States nervously watch debt-ceiling impasse

The U.S. government's stalemate over raising the debt limit is taking a growing toll on states as Tuesday's deadline draws near, with some canceling bond sales and identifying roadwork and other expenditures that could be delayed.

"As the deadline to Aug. 2 comes closer, people are really, really worried," says Scott Pattison, executive director of the National Association of State Budget Officers.

A failure by Congress to raise the $14.3 trillion federal debt limit would lower the nation's credit rating and raise borrowing costs for states as well as 7,000 cities, counties, universities and non-profits. That's partly because many interest rates — for everything from municipal bonds to mortgages — are benchmarked to U.S. Treasuries.

Even more worrisome is that states receive about 35% of their revenue from the federal government, including funds to build roads and schools and to help pay Medicaid and unemployment insurance, according to NASBO. To avoid defaulting on its debt and further harming its credit rating, the U.S. government likely would pay its bondholders but curtail other expenditures, such as disbursements to states, Standard & Poor's says.

Even if the White House and Congress reach a deal, states could be hurt, because an agreement likely would feature deficit-reduction steps such as cuts in payments to states, says Anthony Valeri, LPL Financial fixed-income strategist.

Moody's Investor Service has identified five states — Maryland, Virginia, New Mexico, South Carolina and Tennessee — whose credit ratings likely would be downgraded if U.S. Treasuries are given a lower rating. Like the U.S., these states enjoy triple-A ratings, and their financial health is more closely linked to the nation's.

Maryland and Virginia have large numbers of federal workers and contractors who likely would lose income, reducing state tax revenue. New Mexico, Tennessee and South Carolina get a big share of their Medicaid funds from the U.S.

"To out of the blue be placed on a negative watch because the feds can't get it done, that is frustrating," says Richard Brown, Virginia's secretary of finance.

Ten other states with triple-A ratings would be unaffected by a one-notch downgrade of U.S. debt but could be hurt by a bigger drop, Moody's says. Yet once federal budget cuts are approved, "Clearly there are implications for all states," says Bob Kurtter, Moody's managing director for public finance. Among states taking action:

•California this week secured a $5.3 billion bridge loan for operating expenses instead of completing a planned late-August bond sale because state officials feared a spike in interest rates that would raise borrowing costs, says Tom Dresslar, spokesman for state Treasurer Bill Lockyer. Officials also wanted to have cash in hand in case federal payments are slashed, he says.

•Maryland postponed this week's planned refinancing of a $200 million bond "until the markets get more settled," says state Treasurer Nancy Kopp.

•New Mexico plans to issue a $500 million note in case it doesn't get U.S. Medicaid contributions, and it's eyeing road projects and unemployment payments that could be delayed or slowed, says state Treasurer James Lewis.

Cities also would be affected. Salt Lake City Mayor Ralph Becker says the city may downscale a $125 million public-safety building because of higher borrowing costs and shelve a $44 million streetcar line that hinges on federal funding.