Even though the recession officially ended more than two years ago, the still-weak U.S. economy and a pullback in federal support means the outlook for states and local governments remains negative, Moody's Investors Service said on Monday.

The two sectors of the $3.7 trillion U.S. municipal bond market were originally branded with negative outlooks by Moody's in 2009 as tax revenue tanked.

The rating agency noted that revenue collections have improved, but not enough for states to completely replace federal stimulus funding that ended in June. Another reduction is expected as Congress wrestles with ways to reduce the U.S. deficit.

The determination of both political parties to reduce project federal budget deficits is certain to result in reduced funding for federal programs run by the states, Moody's said in a report.

States also face pressures from Medicaid, the healthcare program for the poor, and big unfunded employee pension liabilities. In addition, there is the prospect of potentially having to bail out fiscally troubled local governments, Moody's said, pointing to situations in states such as Alabama, Michigan, Pennsylvania and Rhode Island where bankruptcy has been eyed by cities or counties.

Still, states have the flexibility to deal with financial strain and support their ratings, Moody's said, adding the median state rating was Aa1.

For local governments, the real estate market remains a problem as property tax collections fell for two consecutive quarters, including a 1.6 percent dip in the first quarter of 2011. Moody's said that trend is likely to continue into fiscal 2012 as assessed value declines outpace rate increases.

Meanwhile, the budgets of cities, counties and other local governments are bound to be hit with reductions in state aid as states in turn deal with lower federal funding, according to Moody's.

Given the numerous challenges facing the local government sector, we believe that rating downgrades will continue to outpace upgrades until we begin to see meaningful economic growth and recovery of property values, the rating agency said.

It added, however, that bond defaults and Chapter 9 bankruptcy filings are expected to remain rare.

(Reporting by Karen Pierog; Editing by James Dalgleish)

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