By Edith Honan
NEW YORK (Reuters) - Standard & Poor's revised California's credit outlook to stable on Thursday, one of the first significant pieces of good news for U.S. state and local governments as they work their way out of the Great Recession.
The outlook on the state's $89 billion of outstanding debt was revised to stable from negative on what S&P said was the better balance between money coming in and cash spent on state operations.
S&P's action comes on the heels of a $129.5 billion budget deal for fiscal 2012 that closed a gap projected to stretch to $26.6 billion through the end of the next fiscal year.
"We really did our analysis with the fact that they built in these triggers for cuts if the revenues don't materialize," S&P credit analyst Gabriel Petek said in an interview.
"There is a possibility down the road for a higher rating," Petek said. "I think that it would be somewhat contingent on the state following through, if the revenues don't materialize, and successfully implementing the cuts that they have included in this budget."
While last month's budget agreement gave California Governor Jerry Brown breathing room, he flagged the possibility of a 2012 initiative to extend tax increases for years to tackle the state government's "wall of debt."
S&P's change covered the "two-year outlook horizon," pointing to the potential for political battles down the road.
"The two years are not the same as forever or five years, and that's something Brown is going to have to explain to people," said Steve Levy, director of the Center for the Continuing Study of the California Economy.
"OUT OF THE WOODSHED"
State governments suffered terribly in the financial crisis as tax revenues crashed and unemployment soared. That caused havoc throughout the $2.9 trillion municipal bond market where investors dumped their holdings on growing fears about the stability of municipal finances.
"It's nice to be out of the woodshed," said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer. "They made it clear there are some uncertainties lingering and we've got more work to do. The fact that they raised the possibility of an upgrade in the wake of this budget is good news."
Josh Gonze, a portfolio manager with Thornburg Investment Management in Santa Fe, New Mexico, said S&P's action could be important "in the popular perception of the man on the street."
The cost of insuring California's debt with credit default swaps fell 11 basis points from Wednesday's levels, dropping to 164 basis points, or $164,000 per year for five years to insure $10 million in debt, according to data provider Markit.
"The fact it's rallying this strongly could be a sign of a significant shift in sentiment here in the near term," said Otis Casey, director of credit research at Markit in New York.
Other municipals also rallied on Thursday. Illinois's debt protection costs fell 15 basis points to 197 basis points. The benchmark muni CDS index fell 7 basis points to 128.5 basis points, Markit data showed.
In January 2010, S&P downgraded California's credit rating from A to A-minus, and assigned a negative outlook. The agency linked the move to the possibility of a recurring cash deficiency.
S&P said on Thursday the budget improved the state's fiscal structure and would likely reduce risks to its liquidity. But S&P's Petek said it still had to make progress in addressing a $35 billion backlog of obligations built up over a decade.
"That represents a drain on future state resources that will continue to hamper the credit going forward," he said.
As for the wider U.S. economy, Petek still saw considerable fiscal stress, but he said states, including California, have improved the fiscal picture by making tough budget choices.
"It really comes back to the management of these states when it comes to how the credit quality will perform through this period, which continues to be choppy at best," he said.
State governments rely on income and sales tax collections for revenue and, as a consequence, their "fiscal condition is going to more closely reflect what's going on in the economy in real time," Petek said. Local governments, by contrast, are powered by property taxes -- a lagging fiscal indicator.
(Additional reporting by Lisa Lambert in Washington, Karen Brettell, Joan Gralla in New York, and Braden Reddall in San Francisco; editing by Andrew Hay, Gary Crosse))