Alert July 29, 2011

Muni Market Holds Its Breath While Politicians Play Chicken With Debt Ceiling

As Congress continues its standoff regarding the country’s debt ceiling, Moody’s Investors Service has placed five triple-A states under review for a possible downgrade in light of their dependence on the ability of the United States to pay its bills.  Many states -- including Virginia and Maryland, two of the five states under Moody’s scrutiny -- receive a significant portion of their revenues directly or indirectly from federally funded programs. For example, if the U.S. government defaults on its obligations to make Medicare and Medicaid payments, states with a significant population who rely on such payments will suffer economically and be ripe for a rating downgrade. Moody’s has already placed the federal government on a credit watch in response to the current debt ceiling debate.

Market analysts differ as to just how a U.S. default might impact the municipal bond market.  Most agree, however, that the impact could be severe.  In addition to its recent announcement regarding the five potential state downgrades, Moody’s has warned that any rating downgrade of U.S. credit, which could occur even without a default, would cause an automatic rating downgrade of approximately 7,000 municipal securities that are backed by U.S. Treasury bonds (i.e., state and local government series securities, or “SLGS”). Although SLGS make up only 5% of the municipal bond market, analysts worry that such a massive downgrade could cause a ripple effect in the market.

Additionally, the federal government pays a significant percentage of the interest on Build America Bonds (“BABs”), a program that was initiated as part of the federal stimulus package in 2009.  More than $180 billion in BABs were issued between 2009 and 2010.  If the U.S. fails to make the interest payments on that outstanding debt, the bond issuers will have to make good on the payments, further straining state and local finances.

But is a default by the United States really inevitable?  Some analysts have suggested that the doomsday scenario being threatened by both parties in Congress – failure to raise the debt ceiling followed by a national default and economic disaster – is merely ammunition in their game of chicken. Those observers believe that one of the parties is bound to blink, rather than risk a serious financial debacle.

Nevertheless, whether the current drama is a serious debate or Congress’s version of Y2K, the fact remains that the U.S. Treasury will lose its ability to borrow funds on or around August 2, 2011 should Congress and the President not agree on a compromise to raise the debt ceiling.