Does the downgrade mean more U.S. towns will go bankrupt?

at 09:00 AM ET, 08/10/2011


Rhode Island’s Central Falls filed for Chapter 9 bankruptcy on Aug. 1. (Brian Snyder - Reuters)
Standard & Poor’s announced another wave of downgrades on Monday, lowering the credit ratings that affect thousands of cities, school districts, public housing and transportation projects directly linked to federal funds. The municipal bond downgrades ranged far and wide -- from financing Jets Stadium to building a high school in Montana’s Hill County -- but all were “explicitly linked to federal funds or are paid from funds appropriated at the federal level,” says Gabriel Petek, a senior S&P analyst. The muni bond market weakened on Tuesday after the list was released. Will this mean higher lending rates for states and cities? And will it push towns already on the brink of financial collapse over the edge into default?

Not necessarily. Overall, Chapter 9 filings by municipalities have actually gone down in the first half of 2011, as compared to 2010 and 2009, as have municipal defaults overall, defying popular predictions last year that the U.S. would soon experience “a tsunami of municipal bankruptcies and defaults.”  

And so far, cities and states may have avoided the worst fallout of a sweeping credit downgrade: S&P hasn’t changed its credit rating of entire states or local governments as a direct result of downgrading the U.S. government, and they’ve tried to affirm that state and local finances are largely independent of the feds. “In our view, the institutional framework for U.S. public finance is among the most stable and predictable in the world. ...U.S. state and local governments function with a high level of revenue independence,” S&P wrote in a report released late Monday, explaining that some states and cities could retain an AAA rating even though the U.S. as a whole has been downgraded.

But the worst may not be over yet. S&P is expected to announce another wave of downgrades later this week. “Where we’re headed is more like spreading a flu. The particular concern is that you’ll  go from AA to A -- that’s where you had a hard time getting bond insurance,” says Frank Shaforth, director of George Mason University’s Center for State and Local Government Leadership. As such, “the real credit damage will accrue to the weaker communities and states more dependent on aid from above,” Municipal Market Advisors wrote in a report this week. And investors note that S&P has made it clear that it will cast its net wide in terms of its credit downgrade, trickling down to the most local level. “They have taken a very inclusive stance as to what the Treasury downgrade means,” says Matt Fabian, MMA’s managing director.

Another wave of downgrades could come at a particularly bad time for some financially troubled corners of the country. Though overall default numbers remain low, there’s already been a recent uptick in the number towns, cities and other municipal bond holders on the brink of solvency. In the last two months, the number of municipalities defaulting for the first time has sped up, outpacing the same time period in 2010, according to the MMA report. Since the beginning of August, 71 bond issuers have missed a payment for the first time, as compared to 80 by the end of August 2010. The total number of municipal defaults in 201 “are still about 30% behind 2010…yet the totals may be much closer than we originally expected,” the MMA report concludes.

A credit downgrade alone certainly won’t send a town into bankruptcy or default. But it could be a wakeup call for towns suffering from major financial problems and that are already heading in that direction. On the same day that S&P downgraded the U.S., for instance, it also downgraded Rhode Island’s West Warwick (Pop: 29, 581) from A1 to Baa1—just two notches above a junk bond rating—as the town struggles to meet its pension fund obligations for public-sector employees. Underfunded pensions have already brought down Central Falls, R.I., which filed for Chapter 9 just a few weeks ago. West Warwick officials aren’t ruling out bankruptcy, but they’ve committed themselves to revamping their pension structure and financing. “States and local governments are trying to live within their means,” says Jim Spiotto, a Chicago-based lawyer and bankruptcy specialist. Credit downgrades, on the whole, “may be motivation for people to make sure they stay the course and continue down the right road.”

 
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