CHICAGO – More than two dozen local governments in Minnesota have seen their bond ratings cut over the last 16 months as they struggle with diminished property tax bases, limited revenue flexibility, and other fiscal strains.

The downgrades underscore the challenges local governments still face despite the economic recovery.

Municipal Market Advisors highlighted the number of downgrades in a recent report which noted the downgrades of at least 26 individual governments, all but one by Moody’s Investors Service. Eight saw multiple-notch downgrades, including two that lost their investment grade ratings.

“These trends are alarming; however, we do not anticipate that the downgrades themselves, or the fiscal strains driving the downgrades, will lead to a material increase in actual impairment,” said the MMA report, authored by Managing Director Lisa Washburn. The above-average downgrade activity, if it continues, could lead to selling and/or reduced liquidity. 

More than half of the governments were originally rated in the single-A category, five in the double-A category, and one was triple-A. Just one was rated in the triple-B category.

After the downgrades, five are now in triple-B territory, two lost their investment-grade ratings, and just two remain in the double-A category.

Many are smaller local governments strained by declines in their property valuation with limited flexibility to raise revenues to offset losses. The declines are not just driven by market values, but by state changes to the property tax system.

Market value previously was subject to taxation and the state was responsible for reimbursing local governments for reductions stemming from homestead credits that reduced taxes. Now only the market value net of any exclusion is subject to taxation.

“Accordingly, financial flexibility of the local government to handle additional deterioration has been reduced,” MMA wrote.

The property tax system in Minnesota is subject to frequent changes, leading to uncertainty for local governments as they make financial plans. While over the last two years local governments have not faced tax caps, they are loathe to raise rates, said one local financial advisor.

“Many make an effort to keep property taxes affordable,” said Mark Ruff, an advisor to local governments at the advisory firm Ehlers, Inc. Some of the local governments have dipped into cash balances as a short-term measure to fund projects or capital needs, which can impact their balance sheets, he added.

Housing prices have continued on a steady upswing into 2013, according to the The S&P/Case-Shiller index. A recovering housing market with rising prices and assessments could eventually ease the budgetary stress but it takes some time for property tax collections to reflect the increases – three to four years in some cases -- just as the drop in home prices took some time to impact budgets.

Some of the downgraded local governments face pressure from their use of a general obligation pledge to support water, sewer, tax-increment financing, and other projects to keep interest rates to a minimum. In some cases, projects which were expected to support themselves are struggling. MMA reported that 25% of Minnesota TIF debt is supported by a GO pledge. While the move helps lower interest rates, it also can strain debt limits and expose the city to enterprise risk which has come under heightened scrutiny from rating agencies.

Minnesota cities saw their state local government aid payments slashed in 2008 and 2010, adding to balance sheet strains. The news on that front has brightened as the state legislature has proposed an increase of $80 million. Gov. Mark Dayton and legislative leaders on Sunday announced a budget and tax deal and a vote is expected soon.

Moody’s analysts Rachel Cortez and Soo Chun said the number of downgrades in Minnesota reflects just a small percentage of the 375 local governments and school districts they rate there. The downgrades reflect the ongoing struggles local governments face as they have yet to feel the full weight of a recovering economy.

The agency has a negative outlook on the local government sector due to slow growth rates, mixed employment indicators and ongoing constraints in revenues, according to a report issued last month.

The two attribute the number of Minnesota downgrades to a combination of factors with the valuation downgrades exacerbating other fiscal challenges. “The declines [in valuation] in some cases have been pretty steep,” Cortez said. Many of the downgraded cities are small and located in more rural areas. “The magnitude of the declines [in those instances] have been material” especially given smaller cities’ limited capacity to offset the losses through other revenue streams.

Local governments with higher wealth levels and stronger economic bases, especially ones located outside the Twin Cities, have fared better.

Le Center was one of two cities that lost its investment-grade rating.

Its rating dropped to Ba2 from A1 last year and it further sank to B1 this year as it turned to borrowing to cover debt service payments. Moody’s assigns a negative outlook to its rating on $7.3 million of bonds.

The rating reflects the city’s heavy reliance on cash flow borrowing from a local bank to fund ongoing operations, including its GO debt service; limited financial flexibility; and narrow cash balances following years of aggressive budgeting assumptions and annual operating deficits, Moody’s wrote in its downgrade report. The city’s small and limited tax base has experienced significant valuation declines and it has a high debt burden.

Vadnais Heights lost its investment grade rating last year for terminating its lease agreement on a sport complex and failing to appropriate rental payments sufficient to meet debt service obligations on $24.8 million of lease revenue bonds issued for the project.

Moody’s action impacted $1.8 million of the city’s $10.6 million of GOs, now rated Ba1 with a stable outlook. The agency does not rate the lease bonds. The facility has struggled to generate sufficient revenues needed to cover debt service since its opening.

“The city’s failure to appropriate represents a significant lack of willingness to pay on a lease obligation that supported debt issued in the capital markets,” Moody’s wrote.

Le Sueur saw its rating drop three notches to Baa1 from A1, Monticello dropped to A2 from Aa3, Gaylord fell three notches to Baa1 from A1 as did Granite Falls, Hayfield fell three notches to Baa3 from A3, and North Mankato dropped three notches to A3 from Aa3.  Some market participants perceive multiple level downgrades as a “sign of significant stress,” Ruff said, adding that in downgrades involving cities he advises that’s not the case.

Monticello’s two-notch downgrade was due in large part to its “diminished financial position resulting in part from multi-year support of the city’s telecommunications enterprise.” The city’s credit otherwise is supported by an adequate general fund balance and liquidity and a favorable location outside the Twin Cities. Its challenges include a decline in its tax base value, a sizeable debt burden, and uncertainty over the future of the telecom system although the city is not on the hook for repayment.

The city funded construction of a city-owned broadband system in 2008 with an unrated $26.4 million bond issue. The system has struggled amid competition and the city decided last year to halt supplemental support provided to cover debt service. The bonds are special, limited obligations of the city with principal and interest payable solely from the system’s operating revenues after operational and maintenance expenses.

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