Who's Next on S&P's Chopping Block?

States and local governments could face repercussions following S&P’s downgrade of U.S. debt.

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State and local governments could face higher borrowing costs and tighter budgets following the first-ever downgrade of U.S. debt, which could result in more job cuts and reductions in social services, experts say.

Credit rating agency Standard and Poor's revised ratings for numerous municipal bond issuers Monday, including school-construction bonds in Irving, Texas, debt backed by a federal lease in Miami, and a bond series for multifamily housing in Oceanside, Calif., Bloomberg reported.

An S&P report released Monday emphasized that the agency does not directly link its ratings on state and local governments to its opinion of U.S. sovereign debt, but experts warn that state and local governments could still face further repercussions from the downgrade in coming weeks, confirming that the United States' pristine credit rating won't be the only casualty of the nation's debt woes.

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"It's really about how much funding [state and local governments] get from the federal government," says Ron Florance, managing director of investing strategy at Wells Fargo Private Bank, adding that more than 170 top-rated states and municipalities are under review by credit rating agency Moody's, including Virginia, Tennessee, South Carolina, Maryland, and New Mexico. "Just because they receive such significant funding from the federal government."

As with Fannie Mae and Freddie Mac—agencies both closely tied to the federal government that were downgraded to AA+ on Monday—experts say the main driver behind ratings adjustments is an entity's dependence on the federal government. "If they're dependent on federal funds at a time when the federal government is cutting back, that puts their creditworthiness at risk," says Greg McBride, senior financial analyst at Bankrate.com. Questions about creditworthiness could lead to small ratings revisions, experts say, which could in turn lead to higher borrowing costs for state and local governments.

Higher borrowing costs could imperil some state and local governments already facing fragile budgets. Add to that the potential for reduced federal funding on the heels of the debt-ceiling deal forged in August that calls for more than $2 trillion in total spending cuts, and states and local governments could have an even bigger budget shortfall to fill.

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"There's a combination of the worry that [states and local governments] will cut back on spending further, which is obviously not good for employment or that they'll have to issue more debt to try to make up the shortfalls," says Laura LaRosa, director of fixed-income strategy at investment and wealth management firm Glenmede.

In 2010, states and local governments received more than $470 billion in federal funding for education, unemployment benefits, and Medicare programs. Curtailing that funding places additional stress on those entities, which are already struggling under the weight of budget cuts and lower tax receipts.

Despite the bleak economic environment of the past several years, states and local governments have proved relatively resilient, says Tom Kozlik, municipal credit analyst for Philadelphia-based financial services firm Janney Capital Markets. That's a testament to their ability to adapt. "States have the power to control their own budgets, control their own revenue, control spending," he says. "They really are masters of their own destiny."

While Kozlik doesn't anticipate sweeping downgrades of municipal issuers in the coming weeks, he says a lot is still up in the air concerning S&P's next move and how the federal government plans to handle reducing its deficit. Congress hasn't yet formed the 12-member debt reduction committee tasked with shaving $1.5 trillion from the federal budget deficit over the next 10 years, but experts expect President Obama to make his recommendations for the group's staff in coming weeks. "We're waiting to see more from S&P and the Congressional cut committee before we'll have a full knowledge of credit risks," Kozlik wrote in a report Monday.

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