S&P Downgrades California To A-, Outlook Negative
The following is a press release from Standard & Poor's:
SAN FRANCISCO (Standard & Poor's) Jan. 13, 2010--Standard & Poor's Ratings Services lowered to 'A-' from 'A' its ratings and underlying ratings (SPURs) on California's $63.9 billion of general obligation (GO) debt, and to 'BBB+' from 'A-' its ratings and SPURs on the state's $9.4 billion of
appropriation-backed lease revenue bonds. We also lowered to 'A-' from 'A' our rating on the state's $1.9 billion proposition 1A receivables program bonds, and to 'A-2' from 'A-1'our rating on the state's $2 billion commercial paper (CP) program. At the same time, we affirmed our 'SP-1' short-term rating on the state's $8.8 billion in revenue anticipation notes (RANs). The outlook is
Our 'A+' ratings and SPURs on the state's roughly $8.06 billion of sales tax-supported GO economic recovery bonds are not affected. These ratings have a stable outlook.
The rating actions reflect our view of the state's credit quality in light of its severe fiscal imbalance and the impending recurrence of a cash deficiency if the state's revenue and spending trajectories continue. With the recent release of his fiscal 2010-2011 budget proposal, Gov. Arnold Schwarzenegger declared a fiscal emergency. We understand that the governor seeks swift
adoption of $8.9 billion of the $19.9 billion of budget solutions in his proposal because if the legislature does not approve them by March 1, the full amount of estimated savings may not be attainable. The fiscal emergency declaration also reflects that forecasts of cash flows indicate the general fund will experience insufficient cash positions in March and July. According to the Department of Finance (DOF), adoption of the governor's proposal, including a plan to supplement financial liquidity with an external borrowing, should improve the state's cash position in July, although the DOF still expects a dearth of cash in March. To cover the low cash period in March, the governor's budget includes $1 billion in as-yet-undetermined cash solutions. However, the projected cash position improves toward the end of fiscal 2010 even without approval of a budget revision, providing 3.2x coverage of the $2.83 billion in RANs that mature in May and 2.02x the $5.98 billion of RANs maturing in June.
We believe that, relative to the past fiscal year, uncertain assumptions for major portions of the budget balancing proposal make the state's credit more susceptible to adverse economic or other developments.
Although the governor's budget proposal seeks structural improvement to the state's projected fiscal imbalance, it does so by assuming what we consider to be significant increases in federal reimbursements and funding ($6.9 billion) and reduced federal spending mandates -- provisions over which the state lacks singular or direct authority. It also requires voter approval of two ballot
measures to allow the redirection of $1 billion in funds presently earmarked pursuant to two prior election results. The budget proposal concurrently depends on a supermajority of state legislators agreeing to make vast cuts totaling $8.5 billion across a wide range of programs and agencies in addition to significant alternative funding ($3.9 billion). A trigger for even deeper cuts, including the outright elimination of CalWorks (the state's version of the federal temporary aid for needy families program) and numerous other social service programs, is in the budget proposal in case the new federal funding is not forthcoming before July 15, 2010. The trigger proposal also extends several previously adopted temporary tax increases that will phase out under existing law. We believe these assumptions and the scope of the proposed solutions increase the state's credit risk, particularly as it confronts redressing -- at least somewhat -- the existing budget for fiscal 2010, which is significantly out of balance in our view.
From the middle of fiscal 2009 and into early fiscal 2010, lawmakers addressed a cumulative budget gap of over $60 billion spanning the 18 months through June 2010, relying extensively on nonrecurring solutions. At its adoption, the amended fiscal 2010 budget assumed a balanced position for the year and, incorporating the expiration of the nonrecurring measures, projected a $7.4 billion shortfall in fiscal 2011. A number of the budget measures are not functioning as planned, contributing to a shortfall of $6.6 billion for the remainder of fiscal 2010 and building to a $12.3 billion projected deficit for fiscal 2011. These deficits represent 7.6% and 12% of total estimated budget expenses for fiscals 2010 and 2011, respectively (when measured as a portion
of the baseline workload budgets for each year as of July 2009, when the fiscal 2010 budget amendment was adopted). We believe the state's options have narrowed considerably as the one-time measures and funding have lapsed.
In our view, the combination of fewer unconventional nonrecurring potential budget solutions, reliance on what we consider to be extraordinary federal cooperation, voter approval, and difficulty in achieving the legislative agreement to make deep cuts as proposed could impede meaningful and timely progress on a budget agreement. The speed at which a budget stalemate among lawmakers could translate to a cash crisis depends to a large extent on the state's economic and revenue performance, adding urgency to the state's overall financial situation.
In our view, the following factors constrain the state's credit quality, including:
-- Constitutional requirements for a two-thirds majority vote of the legislature for both budget approval and to increase taxes, which we believe complicates the former and effectively precludes the latter, given the legislature's political composition;
-- General fund revenue composition, which in our view is highly sensitive to economic and equity market performance;
-- Existing and proposed constitutional amendments that limit discretion over major portions of general fund spending, especially when combined with federal maintenance of effort requirements; and
-- Our Financial Management Assessment (FMA), which at "standard" is the lowest of our state FMA scores.
We also believe the following factors underpin the current budget deficit while contributing to the difficulty of restoring balance in fiscal 2011:
-- A reliance in the Amended 2009 Budget Act (for fiscal 2010) on approximately $20 billion (according to the state Legislative Analyst's Office) in nonrecurring or expiring budget solutions that are not available for the remainder of fiscal 2010 or 2011;
-- Numerous fiscal 2010 budget solutions representing $7.2 billion of revenue or savings that either failed to materialize, eroded, or succumbed to legal challenges (many of which remain ongoing); and
-- Upward pressure on spending due to current and projected population and caseload growth combined with a lowered revenue forecast, adding $4.8 billion to the projected deficit.
Despite its problematic areas, we believe the state's budget and finances benefit from a number of attributes, including:
-- Indications of economic stabilization and revenue performance that have held up reasonably well compared with the state's budget assumptions, with general fund cash collections just 0.9% below budget assumptions for the fiscal year as of December 2009, according to the state controller;
-- The state controller's demonstrated willingness and authority to exercise what we consider to be extraordinary cash management maneuvers that protect the state's priority payments, including those for debt service;
-- Modest structural reform adopted in the Amended 2009 Budget Act (for fiscal 2010) that eliminated statutes providing for automatic inflationary cost-of-living adjustments in the annual budget process for some social services and state employee salaries (with an estimated value of $590 million in fiscal 2011); and
-- A budget structure that assumes that the less-certain revenues and budget savings will occur late in fiscal 2010, coinciding with the stronger phase of the state's annual cash flow cycle, thereby mitigating and delaying the impact of their not materializing.
Longer-term credit attributes of the state include our view of:
-- The magnitude and diversity of its economy, which accounts for nearly 13% of U.S. GDP and covers a broad array of industries;
-- An educated workforce that, if sustained, can attract firms in progressive sectors and make California a leading venture capital recipient state; and
-- A conservatively structured, albeit growing, debt burden.
Serving as the source of repayment for all of the GO bonds and CP is the state's general fund, which the state has pledged under its full faith and credit. The public school system and public institutions of higher education are the state's only obligations that have a higher priority than debt service payments. The state's lease and appropriation-backed debt are among its other
priority payments that fall behind payments for education and GO bonds.
As noted, the CP is a general obligation of the state's credit and the state is authorized to issue CP notes on an interim basis in lieu of approved but unissued GO bonds. The CP also has security from a letter of credit (LOC) agreement, which includes provisions limiting the state to $2 billion in notes outstanding at any given time, provided severally from a consortium of banks. However, because the lowest-rated bank is Bayerische Landesbank (NR), Standard & Poor's does not incorporate the LOC into the rating at this time. The CP rating (A-2) is therefore based solely on the higher-rated support, that of the State of California (A-/Negative).
Debt service on the proposition 1A bonds takes priority over other obligations of the state, subject only to prior and constitutionally required payments for
S&P Lowers Various California Debt schools and debt service on the state's GO bonds. Authorization of legislation for the bonds also provides for a continuing resolution so that late budget adoption by the state will not impair semiannual interest payments, which are due on June 15 and Dec. 15 each year, or the principal payment, due on June 15, 2013.
The state's RANs are unsecured obligations of the general fund, subject to prior claims for schools, GO debt service, repayment of internal loans, wages and benefits payments, and lease payments supporting the state's lease revenue bonds.
Although the proposed state budget projects, assuming its adoption, that revenue in fiscals 2010 and 2011 will exceed expenses, the state's finances must also absorb the prior-year deficit of almost $6 billion carried into fiscal 2010. Prior- and current-year deficits, according to existing budget law, underlie the general fund's cumulative cash deficit, which is currently $24.8 billion, according to the state controller. A combination of internal ($16 billion) and external ($8.8 billion) borrowing provide interim financial liquidity to the state's general fund, according to the controller. As during the prior fiscal year, we believe the state's constitutionally based and,
relative to most other states, high requisite consensus among lawmakers to adopt a budget could put the state on course for another budget negotiation stalemate. Until legislators and the governor reach agreement on a budget revision, cash outflow will continue in accordance with existing law, unless the controller utilizes his extraordinary discretion to adjust the timing of the cash disbursements. Absent a change to the current budget, we expect that disbursements relative to cash receipts would very nearly deplete the state's general fund and borrowable cash resources in March, with the potential for an even weaker cash position in July.
We believe that these challenges, when combined with a reliance on federal funding and consent for relief from certain spending requirements, separate California's credit quality today from that of the prior fiscal year and of other states, all of which have higher GO or issuer credit ratings as a result.
We nonetheless believe the state controller's demonstrated capacity (in fiscals 2009 and 2010) to exert control over the timing of certain cash outflows helps protect the state's ability to meet its priority obligations, including its debt service. This quality of the state as a sovereign entity partially underscores our view of the state's fundamental credit quality, which we generally view as strong even if strained.
At its core, and absent the infusion of new federal funding sought by the state, adopting a balanced budget as mandated by the state constitution requires that lawmakers consider a mix of spending cuts or revenue increases. In our view, either cutting spending or increasing taxes could potentially subdue the incipient economic recovery underway in the state. We recognize that portions of recent budget solutions for fiscal 2010 included deferrals, furloughs, and revenue shifting from local governments. However, these often have a similar economic effect as outright spending reductions. Providing some offset to this are the governor's proposals for $700 million of job training funding and first-time homebuyer tax credits. If the $500 million job training program works as envisioned by the DOF, it will increase employment, particularly among those unemployed for nine months or more, by 100,000 throughout the state, which has lost approximately 1 million jobs since the recession began. According to the state's Employment Development Department, the unemployment rate was 12.3% as of December 2009, well above the national rate of 10% as of January 2010.
Two constitutional provisions outline California's ability to service its debt from a budget and cash flow perspective. Proposition 98, passed by voters in 1988, establishes the required minimum funding level for K-14 institutions (kindergarten through community college), with an estimated cost to the general fund of $36.09 billion in fiscal 2011. Meeting this requirement would leave $49.2 billion to fund an estimated $6.15 billion in GO and appropriation-backed debt service. Debt service represents what we consider a low 7.4% of total budgeted expenses but a more moderate 13% after adjusting for the proposition 98 funding requirement. The constitution separately establishes the state's required priority payments for education, which includes public higher education institutions (the California State University and University of California systems) as well as K-14 education. For 2011, the required education payments that enjoy a priority status, according to the proposed budget, total approximately $40.5 billion, and debt service therefore
represents 14.5% of the remaining $45 billion budget.
The negative outlook reflects our concerns about the large structural projected budget deficits facing the state and their implications for the state's cash position. Following a year in which the state grappled with a more than $60 billion deficit, we think the current deficit of approximately $19 billion could be more difficult to resolve given the state's extensive reliance on nonrecurring measures in the prior budget cycle. We believe indications of economic stabilization suggest that a recovery, if underway, remains precarious. Furthermore, if economic or revenue trends substantially falter, we could lower the state rating during the next six to 12 months.
In this environment, the state's ability and willingness to raise revenues or reduce expenditures through tax increases or program reductions could become integral to maintaining credit quality because a significant delay could result in another episode of cash deficiency for the general fund. We remain concerned that the political process could impede timely solutions. The absence of timely action could result in our lowering the GO rating. On the other hand, if revenue performance is in our view adequate relative to budget assumptions and if lawmakers reach agreement on a reliable set of solutions in a timely manner, we could revise the outlook to stable.
GOVERNMENT REFORM AND VOTER INITIATIVES
We recognize that numerous government and budget reform initiatives are underway and in the public discourse. Although we incorporate the implications of each when assessing whether they have a material impact on credit, we observe that their cumulative effect has complicated and reduced discretion over the state's fiscal management. We estimate that because of a combination of constitutional amendments, provisions, or federal maintenance of effort
requirements, there is limited discretion for approximately 65% of general fund expenditures, absent what we consider to be extraordinary action in the course of budget adoption.