August 9, 2011; Source: Wall Street Journal | On Monday, Standard & Poor’s followed its downgrade of the U.S. credit rating from AAA to AA+ with a similar downgrade of Fannie Mae and Freddie Mac. At the same time, the National League of Cities (NLC) acknowledged that municipal bonds might also take a hit.

They were right. On Tuesday, S&P downgraded 11,000 municipal debt obligations. The muni market sold off a bit, but not much. Maybe that’s because while 11,000 bonds sounds like a lot, it actually represents less than 1 percent of the 1.2 million outstanding debt issues in the vast $2.9 trillion municipal bond market. Moreover the downgrades were largely automatic, affecting municipal debt obligations linked to the federal government—for example, bonds with insurance from the Federal Housing Administration, or debt that is backed by investments in short-term federal instruments.

In response to the downgrades, NLC pointed out several key differences between federal and municipal debt: First, “municipal debt is typically not used to finance day-to-day operations…[but rather] to finance infrastructure projects.” Second, debt constitutes “a relatively small portion of local and state budgets, about 5 percent on average.” Finally, state and local governments borrow almost exclusively long-term, for 20 or 30 years, making their debt service payments predictable.

And despite the downgrades, S&P also had some nice things to say about state and local government:

“In our view, the institutional framework for U.S. public finance is among the most stable and predictable in the world. We believe this is primarily a result of the constitutional separation of power between the central and sub-national levels of government that is intended to restrain intervention in state and local government administration. U.S. state and local governments enjoy considerable financial autonomy from federal intervention. State—and in many cases local—governments have authority to establish and maintain laws pertaining to tax rates and collections, as well as the ability to add new taxes and other forms of revenue generation.”

Increasingly, the S&P actions since last Friday look like a resounding vote of “no confidence” in the federal government’s mishigas, combined with a rousing defense of state and local government. For those of us with experience as public office holders in U.S. cities, we would never have expected this topsy-turvy analysis.—Rick Cohen