Analysis: Default threat rattles munis as does compromise

WASHINGTON Fri Jul 22, 2011 9:06am EDT

U.S. President Barack Obama pauses during a news conference in the Brady Press Briefing Room at the White House in Washington July 15, 2011. REUTERS/Larry Downing

U.S. President Barack Obama pauses during a news conference in the Brady Press Briefing Room at the White House in Washington July 15, 2011.

Credit: Reuters/Larry Downing

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WASHINGTON (Reuters) - The possibility the United States could default on its debt next month has made the municipal bond market anxious, but the potential compromises Congress and President Barack Obama might strike to avoid a default may be making it even more nervous.

Moody's Investors Service put five U.S. states on review for a possible rating downgrade on Tuesday because their ties to the U.S. government, in terms of high federal employment levels or Medicaid exposure, put them in jeopardy if the United States' credit rating is cut.

The threat of a U.S. downgrade comes after months of jostling between congressional Republicans and Obama over raising limits on how much debt the country can take on. They are edging closer to a deal, but no one is certain how or when the issue will be resolved.

For those states caught in the ratings crossfire with the United States, downgrades would drive up their borrowing costs. A U.S. debt default would also hurt pre-refunded municipal bonds, which are secured with federal government and agency securities, Wells Fargo Securities Municipal Securities Research said in a mid-year review of the market released on Wednesday.

But when it comes to the real likelihood of default, the research division wrote "the market does not seem to believe this will happen."

Still, there are threats posed by what Obama and Congress might agree to cut in order to lower the $1.4 trillion deficit. One of the biggest is in the form of Medicaid, the health insurance program for the poor that states administer with reimbursements from the federal government.

Wells Fargo said Medicaid cuts threaten states' cash flow. Since all U.S. states except Vermont must end their fiscal years with balanced budgets, they would likely cut Medicaid services, it added.

Medicaid accounts for as much as 30 percent of state spending, an amount that is growing. States, still smarting from the effects of the recession which forced them to slash spending and hike taxes, are worried about having to cut funds for other areas to cover Medicaid needs in the near future.

"If Congress and the administration get through the debt ceiling crisis, which we believe is highly likely, that does not necessarily diminish the potential for downgrades" of U.S. debt, wrote Alan Schankel, a Janney Capital Markets managing director, in a special commentary on Wednesday.

"Depending on short-term and long-term details of any budget agreements, Moody's and other rating agencies could downgrade U.S. debt."

He added that even if the United States maintains its ratings, "significant spending cuts enacted as part of any deficit reduction plan could negatively impact federal employment, Medicaid payments and other federal spending which benefit state and municipal government."

Lawmakers are also weighing cutting funding for infrastructure, housing assistance, community development and homeland security, according to a brief released on Wednesday by the Pew Center on the States.

"Cities and states also worry that the federal tax exemption for newly issued municipal bonds could be eliminated," it added, making borrowing more expensive.

By exempting interest payments on municipal debt from federal income taxes, the U.S. government helps keep borrowing costs low for states and cities because debt buyers are more willing to accept lower interest payments.

Recently, members of Congress have discussed moving to tax credit bonds, where buyers receive credits against their taxes in lieu of interest payments, or subsidized bonds, where the U.S. government pays issuers rebates on their taxable debt.

A proposal for compromise include eliminating the Alternative Minimum Tax, which could lead to the loss of tax-exemption for muni debt sold for private entities, said Gary Pollack, managing director at Deutsche Bank Private Wealth Management.

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