WASHINGTON — This year will be the “toughest year so far” for state and local governments since the economic plunge began in 2008, with rating downgrades expected to outnumber upgrades, according to Moody’s Investors Service.

“With all of the financial problems facing the municipal bond sector, we do expect more defaults in 2011,” said Naomi Richman, managing director of Moody’s public finance team, as the agency released its first-quarter ratings report. “We do see some very stressed credits.” 

Two of the issuers and borrowers that Moody’s rates defaulted on their municipal debt in 2010, Richman said.

Besides more defaults, Moody’s also expects several “near misses,” where defaults are avoided only at the last minute.

That applies especially for those local governments that have drained their reserves, already turned to one-shots like asset sales, have exposure to enterprise risk, face rollover risk for their debt, or face a political impasse, according to the rating agency.

Downgrades ran ahead of upgrades 3.9 to 1 in the first quarter of the year, the ninth consecutive quarter with more downgrades, Moody’s said.

There were 66 downgrades and 17 upgrades across the public finance sector among the issuers and borrowers rated by Moody’s.

 Only the last quarter of 2010 was worse for munis, with a ratio of 4.6 to 1 for downgrades compared to upgrades.

Downgrades of $23 billion par value of bonds in the first quarter were way higher than upgrades of $2.8 billion.

“We expect downgrades to continue to exceed upgrades throughout 2011 for states and local governments and school districts,” said Conor McEachern, Moody’s assistant vice president and the report’s author.

State ratings will continue to show credit stress as governments have lost not only tax revenue associated with the recession, but also federal stimulus money from the American Recovery and Reinvestment Act, which expired Dec. 31.

Many of the jobs that the Obama administration contended would be saved or created by the ARRA may now be lost because of state budget cutbacks.

A number of states have depleted their reserves but still face significant spending obligations.

Moody’s said two states were downgraded during the first quarter: Kentucky and Nevada.

Both were downgraded because of the recession and narrow economic bases, according to the rating agency.

About 37 cities and towns made up almost half of the first-quarter downgrades, Moody’s found.

“States are pushing down their cuts” to the local level, Richman said.

The other major problem, she said, is the lag between falling home prices and the resulting drop in real estate tax revenue.

Home prices have been declining steadily for several years, but lower assessed valuations are only now catching up. That means localities are only now seeing the resulting declines in property taxes.

Moody’s reported six downgrades and no upgrades among infrastructure ratings in the last quarter. Highway, airports, and power projects all lost income from lower usage.

The rating agency also downgraded six not-for-profit hospitals.

Revenue problems will continue as reimbursement pressures from insurers mount, patient volume flattens or declines, and the recession produces higher levels of uncompensated care.

Ratings of higher education and other nonprofit issuers ratings fell because of nondiversified sources of revenue, including state budget cutbacks.

Moody’s analysts expect colleges and universities will not be able to continue to increase tuition and will be forced to make more budget cuts.

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