FALLOUT FROM THE BUDGET BATTLE : Municipalities May Feel Credit-Rating Crunch

California averted another blow to its credit rating with the budget agreement reached early Wednesday, but the state’s municipalities may not fare as well.

With deep cuts in state funding looming for counties, cities, higher education authorities and other local government entities, the tax-exempt bonds issued by those municipalities now face tough scrutiny by professional investors and bond-rating services.

As state support diminishes, “I think there very well could be some credit deterioration at the local level,” said Steven Zimmermann, California bond analyst for rating service Standard & Poor’s Corp. in San Francisco.

S&P;, along with competitors Moody’s Investors Service and Fitch Investors Service, are expected to reaffirm their current ratings on the state’s general obligation debt now that a budget has been reached. Moody’s and Fitch rate the state’s debt one notch under top-quality; S&P; rates the debt two notches below the top.

But the state’s general obligation bonds are only a minority of the estimated $130 billion in California muni bonds outstanding. Most of that debt has been issued by local governments and special districts to finance hospitals, schools, real estate developments and other projects.

Also, most of the debt is owned by individual Californians, who have been attracted to the securities because the interest paid is exempt from both state and federal income tax.

In balancing its own budget, the state has slashed financial payments to its municipalities--which will force them to rebalance their own recession-ravaged budgets. Bond analysts fear that some strapped municipalities may have to choose between paying interest on their debt or paying for essential public services.

The question for some bond issuers may be, “Do you make the (bond) payment on your courthouse first, or do you pay your police force?” said Zane Mann, publisher of California Municipal Bond Advisor, a Palm Springs-based investor newsletter. “We have no way of knowing how city councils will react to that choice.”

Mann and other experts agree that most California municipalities will find a way to honor their interest payments, because default is so destructive: It brands the city or district as a financial pariah.

Still, the level of concern about some smaller bond issuers is rising because the current fiscal crisis is the worst since the Great Depression and because it follows massive borrowing in the 1980s.

“I see more problems ahead at the local level,” said Claire Cohen, California bond analyst at Fitch. Bond payments “are going to be competing with every other need in the (localities’) general funds.”

While still sorting out the state budget’s ramifications Wednesday, many analysts said their greatest concerns were about bonds issued by counties and school districts.

“The counties have been hit hard because they bear the brunt of social services and health care costs,” said Paul Flynn, bond analyst at the Vanguard Group of mutual funds in Valley Forge, Pa.

But the fiscal differences among counties in California are large, Flynn noted. “San Diego County is just barely scraping by, while Sacramento County is doing remarkably well,” he said.

Meanwhile, school districts--while escaping deep cuts under the new state budget--still face severe financial pressures, analysts warn.

Considered relatively unscathed: Bonds issued by transit, water and power agencies, which like cities can raise fees to cover costs.

Some analysts expressed renewed worry Wednesday about special lease securities, known as Certificates of Participation, which have become a popular form of municipal financing in California.

Unlike general obligation bonds, which require the issuer to raise taxes if necessary to make interest payments, interest on COPs is payable at the issuer’s discretion. In practice, COPs have posed few problems. But the chance that some issuers could legally step away from payments has scared off some investors who ordinarily might have purchased COPs this year.

S&P; said Wednesday that the state’s own $2.8 billion in lease obligations remain on “negative credit watch,” meaning S&P; could further downgrade their quality ratings. In the wake of the budget, “we may want to make some further differentiation among” these securities, Zimmermann said.

* MAIN STORY: A1

California’s Muni Bond Flood

The state and its municipalities issued a record $34.8 billion in debt last year, up 43% from 1990 issuance. How the 1991 debt was divided among issuers:

No. of Value Pct. of Issuer bonds (billions) total State 86 $9.773 28.1% Counties 127 4.909 14.1% Cities 272 3.962 11.4% State agencies 36 3.095 8.9% School districts 455 2.414 6.9% Transit authorities 17 2.153 6.2% Water districts 40 1.321 3.8% Redevelopment agencies 77 1.045 3.0% Other 342 6.150 17.6% Total 1,452 $34.822 100%

Source: California Debt Advisory Commission