What the Debt Ceiling Default Could Mean for States and Localities

If Congress doesn't raise the debt ceiling later this month, state and local programs could experience massive spending cuts. But the impact depends on a number of factors, experts say.
by | October 3, 2013 AT 12:00 AM

As the federal government goes dark, states and localities are left to wonder if the stalemate will lead to a first-ever default on U.S.-held debt later this month. Many believe a failure to raise the debt cap could be far more damaging to local economies than the shutdown.

READ: Full coverage of the federal shutdown's impact on states and localities.

Looming ahead this month is the Oct. 17 deadline – the date which the Treasury estimates it will have only $30 billion per day to fund commitments if an agreement to raise the country’s $16.7 trillion debt ceiling is not reached. (The country’s net daily expenditures can be as high as $60 billion.) If the debt ceiling is not increased, all spending – including non-discretionary spending that is protected in a government shutdown – would be eligible for cuts in order to avoid a default on payments.

States and localities are expected to bear the brunt of those cuts, said Matt Fabian, an analyst for Municipal Market Advisors. “They could further cut aid to state and locals, or push unfunded mandates down, or change tax preferences, or do something that passes costs on further,” he said. “They did that with the sequester and they could easily do it again.”

The biggest and most immediate impact would likely be to Medicaid payments, said Nick Samuels, a public finance analyst for Moody’s Investor Service. If Uncle Sam slows the rate of Medicaid reimbursements to states, “states in turn might say, ‘We’re going to slow payments to healthcare providers,’” Samuels said.

Additionally, federal monies for other programs (or in some cases to pay for debt service), could see at least a reduction – if not a total wipeout – of the funding. That will leave states to figure out how or if they want to keep some federally assisted programs going. The uncertainty is nothing new for states. For example, Utah back in 2010 passed legislation that required its government agencies to have contingency plans if they saw up to a 25 percent reduction in federal payments. But Richard Ellis, the state’s treasurer and current senior vice president of the National Association of State Treasurers, said bracing for an impact does not necessarily lessen its severity.

“For states, the uncertainty is difficult to deal with,” he said. “My legislature has been concerned going back 10 years with regard to federal programs and grants that flow to states and whether we want to be involved with those grants. I think it makes states very leery going forward as to what programs do we want to become involved with and how dependant we want to become on those programs.”

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A capped debt ceiling’s impact on the municipal market is less clear. One piece of good news from analysts is that states and localities are unlikely to see a repeat of the summer of 2011. That year, some states and localities were sent reeling when Standard & Poor’s downgraded the United States’ credit rating after a showdown over the debt ceiling that led to the Budget Control Act of 2011. Municipal market credits with a direct relationship to the federal government saw their ratings also lowered by S&P in August and September of that year, an action that Janney Montgomery Scott analyst Tom Kozlik calls in his October note, “one of the more significant parts of the fallout from the Debt Ceiling Debate Part I.”

This time around, however, the ratings agencies have already factored the federal uncertainty into their ratings, including the U.S. sovereign rating. (Kozlik notes it is more likely this time that the rating agencies will leave the U.S. rating alone, “unless DC policymakers completely fumble the fiscal policy football over the next few weeks.”) Some are still highly vulnerable – Moody’s has said that any downgrade of the U.S. rating would result in an automatic downgrade in the ratings of Maryland, Virginia, New Mexico and Missouri. But most issuers would be insulated.

“In general, this having happened before, I think people are a little more jaded this time around,” said Fabian. “It’s the second time in two years. This could certainly happen again, you could see ratings go down or prices fall. But I think the agencies and evaluators are more likely to wait until something actually hits [an issuer].”

What is more likely to impact municipal ratings is how prepared they are to deal with reduced federal funding (for states) or less money flowing through the economy (for localities). Moody’s identified 15 states where federal revenues make up more than 40 percent of government funds (Alabama, Arizona, Arkansas, Georgia, Idaho, Maine, Mississippi, Missouri, Montana, Nevada, Ohio, Oregon, Rhode Island, South Dakota and Tennessee) while more than 50 percent of Louisiana’s funds are from the feds. But Samuels cautioned that doesn’t necessarily mean a state with more federal funds is more at risk in the debt ceiling scenario.

“We would look at states whose liquidity is strongest and what tools they have available to float cash for a period if federal funds close down,” he said. States without those resources would likely face higher borrowing costs and market access would be challenging, he added.

But as murky as the future is now, some are just as wary of whatever solution might surface: “Investors should remember that the Debt Ceiling Debate Part I resulted in the Budget Control Act Phase I, the Budget Control Act Phase II, and Sequestration (nobody’s favorite),” says Kozlik. “This time we are not sure exactly what to expect, but we are on the look-out for anything like this that may be a wolf in sheep’s clothing.”