updated 9/9/2005 8:17:54 AM ET 2005-09-09T12:17:54

The floods and damage of Hurricane Katrina have brought into question how state and local governments in Louisiana and Mississippi will be able to pay investors holding their debt because many of their income sources — taxes from businesses and their inhabitants — have been disrupted.

As a result, one of three rating agencies in New York which tracks the creditworthiness, Moody’s Investors Service warned investors Thursday it may downgrade close to $10 billion of debt issued by these local governments and the states themselves.

“Moody’s has placed the ratings of 51 credits in the states of Louisiana and Mississippi on Watchlist for possible downgrade as a consequence of Hurricane Katrina,” the rating agency said in a report on Thursday.

According to the report, the rating agency said it does not anticipate any defaults “but the ultimate extent of credit deterioration, if any, remains unknown.”

While Alabama was affected by the hurricane, the rating agency said it expects the damage in the state to be manageable. As a result, Moody’s did not put any Alabama municipal debt on its watchlist.

Some of the debt on Moody’s watchlist for a possible downgrade includes issues from the states of Louisiana and Mississippi as well as the City of New Orleans, the City of Slidell, Jefferson Parish and the cities of Biloxi and Gulfport.

Some of the debt issued by Slidell and Jefferson, for example is backed by a sales tax and the Greater New Orleans Expressway Commission has debt backed by toll revenue, according to the report.

While the rating agency acknowledged that a regional recovery will be funded by federal support, private insurance and private philanthropy, “the pace and duration of recovery and rebuilding could be protracted, creating longer-term credit risks in some cases.”

In assembling the information for its report, Moody’s said it has not been able to reach many local officials in the most-affected areas because of disruptions in communications.

But, the rating agency said that as far as it has been able to ascertain, all debt service payments recently or immediately due have been made.

“We would not be surprised to see some interruptions, but it’s going to be minimal because a bulk of this debt is insured,” said Robert Gardella, municipal bond analyst at Lord Abbett who listened in on the Moody’s call Thursday.

Many debt offerings sold by local governments that are rated by agencies like Moody’s have a so-called insurance wrap that ensures bondholders will receive timely payment of principal and interest.

These bond insurers include companies like Armonk, N.Y., based MBIA Inc., and Ambac Financial Group Inc. of New York and Financial Security Holdings Ltd’s New York-based subsidiary Financial Security Assurance Inc.

Daniel Genter, president and chief executive of RNC Genter Capital Management which holds some Louisiana debt, also was comforted by insurance wrap on his debt. But, “we do feel the exposure for large insurance companies will be great,” he said.

At the same time, Genter warned that there are some municipal bond investors who should keep a close eye on their municipal bond holdings. In particular, he said, uninsured muni bonds, especially those which are not rated by credit rating agencies like Moody’s, are vulnerable because of default risk.

Typically, buyers of these unrated and uninsured issues are residents of the towns or cities that issue the debt.

So, Genter said, “the people who lost everything in floods could also lose their life savings.”

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