Moody’s Investors Service has assigned a negative credit watch for all local governments across the United States. Never before has the agency issued such a blanket report on municipalities, counties, towns and school districts, an unprecedented development that underscores the severity of the nation’s economic crisis.

In a special report made public on April 7, Moody’s said that revenues were falling almost everywhere and that many municipalities were being dragged under by debt overload. Many local governments had used complex debt derivative products that were supposed to help lower payments, but these have actually sent debt payments soaring.

Additionally, as housing prices have declined across the country, property-tax revenue has collapsed. Job losses have also reduced local spending and the related sources of local taxes. Manufacturing, tourism and finance industries are also contracting, and governments that relied on these industries are likely to feel an extra pinch, warned Moody’s. Thus, taken together, virtually every local government across the nation is in danger of having its credit rating cut.

A credit downgrade makes it more difficult and more expensive for governments to access credit markets. It also makes it much harder for them to borrow new money to pay back old loans.

A wave of state downgrades may have already begun. Coinciding with the report’s release, Moody’s cut Illinois’s credit rating down from the AA level to A, citing a massively underfunded state pension plan and its difficulty managing its cash.

Federal Reserve Chairman Ben Bernanke said he was aware of the problem some governments are facing and how they are having trouble making payments on their derivative interest rate swaps. However, he said that municipal debt had “unique characteristics” that made it “unlikely” that the Fed could intervene to help them. He suggested that Congress consider an additional “assistance” package, such as a federal bond reinsurance program, to address state needs, the New York Times said.

The debt problem now facing local governments is somewhat similar to the problem facing aig, says financial analyst Thomas Tan. Even though aig has some decent moneymaking business units, the derivatives in one small unit bankrupted the whole company. “The sad thing here is even if some cities/counties are still financially viable with local tax revenue inflows,” Tan says, “at the end, these derivatives will bankrupt most of them, swapping more taxpayers’ money to the bankers.”

The question soon to be facing investors and foreign creditors alike is: If so many American cities, states and local governments are considered a credit risk, how much of a credit risk is the federal government? The answer to that question has big implications for interest rates, the dollar, and your standard of living.