WASHINGTON -- There’s more to a state rainy-day fund than keeping a high balance.

Dynamics are much more nuanced, especially with revenue volatility complicating year-to-year budgeting. Variables include when to tap into a stabilization fund in relation to state and national economic trends, as well as local needs.

Bond rating agency opinions raise another concern.

“There seems to be some fear, whether appropriate or not, that there is something from the rating agencies that could come to them," Jonathan Moody, a research officer at Pew Charitable Trusts, said July 18 at the Brookings Municipal Finance Conference. "Of course, they're afraid that there might be a downgrade,”

Pew released a report about rainy-day funds and state credit ratings.

“I think the understatement of the day would be [that] state policymakers are concerned about how these funds relate to their credit ratings,” Moody said.

Pew researchers examined 149 rating action reports between 1992 and 2015 in which Moody's Investors Service raised or lowered a state's rating. They said 81% mentioned reserves generally and 42% specifically noted the condition of the state's rainy day fund and cited it by name.

“Whether it be Alaska, and their tapping [of] their reserves to try and deal with the decline in oil prices, or even in cases like Texas, where frankly they have a sizable reserve and just a one-year blip, it looks like, they're still very worried about what exactly using these funds means for their credit ratings, and essentially asking the question that I think we're all curious, if you use these funds, will you be downgraded?”

Moody’s two weeks ago cut Alaska’s general obligation debt to Aa3 from Aa2. Alaska, relying on its constitutional reserves to keep operating, is burning through those reserves at a rate that will deplete them entirely within two years.

In the Northeast, Massachusetts last month received its first general-obligation downgrade since 1990 when S&P Global Ratings dropped its rating on the Bay State to AA from AA-plus. S&P scolded state officials for not following through on rainy-day replenishment during a prolonged economic expansion when the state's growth stood above the national average.

The downgrade prompted calls from Gov. Charlie Baker and state Treasurer Deborah Goldberg to replenish the commonwealth’s stabilization fund, which dropped from fiscal 2012 to 2014 by 24.5%, to $1.25 billion from $1.65 billion, even as state tax revenue growth of 10.7%, to $22.9 billion from $20.71 billion. Reserves dropped even further in subsequent years,

Baker signed a $39.4 billion budget for fiscal 2018 that included a $98.4 million increase to the stabilization fund, lifting reserves to $1.4 billion.

Lois Scott is one of the four founders of Women in Public Finance.
“Rating agencies do not rate the quality of infrastructure. It’s not even discussed," said former Chicago CFO Lois Scott. "I think it is some of those third party actors that are influencing behaviors.”

Connecticut, facing a deficit of up to $5 billion for fiscal 2018-19 and late with its biennial budget, at least won't have to dip into its stabilization fund to balance FY17. Thanks to austerity measures and improved revenue, the state ended the fiscal year with a $35.7 million surplus and was able to increase its rainy-day balance to a still-thin $271.3 million.

That figure could change, said state budget chief Benjamin Barnes, based on remaining revenue accruals and adjustments under generally accepted accounting principles.

Policies regarding rainy-day usage vary by state. Most categorize them as budget reserve or budget stabilization accounts. California calls one of its accounts a “special fund for economic uncertainties” while Michigan has a “countercyclical budget and economic stabilization fund.”

Some states have reserves for specific purposes, such as education funding.

“When I do an analysis, I look at a rainy day fund as part of general fund reserves,” said Alan Schankel, a managing director at Janney Capital Markets. “States should go out of their way to be reluctant to tap into them, because if you do it, too often it becomes a joke after a while.”

Bond rating analysts frown on arbitrary withdrawals or using reserves to plug longstanding structural budget gaps.

According to Moody, Pew’s research found that rating analysts scrutinize how states structure their reserves, whether policymakers are disciplined about controlling deposits and withdrawals, and how officials integrate rainy day fund policy with spending and revenue decisions.

The rating agencies, he said, typically favor states that design such funds to align with the turns in the economic cycle, by depositing revenue into the fund during upturns and spending those reserves during downturns as one way to help cover budget shortfalls.

States that withdraw during recessions, or when an event such as a natural disaster lowers revenue, will not necessarily jeopardize their credit ratings as long as other budgetary actions meant to grasp the decline in revenue are also part of the mix, according to Pew’s findings.

Only 12 states have the maximum triple-A ratings across all three major credit rating agencies: Maryland, Texas, Delaware, Georgia, Indiana, Iowa, Missouri, North Carolina, South Dakota, Tennessee, Utah and Virginia.

Most of them have reserves 5% or more -- the benchmark bond rating agencies prefer, according to data culled from the National Association of State Budget Officers.

Pew recommends state policymakers design rainy day funds with “clear, objective goals” to which policymakers can refer to regardless of changes in governors, legislatures, and business cycles; structure rainy day funds in line with the economy; and base the decision to tap rainy day funds on the state’s fiscal situation, withdrawing money as appropriate during budget crises but resuming deposits when economic and fiscal conditions improve.

“If your sewer system is backed up, that might be a good use of rainy-day funds,” said Janney’s Schankel. “But spending for the prettiest fire truck, you don't want to go that way.”

The emergence of rating agencies' as de-facto overseers presents an odd dynamic, said Kim Rueben, a senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute.

“It is super-interesting to me that we've effectively gotten to a point where what seems like the regulators for states, in sort of what seems to me in part guaranteeing state good behavior, are the rating agencies," she said.

The fear factor, while prodding Illinois to end a two-year budget impasse under the threat of a downgrade to junk, could also inhibit decision-making outside the box or discourage transparency, she added.

"There is sort of this interesting ‘push-me, pull-me,’ ” she said. “It's also a little weird for your disciplinarian to be your customer in the fact that states actually pay to get ratings. And so there’s a complicated relationship.”

That also makes many state and municipal issuers hesitant to borrow more for the kinds of projects in public demand such as infrastructure, according to Lois Scott, former chief financial officer for the city of Chicago.

“Rating agencies do not rate the quality of infrastructure. It’s not even discussed,” she said. “At the city of Chicago we have 45 separate ratings. The quality of infrastructure was rarely discussed.

“What is asked is what’s your leverage, how much debt are you adding, what’s your debt service as a percent of budget, so I think it is some of those third party actors that are influencing behaviors.”

Schankel advises municipal officials not to overreact to fears of a rating downgrade.

“If you're a governor you should not be looking over your shoulder at the rating agencies every time you have to make a decision.”

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