The nationwide recession may be over, but economic recovery is tepid, according to Robert Kurtter, Managing Director of U.S. Public Finance at Moody’s Investors Service. “State and local governments are lagging in recovery, exerting continued stress on their economies.”

“While downgrades are expected to outpace upgrades, no state defaults are expected,” he says. In the interview that follows, Kurtter shares his insights on the current condition of and outlook for state and local government credits.

MuniNet: You mentioned that states have “inherent credit strengths.” What are some of these strengths?

Kurtter: There are several factors that lend strength to state governments. First, states are large and diverse. Even the smallest and poorest states have a large and diverse tax base compared to local governments and school districts. By law, states cannot declare bankruptcy, nor can they be sued without their consent (“sovereign immunity”). State debt is relatively affordable, and is usually issued for projects – e.g., roads, schools, and other tangible structures – not to cover operating costs, which is a factor in their high ratings. With the exception of a few states (including, Missouri, Michigan and Oklahoma for example, which have self-imposed restrictions on raising taxes), states have the power to raise revenues and to cut costs.

In addition, when natural disasters strike, the federal government provides funding to help repair damage to public buildings and infrastructure, easing the burden on state and local governments as they recover and rebuild. And despite the national recession, states still draw benefits from the United States’ large and vibrant economy – the most powerful in the world.

MuniNet: Why are many local governments in a more precarious financial position than states?

Kurtter: Local governments and districts derive revenues from two principal revenue sources: state aid and property tax revenues. Property taxes had remained relatively stable through the past 11 business cycles since the Great Depression. This economic downturn, however, the longest-running recession since then, was driven by the decline in the housing market. Local governments, therefore, are feeling the sting from the pressure on both revenue sources.

Municipalities can get some relief through supplementing state aid and property tax revenue with funding from other sources, such as fees, fines, and special taxes. School districts, however, which comprise a large percentage of local government bond issuers, are particularly vulnerable to state budget cuts and declines in local property taxes.

Budget cuts have the potential to really hurt school districts that heavily depend on state aid. State aid to schools is formula-based, using a “full-value-per-capita” ratio, which is an adjusted assessed value figure. While more affluent school districts may get very little state aid, some poorer districts may depend on state aid for a significant portion of their funding.

MuniNet: Do local governments have their own inherent credit strengths?

Kurtter: Historically, local governments have enjoyed a more stable revenue stream than other levels of government. Even in the current economy, property tax revenues have been less volatile than the sales and income taxes on which state governments rely.

It is important to bear in mind, however, that the vast majority of rated local government credits are relatively sound.

Because local governments have a narrower mission, and offer fewer social services (healthcare, social service, etc.) than states, they are generally more easily managed.

MuniNet: Are fiscal challenges translating into greater default risks? Might they down the road?

Kurtter: To date, states have been very unblemished by defaults. There has not been a single state default since the Great Depression, and we don’t expect to see any on the horizon. While we will likely continue to see downgrades among state credit ratings, in general, we believe that states will be able to manage their finances.

The picture is a little different for local governments, however, where we could see more defaults. Still, there is a bit of confusion in the marketplace regarding default risk for rated versus non-rated municipal bond issues. Between 2000 and 2009, only 54 rated municipal market issues went into default. Of these, approximately 80 percent were healthcare or housing related; three were general obligation bonds, and five were municipal special purpose (recreation facilities, enterprise, other revenue) bonds.

While the federal government is in the economic driver’s seat in most cases, state and local governments need to adapt their plans accordingly and manage their finances and debt in both upward and downward national economic cycles.

There is a much higher default risk among non-rated issues. These include smaller and/or weaker credits, sometimes speculative in nature – e.g., land deals and local developments.

MuniNet: When we consider economic recovery, is there a hierarchy among federal, state, and local governments?

Kurtter: Generally speaking, yes – there is a hierarchy of recovery. The federal government is much more in control of its own economy than state and local governments are, primarily because of the impact of the monetary and fiscal policies at the federal level. While the federal government is in the economic driver’s seat in most cases, state and local governments need to adapt their plans accordingly and manage their finances and debt in both upward and downward national economic cycles.

But not every state or locality’s economy moves closely to the national economy. For example, the economy of a state like Alaska is primarily driven by oil prices, or areas of the country that are tourist dependent like Hawaii or Nevada. At the local level, for example, college towns whose economies are driven by universities are often less affected by economic cycles.

MuniNet: How can investors and the municipal investment community balance the “gloom and doom” media hype with economic realities?

Kurtter: The financial problems of many states and municipalities have reverberated throughout the nation, creating news headlines about a sector once considered to be stable and secure. While the headlines are very dramatic, it is clear that state and local governments are facing unprecedented fiscal stress. We tend to hear more about states’ financial woes than localities simply because they are more visible and affect more people.

Some smaller municipalities have also earned dubious fame for their extreme financial problems; one thing we’ve learned is that when it comes to financial problems and the municipal market, size doesn’t matter. Take the case of Central Falls, Rhode Island, one of the smallest, poorest cities in the state – with about $20 million in debt. Central Falls’ financial problems became front page financial news across the nation, as did Bell, California, and Harrisburg, Pennsylvania.

These cases of serious fiscal stress remain rare and represent a tiny fraction of the rated entities in the municipal market, yet the longer the economic downturn lasts, the more likely we are to see an increase in municipal defaults. It is important to bear in mind, however, that the vast majority of rated local government credits are relatively sound.

About the Expert:

Robert Kurtter has been with Moody’s Investors Service since 1991, and is the Managing Director for U.S. State and Regional Ratings. Prior to joining Moody’s, Robert served as Deputy County Executive for Finance in Suffolk County, New York.

Robert also served in New York state legislative staff positions, including as the Director of Budget Studies for the New York State Assembly Ways and Means Committee.

He received his bachelor’s degree from Union College, and his master’s degree in Public Policy from the University of Michigan.