The following question was recently posted on Quora:
“Credit Ratings: Should S&P include state and local debt in its calculation of US sovereign debt?”
Read responses arguing both sides of the debate:
Of course not. Municipal debt is not sovereign; municipalities are not subject to sovereign immunity and can be forced into bankruptcy (ask Orange County about that). There’s even an entire chapter of the bankruptcy code to deal with the special considerations of municipal bankruptcy. The United States is not (typically) a guarantor of such debt, and has no obligation to make creditors of defaulted municipal debt whole, and so such debt should not be counted as part of the debt of the United States.
State debt is sovereign; there is no provision for bankruptcy of a state. The only parties with the ability to sue a state in federal court, should it fail to make good its debt obligations, are another state, and the United States itself. The Eleventh Amendment explicitly denies federal courts jurisdiction to hear complaints against a state by citizens of another state or of a foreign nation; any such suit would have to brought in the state’s own courts and would be there limited by the state’s sovereign immunity. A state that defaults will be subjected to the consequences of that default (basically, that it will find it virtually impossible to borrow any further money), but the default of one state has no direct impact on any other state or on the United States. As with municipal debt, the United States has no mandatory obligation to assist creditors impacted by a state default of sovereign debt, and is not (typically) a guarantor of such debt and so such debt is not part of the sovereign debt of the United States. Nobody seriously expects that the feds would bail out a defaulting state.
There have been state defaults in the past: Indiana defaulted on sovereign debt on several occasions in the 1840s, mashing its credit rating for at least the next twenty years and leading to a constitutional convention in 1851 (with the aim of preventing a repeat of the debacle that led to the state default in the first place).
Matt Caire, VP of Investments at a Trust company:
I would argue that S&P should consider the U.S. sovereign debt and municipal (state and local) debt to be mutually exclusive, generally speaking. However, state general obligation debt could very well be at risk of losing federal funding going forward, thus one could consider an overlap in federal and (some) state fiscal budgets.
That being said, the municipal bond market is highly fragmented (from an issuer perspective) in which there are many different idiosyncrasies between issues. For example, a Los Angeles General Obligation, water & sewer revenue, tax allocation, and housing development bond are vastly different from one another and contain much different risk structures; even though they are all issued by the same issuer (Los Angeles). One could argue that the least risky of these would be the water & sewer revenue bond simply because this is considered an essential service which is insulated from the greater economy. This example holds true for the majority of the U.S. municipal market.
The bottom line is that the U.S. sovereign debt and U.S. municipal debt are two different animals altogether. The U.S. has been running a fiscal deficit for as long as many of us can remember, while the state and local budgets (while far from pristine) are dramatically improving. And from a risk standpoint, I would feel much safer holding a long essential service revenue bond than a long U.S. Treasury bond, in my opinion.
Marc Joffe, Former Senior Director at Moody’s:
It only makes sense to include state and municipal bonds in the a sovereign debt rating assessment, if the sovereign can be expected to bail out sub sovereigns on the verge of defaulting. When Jefferson County Alabama defaulted recently, there was no serious discussion of a federal bailout.
I believe that rating agencies use general government debt to GDP for assessing sovereign debt because that data is most readily available from such sources as IMF’s World Economic Outlook database.
My group is trying to address this situation by publishing central government revenue, expenditure, debt and interest expenditure statistics on an historical basis. See A New Free Sovereign Risk Database andhttp://www.publicsectorcredit.or....