WASHINGTON Moody's Investors Services said on Wednesday that most state, local government and public authorities that issue debt in the municipal bond market are "well insulated from shock," but added that some could be vulnerable to risk during major market volatility.
"Most municipal issuers are somewhat weaker than they were prior to the last major market disruption," said Moody's Managing Director Timothy Blake in a statement. "This is why some may face significant stress if hostile market conditions emerge."
While downgrades could happen in those conditions, Moody's does not expect widespread debt defaults or downgrades of more than a single notch.
"We expect that the vast majority of these issuers could successfully manage through a period of diminished market access and tight liquidity without facing a severe deterioration in their credit," the agency said.
"Most municipal debt is used to finance capital projects, and governments have the ability to defer projects if they cannot finance them at rates that make sense," it also said.
Still, states and local governments had more tools at their disposal to take on volatile markets and a wobbly economy before the 2007-09 recession caused their revenues to plunge and their spending demands to swell.
Revenues have still not come back to pre-recession levels, and so Moody's does not expect "an exact repetition of these tactics" to address new threats.
On Tuesday, California's controller said the state's revenue came in 10.3 percent below forecast in July, stoking worries that recent wild swings in the stock market will send the state's finances into disarray.
California relies heavily on wealthy taxpayers and their capital gains to provide a large chunk of revenue and the market meltdown of 2008 helped create a multibillion dollar deficit in the state.
Events in the municipal sector as well as in the global sovereign or banking sectors could create market volatility, Moody's said. It added that "global developments of a political nature" could also generate instability.
In its report, Moody's said one root of volatility could be an unanticipated default.
The agency's comments came after another rating agency, Standard and Poor's, said state and local governments with the highest ratings are not at risk from its decision to downgrade U.S. debt. S&P cited political factors as a reason for the U.S. downgrade.
State and local governments that issue debt to fund operating deficits or rely on short-term notes for seasonal cash flow needs may have greater exposure to risk, Moody's said.
These issuers, such as California and Illinois, would be vulnerable if a slowing economy pushed their budgets off balance, leaving them fewer internal sources of funding, or if they could not function without borrowing cash.
It added that entities that need to roll over bond anticipation notes, who have bonds with mandatory puts, or are struggling with expiring letters of credit and other liquidity backstops may also be at risk.
Moody's said earlier in the week that in the second quarter of 2011, the public finance sector faced a record $40 billion of expiring letters of credit, standby purchase agreements or other liquidity facilities. The expirations had gone well, with a majority of those holding the bank facilities extending the expiration dates or finding a substitute.
With costs of the facilities rising, and the facilities themselves becoming rarer, the municipal bond market had worried issuers would not be able to find substitute backstops, forcing them to sell the bonds to the banks holding the facilities at high penalty rates.
(Additional reporting by Caryn Trokie in New York and Jim Christie in San Francisco; Editing by James Dalgleish)