WASHINGTON - Many state and local governments face their most serious fiscal challenges in decades with declining revenue, difficultly accessing the municipal bond market, and strained liquidity causing uncertainties and threatening their credit ratings, Moody's Investors Service warned in a report issued late last week.

"The duration and severity of the economic downturn is the primary uncertainty facing state and local governments," Moody's said in the report titled "Credit Uncertainties: Public Sector 2009."

"There are other significant uncertainties, however, including the timing, scale, and scope of the federal stimulus package; the disruption of the public finance credit markets; and the weakening liquidity of states and localities," the report said.

Combined with unanticipated changes to market access, the weakening liquidity could create "acute credit pressures," the report said.

Issuers' ratings could be further threatened if the economic downturn is exceedingly long and deep. "In this worst-case scenario, deeper rating downgrades could occur, and they have the potential to be swift, particularly if prompted by a combined lack of liquidity and market access," the rating agency said. "Nonetheless, we expect defaults to still be highly unlikely."

States and municipalities will experience varying levels of stress, according to Moody's. Those issuers with more variable-rate or auction-rate debt, and those that depend on short-term cash-flow borrowing for operations, are particularly vulnerable to credit market turmoil, it said.

States could face budget shortfalls of $100 billion over fiscal 2009 and 2010 as job losses mount and depressed consumer spending and declining housing prices continue to reduce governmental revenues from income, sales, corporate, and property taxes, according to Moody's.

"These declining revenues, when combined with ongoing spending pressures to fund schools, social services, health care, and critical infrastructure needs, have contributed to large state budget shortfalls for fiscal years 2009 and 2010," the report said.

The federal stimulus legislation currently under development represents the most promise of relief for state and local governments, the rating agency said, but the details of House and Senate packages are still unknown to some extent and it is not clear what Congress will agree on.

Unrestricted federal aid is most beneficial for state and local governments for its potential to close budget gaps, the report said. But funds directed at earmarked projects, specifically those focused on infrastructure or job creation, are likely to provide more indirect benefits to government coffers because any generated income or sales tax revenues would experience a time lag, it said.

"With Congress now projecting passage [of the stimulus package] in February, any unrestricted aid or increases in Medicaid funding may not be distributed in time to benefit current-year deficits for governments operating on fiscal years ending June 30," the agency warned.

And municipal market conditions may remain uncertain for state and local governments that rely on market access to support capital and cash-flow needs, Moody's said.

"The past year has seen a fundamental market change, with limitations in market access curtailing the planned issuance of debt and the scarcity of credit enhancement driving up the cost of borrowing," the report said.

The option of triple-A rated bond insurance is almost entirely extinct, and bank credit is limited, which will expose lower-rated issuers to reduced capital market access, it said.

These problems could affect a state or locality's ability to finance capital projects, restructure debt to deal with lower revenues, take out variable-rate debt that has become burdensome due to market conditions, or replace credit enhancement, Moody's said.

The more prolonged the credit disruption the greater the pressures will be on state and local governments to continue servicing variable-rate debt or unfavorable swap agreements, undertake higher cost borrowing, or maintain adequate cash flow, it said.

Liquidity constraints represent a "very serious" uncertainty for 2009, with state and local governments' liquidity positions suffering from depressed revenues, according to the agency. It's unclear whether those governments will have sufficient cash to manage regular operating expenses.

"Prior to this downturn, state and local governments were able to depend on borrowing for cash flow and to address deficits," the report said. "However, with the faltering of the capital markets, governments can no longer assume that this option will be available to them."

Because of the lack of muni market access, negative credit effects are likely to be more acute for governments that routinely need to borrow for cash flow and those that borrow to fund current operating shortfalls.

While Moody's said the length of the recession cannot be determined, analysts said the majority of states and municipalities will manage through it with a combination of spending cuts, revenue enhancement plans, and use of reserves.

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