Investeens

On Friday August 6, Standard & Poor’s announced that it had downgraded the U.S. credit rating from the highest, AAA, to AA+, for the first time in history. The immediate effects of the downgrade were seen on Wall Street as the Dow Jones 30 index plummeted in excess of 600 points. However, now S&P analysts are saying the federal budget situation can start to affect your street: State and local governments.

S&P analyst Gabriel Petek said that the long-term deficit reduction framework part of the budget deal approved last month can undermine the economic recovery and complicate certain aspects of the fiscal management of state and local governments.

According to S&P, this sort of outcome would weaken its view of certain municipalities in the $3.7 trillion U.S. municipal bond market.

The effect of a downgrade of municipal bonds could be potentially devastating. With the lower credit rating of the bonds, states and municipalities are going to have to raise their interest rates on bonds in order to make them even slightly attractive to a buyer. This means states and municipalities are going to have an increased cost of raising money via bonds. Even more costly to the states and municipalities whose bonds could be potentially downgraded is that if such a downgrade could occur they could possibly lose even more money on their insurance expenses. States and municipalities have to insure bonds in event of default (interestingly enough, the federal government almost never has to insure bonds as they can simply print money!). With a lower credit rating, they can possibly be paying more insurance. In other words, the expenses of these states and municipalities are going up while the revenues are staying the same. What this will cause is it to be harder for states and municipalities to raise money, which will translate into a harder time in reducing their own deficits.

If Standard & Poor’s does downgrade the credit rating of certain state and municipal bonds, the situation could be very bad for these bond issuers. The recovery is already fragile. The only conceivable solution to this problem is that these state and local governments adopt policies that make S&P confident that they can deal with certain federal funding cuts in the coming years.