
To avoid these decisions altogether, state and local governments are targeting stimulus extensions as a way to tap the federal governments borrowing strength. Sources said they would like to see all of the bond and tax-credit provisions from the stimulus act extended.
“We don’t know what the new normal is going to be in the municipal bond market,” Etzkorn said. “We don’t know if it is ever going to return to what is was before, but we know the [ARRA] provisions are functioning right now and I suspect that without them there are municipalities that would not be able to be in the market place right now.”
