HEADLINES : Virginia, Maryland, Tennessee

States Prepare for Downgrades & Super Committee Cuts

by Kristen De Pena | August 24, 2011

States continue to brace for more financial woes, and with good reason. For the states, the uncertainty regarding the extent of federal funding available to them will continue until December, when the Congressional super committee must produce legislation to cut federal spending by $1.5 trillion over the coming decade. During the wait, states are also facing possible rating downgrades threatened by Moody's and S&P.

Shaking investor confidence and leading to drastic stock market losses, Standard & Poor's recent downgrade of the United States from a AAA to AA+ rating immediately impacted investors and consumers alike. State governments now face the same fate. Credit ratings vary by state; the agencies base their ratings on several factors, including reliance on federal funding and management capabilities. Many factors will play significant roles in determining which ratings change, according to S&P. Both downgrades and super-downgrades result primarily from unfunded long-term deficit reduction plans, many of these plans heavily reliant on federal aid.

Recently, super-downgrades, marked by falling multiple ratings, is a looming possibility for some local governments and a reality for others. S&P downgraded New Jersey and Nevada, but Manassas Park, Virginia fell five ratings, due to the "significant and rapid deteriorations of the city's financial position." Downgrades will increase the cost of borrowing money in the future and will impact the states' ability to pay for federal employees' salaries, make Medicaid payments, and may mean that states must cancel hundreds of contracts. States will face difficulty refinancing their own debt, making transportation repairs, funding social programs such as food stamps and funding K-12 education. These programs may face cuts as high as 40 percent if interest rates rise and credit ratings fall.

Equally worrisome for states are additional cuts to the federal funding resulting from super committee decisions this fall. The 12 member super committee, charged with cutting an additional $1.5 trillion from the federal deficit over the next decade has until Thanksgiving to make its recommendations. Congress must pass or fail these recommendations without modification before December 23, 2011. If the recommendations are not created or approved, it triggers an automatic $1 trillion spending cut unless a balanced budget amendment to the Constitution is sent to the states for ratification. State lawmakers look to start developing contingency plans while the super committee discusses cuts that will likely limit funding for state programs. To ensure that states have complete plans that account for as many eventualities as possible, it is necessary that state lawmakers be as fully informed about the plans the committee discusses throughout the negotiations to begin making preparations now.

Some states are taking preemptive action to prepare for possible downgrades and future revenue cuts by raising taxes, promising payments, or by cutting spending. In Maryland, Governor Martin O'Malley indicated that tax increases might be necessary in the coming year to overcome the $1 billion budget shortfall. The state will consider a range of "new revenues" to close the projected budget gap and prepare for further cuts made by the super committee to reduce the federal debt.

In Virginia, Governor Bob McDonnell recently announced a new $30 million down payment fund to offset the effects of the super committee's likely cuts to state funding. Critics of this plan call the $30 million down payment a "drop in the bucket," implying that the amount of money is an artificial safeguard for Virginians, particularly considering the state's reliance on federal defense funding, which faces drastic cuts. Gov. McDonnell responded that the fund would signal to credit rating agencies that the state is fiscally responsible, thereby possibly staving off a downgrade.

Tennessee Governor Bill Haslam told state departments to prepare to cut 30 percent from current spending. Planning for two levels of cuts, the Tennessee Finance Commissioner encourages planning for an immediate 15 percent cut, followed by an additional 15 percent cut later. Tennessee relies heavily on federal aid; the money makes up 40 percent of the state budget, and although the cuts are currently hypothetical, the dependency on federal funding makes the possibility more likely to become an eventuality.

Uncertainty leading up to cuts in federal funding and possible state and local credit rating downgrades places states in a precarious position. Developing contingency plans does will not erase the financial repercussions of either, but may mitigate the many effects commentators suggest could arise. State lawmakers and consumers both fear rising interest rates, a double dip recession, and continued employment rate stagnation, or worse, increasing unemployment rates. As the super committee begins negotiations this week, credit rating agencies and the states will wait.