U.S.

-Style Fiscal Federalism Buffers State And Local Governments From Another Federal Shutdown -Somewhat
Primary Credit Analyst: Gabriel J Petek, CFA, San Francisco (1) 415-371-5042; gabriel.petek@standardandpoors.com Secondary Contacts: Jeffrey J Previdi, New York (1) 212-438-1796; jeff.previdi@standardandpoors.com Horacio G Aldrete-Sanchez, Dallas (1) 214-871-1426; horacio.aldrete@standardandpoors.com Robin L Prunty, New York (1) 212-438-2081; robin.prunty@standardandpoors.com

Table Of Contents
States Local Governments Federal Fiscal Uncertainty Is On The Rise Related Criteria And Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

OCTOBER 30, 2013 1

1209310 | 301932398

U.S.-Style Fiscal Federalism Buffers State And Local Governments From Another Federal Shutdown -- Somewhat
In the aftermath of the federal government shutdown and the brush with its statutory debt limit, Standard & Poor's Ratings Services believes any lasting damage to state and local government credit quality will be relatively minimal. Our economists have estimated that the shutdown will have shaved 0.6% from annualized fourth quarter GDP growth, equal to removing about $24 billion from the economy. For states and localities, this macroeconomic estimate doesn't tell the whole story, however. There is also a direct fiscal linkage between the states and localities and the federal government. To date, this relationship -- which fiscal consolidation efforts at the federal level could affect -- has proven relatively robust. For example, enactment of the Budget Control Act of 2011 ushered in a process that could have altered the federal-state fiscal framework but ultimately did not. But we don't take the historic stability of federal funding flows to states for granted. Our awareness of the potential for a disruption in the timely receipt of federal funding has risen with the recurrence of fiscal negotiation stalemates among federal policymakers. And the recently reached agreement reopening the federal government and lifting the debt ceiling represents more of a reprieve than a solution. Come December and January, it's possible, if not likely, that the dynamic among federal policymakers will be broadly similar to what it was in September and October. Although we expect some political brinkmanship leading up to the Jan. 15 expiration of the continuing resolution now in effect, we believe it will likely be somewhat milder. Nevertheless, states confront the possibility of having to endure another federal government shutdown and any fiscal and economic disruption that would come as a result. Overview We expect that most state and local governments are capable of navigating a federal government shutdown, if it's resolved within three to four weeks, with their credit standing intact. In an extended shutdown scenario, we believe policy dilemmas would arise prior to debt crises for state and local governments. Although we don't anticipate it, a prioritization of payments by the Treasury Department presents the most risk to state and local governments.

Just what happens when funding for the federal government expires, including potentially for an extended period of time, becomes an important question in light of the political environment in Washington. The mechanics of state financial management suggest that an extended federal shutdown -- or something worse -- would give rise to policy crises prior to compromising a state's debt-paying capacity. But it would also undermine credit conditions for states, which, depending on the duration of a shutdown scenario, could lead to negative pressure on state and local government ratings.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

OCTOBER 30, 2013 2

1209310 | 301932398

U.S.-Style Fiscal Federalism Buffers State And Local Governments From Another Federal Shutdown -- Somewhat

States
States have a complicated relationship with the federal government. According to data from the U.S. Census Bureau, federal aid makes up about 35% of total state revenue. Much of it comes from among the federal government's nondiscretionary spending, meaning that approximately 80% of aid to states is exempt from spending reductions under sequestration. Furthermore, the bulk of federal funds received by states are restricted and held outside of their general funds. States typically pay for operations and most debt service from their own discretionary revenues, which are held in their general funds. Recent federal spending reductions, such as those under sequestration, have, therefore, had a relatively muted effect on state credit quality. But the situation changes in the absence of federal appropriations authority. Without a federal budget or continuing resolution in effect, policy dilemmas arise for states once previously appropriated federal funds are fully spent. States administer numerous federally financed programs, which typically have up to several weeks of previously appropriated federal funds on hand. While the effects of a federal government shutdown on state credit quality, therefore, are not immediate, we expect they would become more acute after a three-to-four week period. After depleting their federal funds, states confront the prospect of either funding certain important social service programs -- such as nutritional support -- from their own sources or abruptly shutting them down. Neither approach would likely be a panacea for state credit quality, in our view, however. Using state revenues to fund programs that are normally paid for from federal funds could weaken state finances, especially in the event the federal government does not subsequently reimburse them. As it turned out, the Oct. 16 legislation reopening the federal government and suspending the debt limit also included reimbursement provisions for the states. But prior to passage of the legislation, whether states would be repaid was an open question. And we don't believe states can presume they would be made whole following any future shutdowns. The other option for states would be to shutter their social service programs as soon as the federal funds are exhausted. But the unintended economic contraction triggered by a state shutting down its social service network could outstrip any near-term cash savings the program closures might yield. As a result, we believe a state's revenue and credit profile could encounter stress within a matter of months even if it chose to respond to a federal shutdown with one of its own. The most significant fiscal linkage between the states and the federal government is through Medicaid, the health insurance program for qualifying low-income, elderly, and disabled people. Regarding state credit quality, it's important to note that even in the absence of a federal budget, we believe Medicaid presents relatively minimal fiscal risk to states. Critically, disbursement of federal payments to states continues even during instances of federal government shutdowns because, similar to other entitlement programs, Medicaid is a mandatory federal expenditure. Furthermore, Medicaid is a lynchpin of the federal Affordable Care Act's goals of broadly expanding health insurance coverage, making its continued funding an important policy priority of the Obama Administration. And, to date, federal Medicaid funding has been sustained both across presidential administrations and notwithstanding the heightened focus on the federal budget condition in recent years. Insofar as this remains the case, states are among the beneficiaries. From this perspective, as the single largest spending item in state budgets (or the second largest general fund expenditure), Medicaid has a stabilizing effect on state finances and credit quality.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

OCTOBER 30, 2013 3

1209310 | 301932398

U.S.-Style Fiscal Federalism Buffers State And Local Governments From Another Federal Shutdown -- Somewhat

This being said, any advantage held by states vis--vis federal Medicaid funding could become a liability in a more severe scenario in which the federal government resorted to prioritizing its payments. The treatment of Medicaid funds owed to states under a federal payment prioritization scenario would be critical to states' financial outlooks. If federal Medicaid payments were to be reduced or significantly delayed, we would then evaluate each state's corresponding response. To the extent any state opted to support Medicaid (or other federally funded program) in the absence of federal aid, we would examine the state's budget and cash flow capacity. And while states' liquidity is good, they are generally very conservative with their investments and frequently hold a large amount of U.S. Treasury bills. Any circumstances that contributed to a loss of market liquidity for Treasury bills could give rise to cash pressures. There would likely be almost immediate operating stress on states in this scenario. Similarly, because of their reliance on personal income taxes (including capital gains in many cases) state revenues tend to be sensitive to changes in stock prices. If federal negotiations led to a drop in consumer confidence or otherwise unnerved equity market investors, states could see a relatively precipitous decline in their tax revenue collections.

Local Governments
Due to the generally very high credit quality of local governments and a high level of revenue independence, we believe most local governments' credit quality is capable of enduring a federal government shutdown for an even longer period than the states. But similar to states, liquidity is quite good, and conservative investment practices mean portfolios contain large amounts of U.S. government debt. Compared with states, however, local governments receive proportionately much less in direct federal aid, about 5% of general revenue according the U.S. Census Bureau. As a group, therefore, local government finances are somewhat less immediately vulnerable in the event of a sharp pullback in federal spending. Also, given that local governments typically operate relatively few social service programs, we would expect less demand on local government budgets as a result of the economic weakening that would likely follow a sudden reduction in federal spending. But a key consideration for local governments would be the manner in which states react in an extended shutdown scenario or one in which federal aid is sharply reduced. If states cut back spending to local governments in response to federal spending cuts, then more sizable revenue reductions will occur for local governments -- particularly for school districts that depend more directly on state support. If states simply pass along any spending cuts proportionately, then the magnitude of ratings effects will depend largely on the length of any scenario. We expect ratings would hold up reasonably well if the period were only a few weeks, but a much longer period would strain local governments' near-term resources and perhaps create liquidity crises for certain weaker obligors. Local governments do have significant longer-term revenue-raising capabilities (hiking property or sales taxes for example), but they would take time to implement. Those local governments with reliance on sales taxes would likely be sensitive to declines in consumer confidence that could result from an inability of federal policymakers to increase the debt ceiling.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

OCTOBER 30, 2013 4

1209310 | 301932398

U.S.-Style Fiscal Federalism Buffers State And Local Governments From Another Federal Shutdown -- Somewhat

Federal Fiscal Uncertainty Is On The Rise

The sense that federal fiscal policy has injected more uncertainty into state and local government decision making is predicated on recent history. In approximately the past two years, federal policymaking has lurched from the debt ceiling debate of 2011 to fears over the economic consequences of the fiscal cliff in early 2013. Less predictable federal fiscal policy may not all be behind us, either. The recent federal government shutdown and debt limit scare reflect some basic differences in governing philosophies among lawmakers. The agreement putting an end to the October stalemate has deferred but not reconciled this underlying rift. But we stop short of referring to federal funding as a wildcard in state finances. The reality is that states' credit quality doesn't depend on how much federal aid represents as a share of their total revenue. Most of the federal aid received by states is for specific purposes and, once received, resides in budgetary silos that are separate from a state's general operating cash. Where federal unpredictability would pose the greatest risk is under the Medicaid program. But here, federal funding is permanently appropriated and largely unaffected by shutdowns. In addition, we see Medicaid as situated advantageously in the negotiations among federal policymakers, offering it some political cover. The major share of any direct federal funding that goes into local coffers narrowly targets specific public safety programs or research projects. Nevertheless, because of state pass-through funding, local governments may be more dependent on federal aid than their direct transfers suggest. Either way, we expect most aid that originates from federal sources to have little direct bearing on local governments' credit quality. But since no state or locality can completely insulate itself from the influence the macro economy has on its economy, federal policy functions as an overarching rating factor. We have been actively monitoring not just the effect of federal spending on the economy, but also how states have interpreted it. Almost uniformly we have seen states anticipate the slower economy that is now beginning to show. This degree of economic erosion has had minimal impact on credit quality thus far, but it could intensify if the federal pullback -- or its economic effects -- were to become more pronounced.

Related Criteria And Research

State And Local Governments Face Fiscal Challenges Under Federal Debt Deal, Aug. 18, 2011 The End Of A Beautiful Relationship? U.S. Fiscal Federalism, State Credit Quality, And Changing Times, April 29, 2013 States Of Health: Medicaid May Not Imperil State Credit Quality, But It Presents A Long-Term Budget Challenge, Dec. 5, 2011 Impact Of The Debt Ceiling Debate On The U.S. Economy--Getting Worse By The Day, Oct. 16, 2013

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

OCTOBER 30, 2013 5

1209310 | 301932398

Copyright 2013 by Standard & Poor's Financial Services LLC. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

OCTOBER 30, 2013 6

1209310 | 301932398