By Nin-Hai Tseng
July 27, 2011

FORTUNE – Tensions are boiling over in Washington as U.S. lawmakers negotiate a plan to raise the $14.3 trillion debt limit. With an Aug. 2 deadline fast approaching, the U.S. government is nowhere close to forging a deal — an impasse that puts its impeccable triple-A rating at risk.

A downgrade would be bad news for the overall economy on various levels. Much attention has focused on how it could impact consumers: Interest rates for U.S. Treasury bonds would rise, which would lead to higher borrowing costs for everything from home mortgages to car and school loans. And with a fragile economy still slowly recovering from a deep recession, such shocks to the market could send the U.S. back into a downturn.

What has been less talked about is what a downgrade would mean to individual states.

Last week, Moody’s Investor Services placed Maryland, New Mexico, South Carolina, Tennessee and Virginia under watch for a possible downgrade. The five are among the 15 states currently with stellar triple-A credit ratings. Moody’s placed the group of five under watch because of their relatively large exposure to federal funding – from Medicaid payments to government contracts and the like. And any deal to raise the debt ceiling will likely include spending cuts.

Ironically enough, a majority of these states (South Carolina, Tennessee and Virginia) are considered red states, where residents predominantly vote Republican – the party that’s been urging budgetary cuts in everything from health care to Social Security. In listing South Carolina, Moody’s (MCO) factored the state’s vulnerability to federal contracts and Medicaid payments. In Tennessee and Virginia, the economies are heavily dependent on federal government jobs.

The ratings agency says it would review the states on a case-by-case basis if the U.S. lost its triple-A rating. However things work out, the Moody’s alert shouldn’t be taken as a sign that local officials can’t get its finances right. For instance, Virginia recently posted a budget surplus for the second consecutive year. And unlike the federal government — which has the power to print money and pressures to enact policies that encourage employment and a strong economy — virtually all states must balance their budgets.

Many Wall Street bankers say they still believe a default would be avoided. However, it’s less certain what the overall effects might be of a downgrade – either at the federal, state or local levels.

If anything, the likelihood of downgrades at the state level underscores Washington’s delicate balance between cost cutting and additional spending. Standard and Poor’s has said that just raising the debt ceiling isn’t enough. The country’s credit rating might still be downgraded, the agency has warned, unless Congress comes up with a “credible” plan for at least $4 trillion in savings. And yet, some expect that too much cost cutting could cause a ripple effect across local and state governments.

“… It is also symbolic of the bigger picture in that states and communities with Aa, A and other ratings will also be exposed to fiscal challenges should federal expenditures decline dramatically,” analysts at Janney Capital Markets told clients in a note released Tuesday. “If the ratings of these states were to ultimately be downgraded, so too would the rating of many other states, as well as counties and communities.”

In the short-run, a downgrade for the five states that Moody’s has listed could be minimal. Siona Robin Listokin, professor at George Mason University’s public policy school, says borrowing costs would rise but this shouldn’t be too dramatic. And while state budgets are under pressure these days and have little room for error, the annual interest costs aren’t likely to tip them into default.

But over time, a downgrade could put an unwanted spotlight on the fact that these states are overwhelmingly reliant on federal funding.

“In the same way that the federal debt ceiling could speed up ratings downgrades without a major federal deficit reduction plan, the cascade effect to these five states could focus investor attention on structural financial difficulties that have been on the back burner for a time, like state employee pension and health care costs.”

You May Like