Municipal credit ratings survive economic downturn
Over the past decade, Washington, D.C., had earned a reputation as a financial black hole. In January 1995, its general obligation bonds were downgraded to below investment-grade. Its financial ineptitude was so profound that, in April 1995, then-President Bill Clinton signed into law the District of Columbia Financial Responsibility and Management Assistance Act, creating an independent authority to oversee district finances and correct budget deficits and cash shortages.
Four-and-a-half years later, the district regained its investment-grade rating. Last March, its bonds were upgraded again.
D.C.’s success story was all a matter of control, says District Treasurer Anthony Calhoun. “We had a bad deal with the federal government that had to be re-worked,” Calhoun says. “We had an unfunded pension liability of $2.2 billion. And unlike Cleveland, Philadelphia and New York, we didn’t have a state to turn to to help us out.”
The district is now in the process of building up its cash reserves, Calhoun says. And the markets are responding.
Despite indications that the economy is slowing, Calhoun says the district is “guardedly optimistic. We’ve seen no evidence of a downturn. We know it’s around us, but, so far, things are looking good.”
Washington, D.C., is not unusual. Most cities remain optimistic about their ability to weather any economic downturn. In fact, a recent survey by the National League of Cities indicates that, while two of three cities report that their local economic outlooks have worsened or remained unchanged, respondents in four of five cities think they will be able to handle whatever the economy throws at them.
All indications are that the bond market feels similarly. So far, municipal credit quality has not suffered in the economic downturn, despite the fact that slower tax revenue growth has strained some local government budgets. That, however, has not been enough to weaken credit quality materially.
Overall, in recent months, ratings upgrades have outnumbered downgrades by a wide margin in the tax-backed sector. Largely because of California’s energy crisis and revenue and liquidity pressures affecting health care providers, the improvement in revenue-backed credit worth was not as strong.
Because the labor market remains tight and declining mortgage yields have thus far prevented home sales from falling to a recessionary pace, state and local government tax payments continue to grow modestly. The downside is that a slowdown in retail sales has weakened sales tax revenues.
Additionally, the recent reduction in corporate profits has had little effect on local government finances since corporate income taxes account for less than 5 percent of state and local government revenues. However, a huge 187 percent yearly first-quarter increase in announced corporate layoffs and rising initial unemployment claims suggest the latest slowdown in corporate profitability is softening the labor market. Weaker job growth would increase the pressure on personal income and sales taxes, which account for a significant 62 percent of state and local government revenues.
Greater economic diversity and the absence of jarring structural changes such as military base closings distinguish the current state of municipal credit quality from that of the period leading up to and encompassing the last recession. Conservative budgeting as well as the modest municipal debt growth and the dramatic increase in reserves over the last five years should help state and local governments withstand a slowdown in the U.S. economy better than they did in the early 1990s.
“The most important thing would be to control spending, be conservative in estimating revenues and negotiate labor contracts that call for improvements in productivity,” says New York City Budget Director Adam Barski, whose city just saw an upgrade in its general obligation bond rating to its highest point since the city’s fiscal crisis of 1975. “There is a great interdependence between our city economy and Wall Street profitability. Consequently, we project very conservative estimates as to Wall Street profitability. Last year, it was $19 billion; this year, we projected profitability of $5 billion. That’s the number we use in doing financial modeling.”
Lower bond yields also should help local governments that may find themselves with budget gaps by cushioning the blow for any city or county forced to borrow to plug those gaps. The 5.26 percent average long-term municipal bond yield in March has declined from a May 2000 peak of 6.09 percent and remains only modestly above December 1998’s 4.98 percent, which was the lowest since 1969. In the six months prior to the last U.S. recession, a climb in municipal bond yields from 6.85 percent in December 1989 to 7.01 percent in June 1990 made it costlier for stressed municipalities to borrow in credit markets.
Budget flexibility helps
Slower (but still ample) tax-revenue growth helped upgrades significantly outpace downgrades among tax-backed bonds in the first quarter. Most state and local governments were braced for — and had sufficient flexibility to respond to — a slowdown in tax revenue growth. As a result, the effect of weaker revenues on credit ratings-because of the budget shortfalls that arose in some regions was limited.
Even so, the NLC survey indicates that cities are preparing to take precautions against possible shortfalls. Some reported that they will raise taxes or user fees to compensate for anticipated loss of revenue, while one in three reported that it would be making mid-year adjustments to spending estimates. Cities also are considering diverting money into rainy day funds, investing in infrastructure and carrying over funds for general operating purposes.
Cities and counties have been able to offset a decline in the growth of local tax receipts (which grew by an estimated 6.8 percent yearly in the fourth quarter, down from a peak of 9.1 percent in 2000’s second quarter) by cutting annual expenditure growth (which slowed from a peak of 7.5 percent in the first quarter of 2000 to 6.7 percent in the fourth quarter of last year). A decline in spending limits the need to take on additional debt when tax revenues weaken.
Municipal debt protection remains strong. Tax revenues approximated 64 percent of outstanding municipal bonds at the end of 2000, up from 61.3 percent at the end of 1999. Similarly, state and local government tax receipt coverage of interest payments rose to 1,300 percent in the fourth quarter 2000 from 1,241 percent at the end of 1999. Just prior to the onset of the last recession, a thinner 890 percent interest coverage ratio evidenced much less financial flexibility.
Ongoing economic growth, conservative management, spending cuts, receipt of tobacco settlement funds and tax-base expansion (fueled by revaluations and residential and commercial development) contributed to recent upgrades of Boston, Pittsburgh and Denver. Additionally, strong regional economies prompted first-quarter upgrades for seven cities in the Dallas-Fort Worth metropolitan region and four in the Boston metro area.
The power crisis effect
Health care was the weakest revenue-backed sector in the first quarter, but California’s energy crisis also contributed to rating downgrades. Seven of the eight public power downgrades stemmed from California’s energy crisis, while hydroelectric plants that receive the bulk of their revenues from California’s two troubled investor-owned utilities were placed at increased risk of debt-service shortfalls. In Seattle, a record low snowpack and service outages for maintenance and repairs reduced power output and led to a downgrade of municipal light and power bonds.
Like issuers in the tax-backed sector, issuers of revenue-backed bonds benefited greatly from customer growth and higher usage rates that accompanied strong economic growth over the past few years. A slowdown in the U.S. economy creates a more uncertain operating environment that will place greater pressure on revenue-backed credit quality going forward. Issuers not shielded from competition are likely to experience the greatest strain on revenues.
John Puchalla is an economist with Moody’s Investors Service, New York.