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The outlook for U.S. states and local governments continues to be negative for the third straight year as they face unprecedented fiscal strains amid an only slowly improving economy, Moody’s Investors Service concludes in two new reports.

Downgrades in the municipal sector have outpaced upgrades for eight straight quarters, and Moody’s expects more downgrades among state and local governments in 2011.

However, the rating agency also expects that no state will default on its general obligation debt. At the local government level, defaults are likely to increase modestly, but are expected to be neither widespread nor systemic.

Debt is typically structured with level annual payments, and annual debt costs are a relatively small portion — 5% to 8% — of a state or local government’s budget.

On the revenue side, states face the end of most federal stimulus funding in June. States relied heavily on the stimulus to balance their budgets in the last two years, with stimulus funds comprising 18% of state budgets in fiscal 2010 and 14% in fiscal 2011.

State revenues, primarily from income or sales taxes, have hit bottom and are growing again, but growth will be more muted than it has been after prior economic downturns.

States, in turn, will likely reduce aid to local governments, which include cities, counties, and school districts.

Moody’s says that the municipalities most at risk are smaller, weaker local governments with fewer tools at their disposal to deal with these challenges. Additional challenges are faced by those that have “enterprises” associated with them — quasi-public projects from nursing homes to golf courses.

An expanded complimentary summary Moody’s: Outlook for US state, local governments remains negative for 2011 plus the full premium reports Annual U.S. State Outlook: 2011 and 2011 Sector Outlook for U.S. Local Governments — Toughest Year Yet are available at the Alacra Store.

Source: U.S. State and Local Governments Facing Unprecedented Fiscal Strains; Outlook Remains Negative