Ratings

A slower economy affects state and local governments in three big ways, by:

• Sharply lowering the sales tax revenue available to governments,
• Rapidly depleting the "rainy day" reserves they've set up, and
• Causing underperformance of locally derived revenues dependent on economic activity such as building permits, fees, and realty transfer taxes.

Falling sales tax revenues have forced many state governments to alter their budget plans mid-year (see "A Weak Economy Will Tax U.S. States' 2009 Budgets," published March 25, 2008 on RatingsDirect). Not only are sales tax revenues not coming in from day-to-day retail sales, as consumers cut back spending, but those revenues are also taking a hit from the drying up of expenditures fueled by home equity loans. When home prices were high and many believed that they would keep rising, consumers used readily available home equity loans or lines of credit to make big-ticket purchases. But with the decline in home prices and easy credit terms, that source of consumer spending has dried up. Its loss is felt keenly in jurisdictions where income and property taxes are lesser sources of revenue. The federal economic stimulus plan, however, will alleviate the situation to some degree as consumers pump their rebate checks back into the economy.

A slow economy also depletes reserves because governments draw on them to plug unanticipated budget holes. In turn, that can mean more borrowing than previously anticipated, as the viability of internally funded capital projects decreases or disappears altogether. More borrowing again means higher costs for the jurisdiction, raising expenses while revenues are falling.

State and local governments derive a fair share of revenue from economic activity. Strong growth in the housing market early in the decade spurred a surge in new construction, which generated strong sales tax, building permit, and realty transfer revenue for local governments. Year after year these line items exceeded budgeted amounts and provided additional revenue. With the current economic slowdown and housing slump, however, local governments are seeing the opposite effect. Construction-derived revenues are off, and the effects are straining budgets.

While not immune to economic slowdowns, some governments tend to be more proactive in acting quickly to adjust to a weakening economy. Management plays a critical role during tenuous times. The ability to put the brakes on spending, shift resources, and monitor results are tools many successfully managed governments employ. All in all, we expect that the effect of the economic slowdown will mean more belt-tightening for some state and local budgets as they adjust to the lower revenue base.

Because local governments and school districts depend heavily on property taxes, those jurisdictions with high foreclosure rates can end up enduring some degree of fiscal pain. When a lender seizes a home, the lender becomes liable for property tax payments. But there's a time lag between when the lender takes back the property and back taxes are fully paid. As a result, a locality could face potential cash flow pressure, and if short-term borrowing becomes necessary, the result is in an extra expense. To make matters worse, the towns hardest hit by foreclosures find it more difficult to raise property tax rates at a time when they might want the additional revenue.

To date, Standard & Poor's hasn't seen a credit impact on state or local governments directly because of the foreclosure crisis. While the number of foreclosed homes is large and increasing, the vast majority of homeowners are paying their mortgages and taxes on time. The damage from foreclosures, where it has occurred, tends to be greatest in the previously fast-growing exurban areas in the Sunbelt.

A year ago states and municipalities routinely turned to monoline insurers for credit enhancement. But as that insurance sector has come under pressure, and ratings for some insurers have been cut, the game has changed. To lower borrowing costs, issuers will seek to refinance their debt with credit enhanced by one of the more highly rated insurers. Alternately, some public issuers are also tapping the credit markets only on the strength of their Standard & Poor's underlying rating (SPUR)—the rating that we would give issuers without the support of bond insurance or other credit enhancement. While the SPUR is often lower than the 'AAA' rating they might have obtained through bond insurance, it adds some stability back to the credit rating picture.

Over the past few years many municipalities began using more short-term financing to meet their needs, largely because such financing was cheap and readily available. In the past year, with the credit markets in turmoil, that hasn't been the case. Issuers with variable-rate funding have been subject to wild swings in their financing costs, and many are seeking fixed-rate financing instead. Unlike some corporate borrowers who have been shut out of the credit markets, however, public issuers have been able to find the funding they need, though the cost of longer-term debt can be higher.

Swings in the markets also have an effect on state and local finance. Some jurisdictions, for instance, reap significant revenue from taxes on the capital gains of securities. To the extent that those gains are no longer there, states will lose revenue. Because many pension funds hold stocks, drops in the market can also affect them, making it harder to build the assets needed to meet future obligations. And because a falling stock market reduces individual wealth and spending, this can also diminish tax revenue.

While it may be somewhat more difficult for some issuers to fulfill their pension payment obligations, they almost always do. However, meeting their OPEB obligations can prove more problematic. The largest OPEB, health care costs for retirees, has been rising at an alarming pace. While it's well-known that health care is an expensive retirement benefit, some jurisdictions are just beginning to get a handle on the scope of these costs as a result of the implementation of GASB (Government Accounting Standards Board) Statement 45, which mandates that every jurisdiction determine and report the full actuarially required contribution needed to meet their OPEB obligations.

Virtually every governmental jurisdiction will have to make this data public. GASB 45 is effective in three phases based on a government's total annual revenues. The largest employers have already begun implementing it for periods beginning after Dec. 15, 2006. Medium-sized employers have one additional year to implement the standards, and the smallest employers have two additional years. Coming up with the figures can be a massive job involving reams of actuarial data, and complicating the process is the fact that in some states OPEBs can be changed after the fact—that is health care benefits can be changed after an employee is retired--and in some they can't. Some issuers will incur measurable costs to meet the GASB 45 requirement. Standard & Poor's will take the results of GASB 45 under consideration in rating issuers as the results for each jurisdiction become available.

No one, of course, knows how deep or how long the economic slump will last. But it will inform the decisions public issuers make at least through 2008 and perhaps beyond. As issuers adjust to the new realities, so too will Standard & Poor's as it evaluates credit quality. After all, even the relatively stable public issuance sector can't expect smooth sailing all the time.

Writer: Robert McNatt

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