Shock warning on US municipal bonds

The unprecedented warning – the first time Moody's has made such a warning about the US local government system as a whole – was made in the light of the continued recession and the problems that it is causing for city and state governments.

Moody's said that it was assigning a negative outlook to the entire $2.6 trillion (£1.8 trillion) US municipal bond sector – operated by local town, city and state governments – because of the combined collapse in the financial and housing markets.

Analyst Eric Hoffman said what could prove to be the worst recession since the Great Depression of the 1930s will pressure "many if not most local governments" over the next 12 to 18 months.

The warning is important because municipal bonds are one of the key ways local authorities raise medium and long-term finance in the US, and if investors sense that they might not be paid, bond issues are likely to go unsold.

Local governments have been hit by reduced tax intakes as more residents lose their jobs, and as more companies in their areas either close or have produced losses.

The state of California has so far been the poster boy for the problems in local government funding, with Governor Arnold Schwarzenegger faced with reducing a deficit expected to reach $42bn by 2010.

But smaller entities are also hurting, such as Jefferson County, Alabama, which has been threatening to default of some of its bond payments for a number of months.

Mr Hoffman said that those localities most at risk of a downgrade will be those heavily reliant on car manufacturing, property and financial services, as well as those who have been heavily reliant on property taxes or those have a high proportion of fixed costs.