WASHINGTON (Reuters) - The recession that began in 2007 created budget emergencies in most U.S. states and many cities and counties, casting a harsh spotlight on long-standing fiscal problems.
Members of Congress are now worrying publicly that the only solution will be a sweeping federal rescue -- one that Washington can barely afford under the burdens of its own massive deficit.
Analysts, taxpayers and investors in the $2.9 trillion municipal bond market have begun to worry about possible consequences of the budget crises.
Below are the top threats to the economies of state and local governments and to those who buy and trade their debt.
Among the longer-term problems, none looms as large as underfunded pensions and other post-employment benefits for public employees.
The issue has boiled over in Wisconsin and other states where Republicans were recently elected as governors and state legislators. Public workers and Democrats are opposing moves to curb union rights and cut employee benefits.
All three rating agencies are giving greater scrutiny to how pension obligations affect states' credit-worthiness. The U.S. Securities and Exchange Commission has rapped New Jersey for not properly disclosing its low pension funding levels.
No one can say for certain how much states with economic woes have underfunded pensions and other benefits, such as healthcare, promised to retired employees. Estimates for states' pension under-funding range from $660 billion to $3 trillion because of disparities in calculating future returns on investments made by pension systems.
The Pew Center on the States put the total shortfall on promises made to retirees, including healthcare, at $1.26 trillion. In recent years, the Governmental Accounting Standards Board has required states to put promises made to retirees outside of pensions on their books. But these "OPEBs" are easier to change than pensions and could provide places for states to cut.
The housing crisis, financial meltdown and recession reduced nearly all revenue sources for states, cities and counties. The National Governors Association and National Association of State Budget Officers have dubbed the revenue decline a "collapse."
Lately, states have begun to see improvements in their revenue collections, but the increases have been modest and revenue has yet to return to levels reached before the recession. Moreover, some of the recent revenue rise came from states raising taxes, and taxpayers are showing little appetite for further increases.
All states, except for Vermont, and many cities and counties must end their fiscal year with their budgets balanced. To make up for less revenue, many governments were forced to cut spending. Looking ahead, they have fewer areas to adjust if revenue remains soft.
The most obscure-sounding threat -- a shortage of bank liquidity facilities -- could have some of the biggest implications for local governments.
The cost of liquidity facilities, which support commercial paper and variable-rate demand bonds, is likely to rise in the near future because the number of providers is shrinking and the international Basel III accord on banking regulations is strengthening capital requirements for banks. That, in turn, could drive up borrowing costs.
When the bond insurance industry broke down in 2008 and a credit freeze seized the municipal bond market, many local governments bought the facilities to provide liquidity for their debt. Consequently, most facilities will expire around the same time this year.
In the short run, states and local governments are dealing with the end of the $830 billion economic stimulus plan giving states the largest transfer of federal funds in U.S. history.
The last of the money, in the form of additional reimbursements for Medicaid, runs out this summer. Already states and local governments say they are falling off a stimulus "funding cliff."
Another stimulus measure that suspended interest charges on loans the federal government makes to states for unemployment benefits has ended, and states are now looking at mounting bills for those loans.
Republicans, who hold a majority in the House, have made it clear that there will be no additional stimulus and, in a twist, states have said they have no interest in a direct federal bailout. They are more concerned that the federal government's current debates about shutting down, or slashing domestic spending, would cut short any recovery they are experiencing.
Meanwhile, states and local governments are concerned about federal programs that could require them to spend money they do not currently have. Many of the reforms in the healthcare law passed last year to give all Americans access to medical help must be carried out at the state level. The all-encompassing No Child Left Behind education bill has expired, as has the long-range statute laying out how interstate transportation will function, commonly known as the "Highway Bill."
Backlash against bank analyst Meredith Whitney's recent forecast of an impending wave of credit defaults by struggling local governments is growing stronger. Analysts and traders are concerned that anxiety about governments' bad fiscal conditions will worsen those situations.
For seven months, there were sizable net outflows from municipal bond funds, which are popular with individual investors who have been unnerved by the headlines.
Few cities have defaulted since the recession began in 2007. Some of the cities raising the most concern are struggling with unique problems and not nationwide trends. For example, Harrisburg, Pennsylvania, may come close to defaulting because it financed an expensive trash incinerator that has burned through cash without generating revenue.
Still, many local governments are worried about states balancing their budgets by cutting off aid, which could force cities, counties and school districts to lay off workers or slash services.
Writing by Lisa Lambert; Reporting by Lisa Lambert, Jim Christie in San Francisco, Karen Pierog in Chicago, Michael Connor in Miami, Joan Gralla and Edith Honan in New York; Editing by Theodore d'Afflisio and Andrew Hay