U.S. states and cities may increasingly turn to deficit borrowing to deal with still sagging tax revenue and the pending loss of federal stimulus money.

With the fiscal pressures mounting, states are turning to any financing mechanism at their disposal to manage those pressures, said Ted Hampton, an analyst at Moody's Investors Service.

Despite glimmers of an economic recovery, state and local government funds are expected to remain sparse for some time. Meanwhile, the $863 billion American Recovery and Reinvestment Act will largely shut off the federal funding spigot to states at year end.

States and cities left with huge budget holes and fewer remedies in terms of additional spending cuts or politically unpopular tax increases may find deficit borrowing is their only choice. But this move will invite tougher scrutiny by rating agencies looking for issuers to produce long-term solutions to structural budget imbalances.

We look closely at how deficit bond issuance fits in with the overall debt profile and the percentage of the budget solution, said Robin Prunty, a Standard & Poor's Ratings Services analyst.

Following the 2001 recession, states engaged in nearly $30 billion of deficit borrowing, including debt restructurings, asset securitizations and debt to fund current pension costs, according to a December report by Standard & Poor's. For the current recession, the rating agency estimated more than $15 billion of that debt will be sold in an 18-month period, noting that federal stimulus money has limited states' need for this kind of issuance so far.

As the stimulus funds diminish, we expect this trend to change, the report said, adding however that many states are prohibited from deficit borrowing.

For example, New Jersey, which faces a big budget gap, can no longer sell long-term deficit bonds after the state supreme court in 2004 put an end to the practice after allowing one final sale.

Issuers hope that the economy and their revenue will perk up enough in future years to pay off the debt and cover current operating costs.

NEW YORK EYES DEFICIT BONDS

New York Lieutenant Governor Richard Ravitch this week proposed a plan to deal with a five-year, $60 billion structural deficit that includes selling about $2 billion of bonds a year, perhaps for three years.

But there would be strict controls on the debt, which could not be issued if a state control board determined that the deficit was not being closed quickly enough, for example. New York has relied on deficit borrowing in the past, including the sale of bonds backed by the state's share of tobacco settlement revenue to help close a fiscal 2004 deficit, according to the state budget office.

Illinois in early January sold $3.46 billion of taxable five-year bonds to make its fiscal 2010 payment to state pension funds. With the state facing a $13 billion deficit heading into fiscal 2011, the budget plan unveiled by Governor Pat Quinn on Wednesday would turn to various types of borrowing to deal with $4.7 billion of the gap.

Detroit on Thursday sold nearly $250 million of so-called fiscal stabilization bonds that are a key component in the city's plan to eliminate a $326 million cumulative deficit.

Ohio's two-year budget relied on $736 million in cash-flow relief produced by a series of recent restructurings of state debt.

A bill in the Massachusetts Legislature would allow the city of Lawrence to issue up to $35 million of debt with state oversight to deal with its deficit.

(Reporting by Karen Pierog, additional reporting by Joan Gralla in New York; Editing by Kenneth Barry)

New Jersey