WASHINGTON - There are two things that state and local government officials can be certain of in 2009: plummeting tax revenues that will create large, gaping holes in their budgets, and the promise of a massive economic recovery and stimulus package that they are currently salivating over in hopes it will help them fill those gaps, according to market participants.

But what remains to be seen in officials' outlooks for the coming year is the price tag attached to the package that President-elect Barack Obama and congressional leaders are working on, and how funds will be doled out to states and localities. In addition, volatility in the muni market could hamper state and local governments' ability to use debt to help with their budget woes.

Throw in a national economy in recession without a definitive ending, and market participants say state and local governments are in for a few long and challenging years.

"I think we're in one of these situations where it really is that bad," said Scott Pattison, executive director of the National Association of State Budget Officers. "I thought the post-9/11, '02-'03 declines in revenue were about as bad as you can get. But this seems to be worse, because it's just so much broader in so many ways."

Recent reports by state and local government groups and analysts are projecting revenues to drop more significantly than in downturns the country experienced in the past 20 years.

"It's not just going to be a one-year budget challenge, it's going to a multiyear challenge," said Standard & Poor's analyst Robin Prunty. "State revenues tend to lag what's going on in the economy, so even if we start to recover, state revenues are likely to continue to be constrained."

Most analysts said the last recession following the Sept. 11, 2001, terrorist attacks will pale in comparison to the current one.

"The last fiscal crisis, in 2001, was a 50-year event, at least as bad as anything in the prior years. This one is all of that and more," said Don Boyd, a senior fellow at the Rockefeller Institute of Government. "It is just going to hit the states that rely on sales and income taxes far harder than any recession we've seen, certainly since the Great Depression."

Decreased income tax collections are going to ravage state budgets in the April to June time frame because the effect of unemployment numbers won't be realized until people file their tax returns, he said.

"The income tax will be hit very, very hard because, just as last time, there are a lot of layoffs and cuts ... especially for very highly paid people," Boyd said.

And sales taxes will drag as consumers pull back on spending during the recession.

All of this points to states and localities having to make difficult decisions in 2009 and 2010, after already confronting a tumultuous 2008.

So far this fiscal year, 22 states have made $12.1 billion of cuts, 31 states have reported additional budget gaps totaling $29.7 billion since they made the first round of cuts, and five states expect gaps but could not yet predict their depth, according to NASBO.

Standard & Poor's puts the gaps higher. As a result of the economy's performance the past few months, 41 states have identified shortfalls totaling $40 billion, its research shows.

"I think it's certainly going to be a difficult time and I think a lot of what states are looking at is really how they deal with the cuts." NASBO's Pattison said. "They're going to have to cut no matter what, even with the stimulus, so it's how do they deal with this very difficult situation? And I think it's very, very dependent on the national economy. So we have to hope that the economy gets better, and if it improves fairly significantly throughout '09, states will recover much quicker. But if it's a sluggish calendar year, it just pushes us into a much longer time of difficulty."

Depending on which group is asked, the shortfalls faced by just states this fiscal year and next range from $60 billion to $200 billion, which means that any figure is going to require nearly everything in a state's budget to be put on the chopping block.

And nearly every state and local government group is clamoring to be heard by the Obama administration with ready-to-go project wish lists that they say can be financed with a stimulus package that places shovels in the hands of eager construction workers to provide an immediate boost to the economy.

"Because states have to balance their budgets, they really don't have the ability to provide any stimulus because anything they cut takes away from the economy," Pattison said. "A stimulus is helpful because - regardless of the way it works, whether it's just through additional Medicaid funds - it really does provide a benefit."


Obama wants to create a plan that will invest in infrastructure nationwide, create millions of jobs, modernize schools, and make buildings more energy-efficient. The incoming administration over the weekend pledged to create or save three million jobs in the next two years, which is up from the goal of 2.5 million jobs he touted last month.

He wants the plan to be enacted soon after he takes office in January. Some market participants have said the price tag could reach upward of $850 billion, including an infusion of about $100 billion to states for the costs of Medicaid.

And while few details of the stimulus package have emerged, state and local government groups have jumped at the opportunity to advise him and his staff on their needs.

U.S. Conference of Mayors executive director Tom Cochran said that he and some mayors met last week with senior Obama adviser Valerie Jarrett in Chicago to share their views about what they'd like to see in the package for cities. The group presented an updated report last week on projects that are ready to begin.

Roughly 641 cities have a total of 15,221 local infrastructure projects with a $97 billion price tag, which they say would create 1.3 million jobs in calendar years 2009 and 2010.

"It is important to understand that our main street economic recovery plan calls for funds to flow quickly and directly to cities through 10 federal funding streams that are already in existence; many of these have demonstrated their effectiveness over many years," the Conference of Mayors said in a recent release.

The projects include community development, transit, highway infrastructure, green jobs, school modernization, public safety, and public housing.

Tensions are rising between state and local governments over how funds from the stimulus package should be distributed. The mayors are concerned that if money for infrastructure projects is sent only to states so that it can be passed onto localities, they may not get a big enough share.

States do not see the need for changing the way funds usually are distributed: from the federal government to the states, which then dole the funds out to localities.

The National Governors Association has been a force by bringing state needs to the attention of the federal government. It has been a voice for states that have at least $136 billion of ready-to-go infrastructure projects that they say could spur job growth and stabilize state economies as they deal with mounting budget shortfalls.

The NGA has partnered with NASBO and officials from the National Conference of State Legislators to urge Congress to include in the package a two-year enhancement of federal funds for Medicaid, along with increased support for unemployment benefits and food stamps.

The NGA has said that the federal government should provide states with a significantly larger amount of funds for Medicaid than the $20 billion Congress approved in 2003, putting the current needs at as much as $100 billion.

The National League of Cities is lobbying Congress and Obama to extend the authority of the Treasury Department and the Federal Reserve under the economic stabilization and recovery plan to "ensure that state and local governments have access to the capital markets."

In addition, the NLC wants Congress to pass a bill similar to ones introduced in the House and Senate that would raise the bank-qualified debt limit to $30 million from $10 million

The bill would allow banks to deduct 80% of the cost of buying and carrying tax-exempt bonds issued by states, counties, and local governments whose annual bond issuance is $30 million or less.

The National Association of Counties says that 73 counties from 27 states have 2,388 infrastructure projects ready to go within 120 days at a cost of $21.9 billion.

"In this era of shrinking county reserves, increased costs, and growing demands for essential services, financial assistance from the federal government to the nation's 3,068 counties is not only appropriate, but critical for economic development," NACo executive director Larry Naake said in a recent release.


Even if provided funds from an economic stimulus package, state and local governments will still need to make cuts to their budgets. They have often turned to the municipal bond market in past times of fiscal turmoil to ease spending cuts.

Following the 2001 recession, states authorized about $30 billion of debt to fund current operations, employing various bond-financing strategies including tobacco securitization, taxable pension bonds to fund current pension costs, and deficit bonds, according to Standard & Poor's.

But going into the New Year with municipal market conditions uncertain, at best, and pent-up volume leftover from this year combined with scheduled new issuance, it will be more difficult for state and local governments, especially those with lower ratings, to use munis as an alternative to pay-go spending, officials with state groups said.

"It's tough because that's one of the safety valves - the ability of state and local governments to move away from pay-go and move toward debt-financed capital projects," said Boyd of the Rockefeller Institute. "[These conditions] make that safety valve harder to use or more expensive with greater interest rates, not allowing [states and localities] to buy a little budget relief in the short term or long term. It puts them in a pickle, for sure."

Prunty agreed, saying the cost of borrowing is likely to be higher, which will make it difficult for some states to accelerate debt issuance as their economic conditions and revenues continue to decline.

"Given budget pressures on the states, we believe that total cash-flow borrowing by the states for fiscal 2010 will increase," Prunty said in a Standard & Poor's report she co-authored on state budgets that was released last week. "The current market is pushing interest rates higher and it is costing more for states that need access to notes and bonds. We believe that the length of the disruption in the tax-exempt market will determine the price and demand for additional debt and the budget issues associated with it. In our opinion, if the capital markets remain constricted, the ability to borrow may be limited."

Brad Gewehr, head of municipal research for UBS Securities LLC, said while issuers are having difficulty accessing the short-term market to help cushion the holes in their budgets, the market overall should begin to open up.

"I'm optimistic that we'll start to see liquidity return to the municipal market sometime, hopefully in the first half of 2009, and that investors will get fatigued with the kinds of returns they're earning on their Treasuries," Gewehr said. "I think in spite of the wave of credit concerns, which tend to be exaggerated in this market, I think munis still have a very good case to make as part of the quality, low-risk portfolio. I think issuers should be thinking about ways to enhance that perception."

He added that auction-rate securities and variable-rate debt will continue to be a burden to issuers who have those types of securities outstanding.

"I think we're continuing to see the challenges of variable-rate debt, and I suspect that's going to be an important task for a number of issuers, to restructure or to deal with their variable-rate debt," he said. "There are still auction-rate securities that issuers would probably like to restructure, but the tough conditions of the market, the absence of bond insurers, the absence of letters of credit capacity, has made it more challenging to get those things accomplished than before."

It remains to be seen whether the issuers' fiscal troubles result in downgrades.

"Up to this point, states have been very proactive in managing the gaps," which should help them to maintain their ratings, Prunty said. "But clearly, we think the credit is going to be tested."

She added that while there were downward rating changes during the last recession, they were still within a narrow band and the sector as a whole remained strong.

Standard & Poor's will watch the first-quarter budget introductions, gauge how long the national recession will last, and determine what effect those and a federal stimulus package could have on credit durability, Prunty said.

"This 2010 budget cycle is going to be very telling because the decisions made at that time will clearly impact 2010, but also what 2011 looks like," she said.

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