SAN FRANCISCO - Moody's Investors Service assigned a negative outlook to the entire tax-backed local government sector yesterday. It is the first time the agency has ever had a negative outlook on the sector.

"Virtually everyone is struggling right now," Moody's senior vice president Eric Hoffmann said in an interview. "There is no sector or area of the country that is really getting off scot-free in this downturn."

The negative outlook applies to a sector that includes 89,000 cities, counties, school districts, and special districts. It does not apply to enterprise revenue bonds sold by local water, sewer, or transportation agencies.

But with the latest move, Moody's has assigned negative outlooks to much of the municipal marketplace. The agency assigned a negative outlook to the state sector in February 2008.

Moody's also has negative outlooks on health care, higher education, housing, and airport debt. It still has a stable outlook for public power, and it hasn't released outlooks on the water and sewer sector.

"Operating in this environment is going to be difficult, and there are going to be credit challenges that virtually everyone is going to have to address," Hoffmann said.

States and local governments had about $2.2 trillion of debt outstanding at the end of last year, according to Federal Reserve data. The data doesn't distinguish between tax-backed and revenue bonds or rated and unrated debt.

The negative outlook does not mean that Moody's is considering downgrades for each credit, Hoffmann said. Rather, the agency views the environment for local governments as particularly challenging over the next 12 to 18 months.

"Sharply falling property values, contracting consumer spending, job losses, and limited credit availability lead a long list of developments that will make balancing budgets in the coming year particularly difficult," Hoffmann said in the report.

The agency will to continue to analyze credits individually, using its traditional rating criteria, but it plans to give heightened scrutiny to four particular risks - exposure to the short-term credit market, dependence on economically cyclical revenues, exposure to hard-hit economic sectors, and high fixed or mandated costs.

Municipalities that use variable-rate debt have been hard hit by the credit crunch and a shortage of liquidity to back variable-rate debt. Moody's said it plans to "conduct a more detailed analysis" of short-term market risks and counterparty risks for governments that have more than a quarter of their debt in the variable-rate market or more variable-rate debt outstanding than liquid resources.

The agency will also take a closer look at credits where the local economies depend heavily on hard-hit industries, such as auto manufacturing, real-estate development, and financial services.

The agency will also scrutinize issuers that depend heavily on particularly cyclical revenues, such as sales and real estate transfer taxes.

While governments with volatile revenue streams may have built reserves to cushion the downturn, "the sharpness of the housing downturn and speed of the general economic contractions will likely test the sufficiency of those reserve cushions."

In such an environment, the agency plans to assess local government credits on the amount of flexibility they have to cut expenses.

"In an economy of severely strained liquidity, an ability to rapidly reduce expenditures may prove a better indicator of credit quality than the traditional measures of municipal credit risk," Moody's said.

Still, local governments that have strong reserves, rapidly address budget shortfalls, and use conservative budget assumptions are less likely to be downgraded than other credits, despite the risks of the current recession, Moody's said.

"Local governments generally have the flexibility to deal with these things, but they are going to have to be much more vigilant in the current environment than perhaps they have been in the past," Hoffmann said.

The risk to muni ratings comes at a time when many had hoped to be reaping upgrades. Moody's last year agreed to migrate its municipal ratings to a global scale that would make them equivalent to corporate ratings after criticism from government officials such as U.S. Rep. Barney Frank, D-Mass., and California Treasurer Bill Lockyer. But in October, the agency said "unsettled" credit markets would delay the shift. The project remains on hold.

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