Rating agencies weigh in.

• Position: Perspectives

Although pundits and policymakers have focused increasing attention on the fiscal picture for state and local governments, the conclusions they have drawn have been less than accurate. There has been a great deal of talk about how pension liabilities and overall financial woes are going to cause bankruptcies and defaults, ultimately leading to requests for federal bailouts. To get to the truth of the matter, the Government Finance Officers Association asked the rating agencies about these important issues. Below, analysts from Standard & Pools and Fitch Ratings each answer the same six questions about the real condition of state and local government finances.

GABRIEL PETEK, Senior Director, Credit Market Services, Standard & Poor's

1. What do you foresee will be the general state of public finance this year?

   We expect many state and local governments will have to continue operating in a constrained revenue environment, with many having to make difficult budget and policy choices. Large projected budget deficits for fiscal 2012 at the state level may be partially solved by reducing state aid to local governments. State fiscal pressures may, therefore, challenge the cash and budget management activities of many local governments. We believe liquidity management will be especially important for governments with structural budget misalignments and those that have issued certain types of variable-rate debt such as demand obligations subject to optional tenders.

   In this environment, we anticipate that credit quality in the municipal sector could deteriorate somewhat, leading to more rating downgrades, yet we expect that most state and local governments will likely retain medium-to-high investment grade ratings. We have seen the credit quality of many issuers that have adhered to their established policies and practices demonstrate resilience and, in some cases, even continue to improve through this period.

   Rising municipal interest rates--possibly a result of investor concerns about state and local government fiscal health, expiration of the Build America Bond program, or even because of increased investor optimism and a macro reallocation of investment assets to equities--would result in higher borrowing costs for municipal debt issuers.

2. Do you anticipate any changes or additional nuances to the rating criteria?

   Standard & Poor's Ratings Services is dedicated to enhancing ratings transparency and comparability, and we continue to review and update our criteria on an ongoing basis. In advance of criteria changes, we often publish requests for comment (RFCs) that detail the proposed changes and invite feedback from market participants regarding the proposals. Recent examples include our RFC for U.S. state ratings methodology, which is now in effect, and an RFC for bond anticipation note rating criteria.

   The new states' criteria separate the methodology for states from the broader general obligation criteria for the first time. We are keeping the existing general analytic framework for our analysis of states but providing greater transparency of the ratings determination process.

3. Is municipal bankruptcy a true threat for investors? What about defaults?

   Legacy effects from the Great Recession--and the gradual recovery since it ended--are likely to reveal instances of genuine credit pressure, but we differentiate this from a municipal market crippled by widespread defaults or bankruptcies. We believe, moreover, that fundamental credit performance throughout the market--as measured by default rates relative to debt in the market--will remain mostly stable, with the possibility for a modest uptick. Even then, from what we observed in 2010 and as shown by our recent report, "U.S. Public Finance Defaults And Rating Transition Data: 2010 Update," defaults or bankruptcies are less likely among general governments than by issuers of conduit revenue bonds (that actually reflect corporate credit) or certain land-development financings.

   Many governments may endure continued fiscal pressure, but in our view, this should not be confused with outright credit distress. Despite a...