08/09/2011 05:30 pm ET Updated Oct 09, 2011

As S&P Considers Downgrades, State And Local Governments Brace For Prospect Of Higher Costs

NEW YORK -- American state and city governments already struggling to balance their books now must brace for the prospect of increased borrowing costs as Standard & Poor's plans to reevaluate their credit ratings.

Fresh off its unprecedented downgrade of the federal government's creditworthiness, the rating agency said that it will evaluate local governments -- many of which are still struggling to recover from the Great Recession -- after federal lawmakers announce specific spending cuts later this year. Lower ratings could make it more expensive for governments to borrow money in a market where investors use these grades to judge credit quality. With many localities already in the process of enacting difficult budget cuts, downgrades could heap strain on American communities.

"A downgrade means it puts the governor, the legislature and every elected local official in a tough position. Do you raise property taxes? Do you raise water and sewer rates?" said Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University. "Do you invest in the future, or do you stultify? It's not a good choice."

"It will translate into a significant rate increase and a significant tax increase," he added, "on hundreds of thousands of Americans."

Many state and local governments rely on federal aid, either directly or indirectly. In a tersely worded press release this week, S&P suggested it is reviewing the grades of governments deemed particularly dependent on federal support.

"We do not directly link our ratings on U.S. state and local governments to that of the U.S. sovereign debt rating," S&P said in the Monday release. "However, we recognize generally that U.S. state and local governments' economic performance is frequently similar to the nation and they share responsibility for some spending items with the federal government."

After it lowered the rating of the U.S. government to AA+ from AAA on Friday, S&P began downgrading other investments that are directly tied to the sovereign rating. The mortgage giants Fannie Mae and Freddie Mac, which own or guarantee more than half of U.S. mortgages, saw their top grades docked on Monday. Municipal debt issues that are backed by the federal government also saw their grades lowered.

American localities have taken a beating in the wake of the economic downturn, with many forced to slash spending to compensate for depleted coffers. As payroll costs continue to rise, tax revenue growth remains weak. And as a preoccupation with budget austerity grips the halls of federal and state power, small governments are preparing to go without crucial sources of aid.

State and local woes were compounded by predictions that the municipal market would experience widespread defaults. After analyst Meredith Whitney said late last year she expected "hundreds of billions" of municipal defaults over the ensuing 12 months, interest rates on municipal debt rose, a sign that investors saw the debt as riskier.

Those yields later came down, but they rose again in late summer as the federal debt ceiling debate heated up. The difference, or spread, between the yields on an index of municipal bonds and yields on U.S. Treasury debt broke 1 percent in early August, Bloomberg data show -- an indication that investors are edging away from debts deemed riskier.

S&P said it could allow "many" AAA governments to hold on to that rating, even though it is currently above that of the federal government. By implication, though, some of these ratings could be vulnerable. And it's not just the most highly rated governments that might see their grades docked.

"The governments that should truly be worried aren't the AAAs that almost by necessity are going to be downgraded a tick or two. It's the cities and municipalities that were already in trouble," said David Johnson, a partner at the Chicago-based ACM Partners, a boutique financial firm that advises struggling municipalities. "The market has gotten a little bit shakier on risk, and I think those guys are going to get a much harder look."

"And those are the guys that can least afford it," he added.

But James Spiotto, a veteran bankruptcy attorney and head of the bankruptcy practice at Chicago law firm Chapman and Cutler, said that despite the anxiety over ratings, investors shouldn't let a lowered grade affect their decisions. Governments are unlikely to default on their debt, because that would almost inevitably make it more expensive for them to borrow money in the future, he said.

Indeed, municipal defaults have been quite low, as governments choose to cut other budget items before they renege on a promise to bondholders. Last year, the Standard & Poor's/Investortools Municipal Bond Index, which includes $1.27 trillion of municipal debt outstanding, experienced just $2.65 billion of bond defaults, according to a January report from S&P. That was an 8.6 percent decline from 2009, which saw $2.9 billion of bond defaults.

"It's very key to state and local governments that they have market access at a low price," Spiotto said. "The cheapest, most economic thing to do is to stay credible in the market, and do the things to stay credible, because that reduces your costs and increases the benefits to your taxpayers."

In the weeks leading up to S&P's downgrade of the federal government, many financial experts lamented that the company's pronouncements would have any sway in financial markets. That company, many noted, gave unrealistically rosy assessments of subprime mortgage-linked investments in the years leading up to the economic crisis. Those investments later went bust, contributing to a widespread financial panic.

Ratings, though, retain a quasi-legal status. Some institutional investors are required to buy highly rated securities.

"They're like weeds. They're everywhere in financial regulations and practice," said Andrew Ang, Ann F. Kaplan Professor of Business at Columbia Business School. "Hopefully they'll become more irrelevant as time goes on, but that's not the case right now."