The ‘new stable’ for local governments
Moody’s Ratings made a big sector call last week in its U.S. Public Finance outlook:
Moody’s Investors Service has revised its outlook for the US local governments to stable from negative as housing markets continue to stabilize, municipalities’ fund balances remain stable, and cities and school districts modify their expenses.
Moody’s has held a negative outlook on local governments for five years, so the outlook change was a big one. But it had some caveats:
Conditions, however, will remain more difficult for local governments than they were before the 2008 recession, and pockets of serious credit pressure remain.
Moody’s called the state of local governments – the “new stable,” saying, “The ‘new stable’ will be an era of constrained resources, but the worst is over for local governments in most of the country,” says Naomi Richman, a Moody’s Managing Director.” I think local officials will welcome the moniker.
The key drivers of Moody’ s new outlook are:
- The housing market has stabilized in most of the country.
Four years after the collapse in home prices, the housing sector has stabilized and is recovering nationwide. With the stabilization in housing, we expect local government revenues to increase over the next two years, which is a credit positive.
- Property taxes have proven their durability.
One of the main reasons US local governments remain a highly rated sector is the durability of property tax revenues. Even during a downturn as severe as the one that began in 2007, with double digit assessed value declines in some areas, property taxes held up well in aggregate. In contrast to income taxes and sales taxes, property tax receipts nationwide stayed essentially flat (see below). The stability of this revenue source is critical for local governments’ financial planning and budgeting…
…Local government property tax receipts lag home price changes due to assessment practices. Most local governments keep taxable properties on the books at an ‘assessed valuation’ that does not change unless properties change hands or are reassessed. Tax rates are charged on the assessed valuations, not on the market values.
- State funding arrangements have mostly stabilized.
With the growth in gross domestic product and the improvement in states’ finances since the downturn, most states have begun to restore some funding cuts to local governments, although state assistance remains below pre-recession peaks in many cases.
Over the recession, most states responded to declines in their own revenue sources with a number of actions, including cutting aid to municipalities (see below). State aid to local governments fell 2.6 percent in 2010. 4 School districts were the most vulnerable to these cuts, as school districts tend to fund more of their budgets with state aid than cities or counties do.
- Local governments are controlling costs.
Most local governments have recognized the new fiscal landscape. Government officials have become more discriminating in labor negotiations, slowed the growth in salaries, trimmed staff, and taken steps to deleverage. All of these cost-cutting efforts are credit positive.
We expect costs will continue to escalate because of growth in pension and healthcare costs, as well as general governmental inflation. However, the measures that local governments have taken to slow cost increases and deleverage will enable the sector to largely retain financial stability in the face of these increases.
We find the clearest evidence of the sector’s efforts to modify cost structures in employment and wage figures. State and local governments have shrunk staff by more than 500,000 people since 2008 (see Exhibit 7). These figures support our observation that most local governments are shrinking through attrition, consolidating departments, leaving open positions unfilled, resorting to shared services, and, in some cases, laying off workers to reshape their budgets.
Not only do state and local governments now employ fewer people, the growth in the salaries of the people who remain has slowed considerably. According to the Bureau of Labor Statistics, state and local government wage growth slowed to less than 1 percent in 2012, compared with more than 3 percent annually for most of the past 10 years.
- Fund balances have stayed healthy.
The majority of cities and other local governments maintained healthy fund balances throughout the downturn (see below). At the weaker end of the scale, many facing pronounced credit pressures drew their fund balances down, leading to more local governments with low or negative fund balances. In aggregate, though, local governments cut spending, increased taxes, and enacted other budgetary measures to keep a healthy level of reserves to cope with budget contingencies.
The bad news from Moody’s:
- Pockets of pressure remain.
Several states, sectors and individual local governments are exceptions to the newly stable outlook.
We expect downgrade activity to remain concentrated in states and sectors where:
- the local housing market has lagged in recovery, or has not recovered at all
- local governments have failed to modify their cost structures
- state funding difficulties remain
- political will to utilize tools at their disposal is lacking
- structural limitations hamper efforts to raise revenue or cut expenses
- unemployment is persistently high
For the sectors still facing strain, we believe credit quality may continue to erode. Further, for those heavily distressed situations that do arise, we expect defaults to become more common and bondholder recoveries to be lower. In other words, the local government sector rating distribution’s “tail” will fatten, even as most of the sector regains its health.
The bottom rung of the rating distribution has already expanded. There are currently 114 local government ratings in the speculative-grade range of Ba1 or lower. This is a more than five-fold increase from the 20 local government ratings in the spec-grade range in 2008.
This may be the most important muniland report from a ratings agency this year. It certainly signals that it is worthwhile for investors to consider local credits more closely. I’m not sure if muniland will see a sector change for years to come.