Standard & Poor’s began downgrading municipal bonds Monday, giving market participants a sense of the broad impact its downgrade of U.S. debt will likely have on the muni market.

The most likely candidates for downgrades are pre-refunded bonds, which are backed by Treasuries, housing bonds with federal guarantees, investment pools that invested in Treasuries, bonds backed by federal leases, and the bonds of state and local governments that depend on federal programs or facilities and employees, like Maryland and Virginia.

At press time, Standard & Poor’s had already downgraded five industrial development bond issues that had been defeased with Treasuries. The downgrades would affect investors holding those bonds until they can be called and retired, market participants said.

The rating agency also downgraded the Los Angeles Treasurer’s General Pool Fund, the Anaheim, Calif., Treasurer’s Investment Pool Fund, and Broward County, Fla.’s Investment Portfolio Fund — all of which held Treasuries. Bonds backed by federal leases also were downgraded, including those of Miami, Tacoma, Wash., and the Atlanta Downtown Development Authority.

But many market participants said they could not understand why a downgrade of U.S. debt would automatically trigger downgrades of triple-A rated states and local governments.

“What dealers are telling us is that the underlying credit quality hasn’t changed. The fiscal conditions of state and local governments haven’t changed,” said Mike Nicholas, chief executive of the Bond Dealers of America.

Why should states, which have to balance their budgets, which have been improving their finances over the past few months and dealing with pension issues, be adversely affected because Congress and the Obama administration have failed to do what Standard & Poor’s thought they should do? he said, adding the bond market was up Monday.

“There are certain sectors of the municipal market — pre-refunded bonds and bonds directly backed by U.S. government credit support — that could be affected by S&P’s U.S. downgrade,” said Michael Decker, the Securities Industry and Financial Markets Association’s managing director and co-head of its municipal securities division. “However, the overall credit standing of the municipal market, while sensitive to the health of the broader economy, remains generally stable.”

“Up to now, you’ve had the federal government as AAA sovereign that everybody was sort of pegged to. Now you’ve got the prospect that you’ll have AAA states rated higher at least by one rating agency than the federal government,” said Ric Brown, triple-A rated Virginia’s secretary of finance. “That’s a paradigm that we’re not used to. The market is going to have to assess that a little bit. The rating is like a good housekeeping seal. You want it as part of Virginia tradition here. But it doesn’t assure good results in the market so the market will have to be the one to decide now whether a state that ranks above the federal government, does that really pay off in terms of interest rates? I don’t know the answer to that.”

“At the same time, Virginia’s debt load and capacity is unchanged,” Brown said.

The concerns about possible downgrades of housing bonds stem from Standard & Poor’s lowering the ratings of 10 of 12 federal home loan banks, Fannie Mae, and Freddie Mac.

“The question is if financial penalties or our cost to funds will go up in the future,” said Timothy Hsu, financing risk manager for the California Housing Finance Agency. “In near-term, we aren’t going to be impacted, but in the long term, we will have to wait and see what happens.”

A number of market participants noted that Standard & Poor’s is only one of three major rating agencies and that Moody’s Investors Service and Fitch Ratings have maintained their triple-A ratings on U.S. debt.

“I’m not sure a single rating agency downgrade is much of a concern. You’ve got to have two,” one tax expert said. “If Moody’s had done it, along with S&P, that would have been a serious thing.”

Timothy L. Firestine, chief administrative officer for Montgomery County, Md., said: “I think S&P tends to be much more focused on the economy, which is kind of odd in this case that they are going after the management side,” because political bickering was behind the downgrade.

 “There’s considerable disagreement over S&P’s decisions, and I’m not yet persuaded that this move was warranted,” said Vanguard CEO Bill McNabb.

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