Stateline Story

Will States' Credit Suffer From S&P Federal Downgrade?

  • August 08, 2011
  • By John Gramlich
When Moody's Investors Service announced last month that a downgrade of the federal government's credit rating could have a ripple effect in some states , governors and other officials immediately took notice. "We're furious," said Governor Bob McDonnell of Virginia, one of five states put on heightened alert by Moody's. McDonnell blamed politicians in Washington, D.C., for putting his state's financial reputation at risk even though Virginia itself had done nothing to warrant a downgrade.

Now that another credit ratings agency, Standard & Poors, has actually downgraded the federal government for the first time ever, financial experts are racing to understand the move's effects, ranging from the reaction of the international markets to the potential of higher mortgage rates . States, meanwhile, are sure to wonder whether they will be adversely affected, too.

Certainly, the five states singled out by Moody's last month may be more worried than others. Maryland, New Mexico, South Carolina, Tennessee and Virginia all rely heavily on borrowing or federal assistance, and therefore are more vulnerable to sudden changes in investor confidence in the federal government, Moody's warned.

But there are some signs that bad news for the federal government's credit rating doesn't automatically translate into bad news for the states.

First, The Washington Post reports that Moody's and S&P have different views on whether a federal downgrade carries repercussions for "sub-sovereignties," such as state and local governments. Moody's is more likely to say yes, while S&P is more likely to say no, according to The Post .

"Moody's believes that if the parent government is downgraded then they will automatically downgrade the sub-sovereign entities to the same level as the parent governmental entity," Corey Stewart, the chairman of the Prince William County Board in Virginia, tells The Post , noting that S&P takes a more measured view when it comes to states and localities. Since S&P is the agency that downgraded the federal government, states may not be as vulnerable as they might be if had Moody's made the same decision.

In addition, the municipal bond market generally views state and local governments favorably, and not necessarily as being bound to the federal government.  "The immediate market impact of the U.S. credit downgrade might be somewhat muted by the tax-free market's traditional strengths," Reuters notes . "Many of the tens of thousands of tax-free issuers, from states to counties and schools, raise revenue from their own taxes and fees, independently of the federal government. The default rate historically has been under 1 percent. "

S&P currently rates more than a quarter of the states — 13 — with the top AAA score, according to Reuters. As the wire service notes, however, deep spending cuts in the debt-ceiling deal recently reached by Congress and President Obama eventually could force states to borrow more money, making the possibility of lower credit ratings an even greater concern to governors and lawmakers.