By Michael B. Marois – Jul 25, 2011 9:00 PM PT

California will borrow $5 billion today through a temporary loan as U.S. states make plans to cope with any credit-market disruption should lawmakers fail to raise the federal debt ceiling by the Aug. 2 deadline.

Proceeds from California’s bridge loan will help pay bills until the state can sell cash-flow notes that had been scheduled for late August. New Mexico is asking agencies to complete requests for federal reimbursement by midday July 29 to ensure the it can get repaid, and Maryland was forced to cut $206 million off a planned bond sale as the debt talks dragged on.

“Given the uncertainty in Washington with the debt ceiling, the treasurer felt it was prudent to get a bridge loan,” said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer. “We couldn’t have planned on the president and Congress taking us to the brink.”

States and local governments face higher borrowing costs if Congress fails to reach a compromise by the deadline. Because the U.S. borrows money through the sale of Treasury notes to pay its bills and refinance maturing debt, it could default if the limit isn’t increased. That might cost the government its top- ranked credit score, upend financial markets and send interest rates higher.

Moody’s Investors Service has said it may lower its top ratings on Maryland, South Carolina, New Mexico, Tennessee and Virginia because their dependence on federal revenue makes them vulnerable to a U.S. credit cut should talks to raise the debt limit fail.

Costing Taxpayers

Moody’s has also said another 7,000 top-rated municipal credits would have their ratings cut if the U.S. government loses its Aaa grade.

“It would ultimately cost taxpayers in Virginia more” if the state’s rating is cut, said Jeff Caldwell, a spokesman for Virginia Governor Bob McDonnell, a Republican.

Without the ability to borrow, the federal government would have to cut about $134 billion of spending in August, according to a report by the Washington-based Bipartisan Policy Center, which advocates politically balanced policy making. That could prompt the government to choose which payments to make, such as Medicare subsidies, which may affect California’s cash flow.

New Mexico takes in about $500 million of federal funds each month for programs such as aid to unemployed workers and forestry. The New Mexico Board of Finance last week gave the treasurer the authority to issue tax-and-revenue anticipation notes if federal money is cut off and the state runs out of reserves.

Card to Play

“We anticipate we do have money in reserves and we are not alarmed, but this is just another card to play,” said Tim Korte, a spokesman for New Mexico’s Finance and Administration Department.

The prospect of an upheaval in the credit markets has some states and local governments avoiding them. Municipal-bond issuance scheduled for the next 30 days is projected to shrink to about $6.3 billion in the next month, the lowest daily gauge since it reached a 2011 high on July 14, according to Bloomberg’s index of 30-day visible supply.

If no solution is reached, municipal-debt sales may drop further, said John Hallacy, the head of municipal research at Bank of America Merrill Lynch in New York.

“A lot of issuers who are contemplating entering the market will hold back to see what will happen in the aftermath — at least the ones who can,” he said. “We have no benchmark to look at, no history for this kind of thing. Obviously to the extent investors become more skittish, it would require offering higher yields.”

Maryland Cuts Sale

Maryland yesterday reduced a bond sale planned for this week by $206 million to remove a refunding component. Patti Konrad, Maryland’s director of debt management, said in a telephone interview that the state would postpone indefinitely the planned advance refunding as the refinancing may not generate enough savings. The state is still offering about $512 million of securities this week.

California’s Lockyer had planned on borrowing about $5 billion through revenue-anticipation notes, or RANs, at the end of August to pay state bills until the bulk of tax revenue comes in later in the years. Without those short-term securities, the state may run out of cash, as it did in 2009, when it issued $2.6 billion of IOUs.

California Loan

Facing market turmoil that could boost the state’s borrowing costs if he waited until August, Lockyer instead will accept competitive bids from investment banks, commercial banks, credit unions and investment funds for a private $5 billion loan today.

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