After 14 straight quarters of revenue growth, most U.S. states are heading into the new year with a stable outlook even as local governments will continue to feel the financial pressures they experienced over the course of the economic downturn, according to Fitch Ratings.
States in Good Shape, Fitch Says
Many states’ reserves were replenished in a strong fiscal 2013 as taxpayers sought to avoid federal tax hikes, the agency said. Those that are seeing below-average economic recovery are facing specific budget challenges, such as rising pension funding demands, or are suffering from management weaknesses, according to Fitch.
“At this point in the recovery there is a clear contrast between the majority of states -- which are experiencing sustained economic and revenue recovery, rebuilding their financial cushions, and benefitting from structurally balanced budgets -- and those that are still struggling,” Laura Porter, Fitch Managing Director, said in a press release. “As states once again show their fundamental strengths, those with fundamental challenges stand out more.”
Pensions remain a challenge for the most fiscally pressured states -- all four states which currently carry a negative rating outlook from the agency face significant unfunded liabilities or escalating annual pension costs.
Fitch Says Municipalities Stressed
For local governments, the rating agency forecasts that slow revenue growth and increased spending will result in more downgrades than upgrades in 2014. The agency also cited some municipal bankruptcy cases as potentially being precedent setting.
“Willingness to repay debts has been a hallmark of the municipal credit market, but evidence of management's failure to prioritize debt service payments in a limited number of bankruptcy cases is troubling,” Amy Laskey, Managing Director of Fitch's Public Finance Group, said in a press release. “Fitch expects the current bankruptcy cases to set important precedents for other distressed municipalities.”
She said the impact will depend upon upcoming benefit rulings in a few Chapter 9 cases.
“If pending bankruptcy rulings demonstrate that pensions take priority over general obligation debt service, or require debt restructuring along with benefit adjustments, more cities may be encouraged to take this path,” Laskey said. “Fitch would likely re-evaluate the strength of the general obligation pledge in states where benefits are clearly placed ahead of G.O. debt.”
Over the last few years many local governments have been able to achieve significant labor savings, the agency said, but that benefit spending growth will continue to put pressure on budgets next year.
Pension plan reform efforts at both the state and local levels continue to be encouraging, Fitch says, although this will not have a meaningful impact on liabilities or annual payments for many years.
“Flexibility to reduce OPEB is not always clear-cut and varies by state. Litigation related to post-employment benefits, some as part of ongoing bankruptcy cases, will provide some insight into the ability of governments to make changes in these areas,” the report said.
Some Clouds on the Horizon
But all is not clear sailing for states.
Fitch cites the federal government as being the most significant threat to state budgets. State revenues reflect economic conditions, so if federal action or inaction hurts the economy, it hurts the states.
Next year, federal healthcare reform will affect all states, whether they expand Medicaid or not.
“Enacted budgets for fiscal 2014 include an estimated impact of reform and, despite guesswork in the estimates, deviations from the forecast are expected to be modest in the context of overall health care spending,” the report said.
Moody's Chimes In but Says Locals Stable
For the first time in five years, Moody's Investors Service revised its outlook for local governments to stable from negative, as housing markets continue to stabilize, municipalities' fund balances remain healthy and cities and school districts control their costs.
But in its "2014 Outlook - U.S. Local Governments," the rating agency cautioned that conditions will remain more difficult for local governments than before the 2008 recession and that "'pockets' of serious credit pressure remain."
Moody's said there is a "new stable," which means that credit risks are more visible and predictable and that localities have reduced costs and expectations to cope with limited resources.
"The 'new stable' will be an era of constrained resources but the worst is over for local governments in most of the country," said Naomi Richman, a Moody's managing director.
The housing sector has stabilized and is recovering nationwide, four years after the collapse of housing prices, Moody's said in its outlook.
"With the stabilization in housing, we expect local government revenues to increase over the next two years, which is a credit positive," it said.
One of the main reasons the local government sector has remained a highly-rated sector is that property tax revenues proved to be durable during the Great Recession, staying mostly flat in contrast to income taxes and sales taxes, which fell for many governments.
States have begun to restore some of their funding cuts to local governments, Moody's said. In addition, local governments "have recognized the new fiscal landscape" and taken steps to give less to labor in negotiations, slow the growth of salaries, trim staff, and de-leverage, it said, adding, "All of these cost-cutting efforts are credit-positive."
However, Moody's said rating downgrades may remain concentrated in states and sectors where: the local housing market has lagged or not recovered at all; localities have not cut costs or spending; there is a continued loss of state aid; the political will to use available tools is lacking; and unemployment remains consistently high.
"The bottom rung of the rating distribution has already expanded," the rating agency said. "There are currently 114 local government ratings in the speculative-grade range of Ba1 or lower. This is a more than five-fold increase from the 20 local governments ... in 2008."
Moody’s Says States’ Outlook Remains Stable
The outlook for the states sector remains stable as revenues and reserves stabilize despite the slow but steady economic recovery, says Moody's Investors Service in its "2014 Outlook - U.S. States."
"Since we revised our outlook to stable from negative in August, economic recovery has continued, although at a somewhat slower pace. However, stock market gains and private sector expansion continue to support state revenue growth, and states' reserves are on the rise," Baye Larsen, the Moody's Vice President Senior Analyst who wrote the outlook, said in a release.
Drivers of the stable outlook are the subdued but real recovery in the economy, continuing revenue growth among the states, with many states recording better-than-expected results, and states adding to their reserves. Moody's said reserves are now at levels comfortably above their fiscal 2010 low, although still well below their pre-recession peak.
"Risks to the stable outlook include various revenue and spending uncertainties, the protracted debate regarding federal funding priorities, continued budgetary pressure from pension contributions and regionally uneven economic growth," said Moody's.
"Despite these challenges, we expect most states to maintain fiscal stability through tight budgeting and spending restraint practices that became common in the recent recession," says Moody's Larsen said.
The Bond Buyer's Lynn Hume contributed to this report.
