Fitch Affirms California Public Works Board at 'BBB-'; Outlook Stable

NEW YORK--(BUSINESS WIRE)--

Fitch Ratings assigns a 'BBB-' rating to approximately $180.6 million in State Public Works Board (PWB) of the State of California lease revenue bonds (Trustees of the California State University), series 2010B (various California State University projects). The sale is expected to consist of subseries 2010B-1 (tax-exempt bonds) and subseries 2010B-2 (federally taxable Build America Bonds); precise par amounts will be finalized upon sale, expected via negotiation on or about April 14, 2010.

In addition, Fitch affirms the following ratings:

--Approximately $7.3 billion in outstanding state appropriation bonds of the PWB and certain other agencies at 'BBB-'.

The Rating Outlook is Stable.

Fitch will recalibrate the ratings on the above referenced bonds on April 5, 2010 as described in the March 25, 2010 report 'Recalibration of U.S. Public Finance Ratings', available at 'www.fitchratings.com'. At that time the ratings will be revised as described below.

--The rating on the PWB lease revenue bonds (Trustees of the California State University), series 2010B (various California State University projects) will be revised to 'BBB+' with a Stable Outlook.

RATING RATIONALE:

--A large and persistent structural imbalance over the last decade combined with pronounced revenue cyclicality periodically has led to acute budget crises. State revenues are dominated by volatile personal income taxes and the sales tax, both of which are experiencing severe recession-related declines.

--Institutional weaknesses, including inflexibility imposed by voter initiatives and a partisan policy-making environment, have repeatedly delayed action on addressing fiscal challenges, resulting in ineffective budgetary solutions and impairing future-year budget making.

--Expenditure pressures are significant, including for education, corrections and infrastructure, and driven in part by voter-approved measures and court mandates.

--The state's cash flow continues to experience severe stress and has required periodic emergency measures by the controller, including payment delays and issuing IOUs.

--The economy is broad, diverse and wealthy, despite currently suffering through a very severe economic contraction led by the housing market downturn.

--Debt levels are currently manageable but have grown rapidly as longstanding infrastructure needs are addressed; a significant portion of debt outstanding was used to cover prior budget gaps. Lease debt carries appropriation and abatement risk.

KEY RATING DRIVERS:

--Ability to manage continued budgetary and cash flow risks;

--Economic and revenue performance.

SECURITY:

Secured by lease rental payments made by California State University to the PWB for use and occupancy of the facilities; includes the PWB's master indenture reserve fund.

CREDIT SUMMARY:

The 'BBB-' rating reflects the state's underlying credit characteristics. The PWB is the state's primary means of financing state facilities, with bonds benefiting from a strong lease structure and the essential nature of leased assets. Debt service is paid from lease rental payments made pursuant to specific project leases. Lease rental payments are appropriated annually by the legislature, with the lessee required by law to use the first funds appropriated to it for lease payments supporting existing PWB debt. Abatement is possible, but projects require rental interruption insurance. The series are secured further by the PWB's master indenture reserve, which backs approximately $7.6 billion in outstanding PWB lease bonds prior to this sale.

The state's 'BBB' GO bond rating is based on the magnitude of its fiscal challenges and severely limited flexibility in the context of already deep long-term structural deficits and institutional constraints to effective budget-making. Although the precipitous revenue decline of the last two years appears to be easing, the governor's proposed budget released in January 2010 estimated that failure of previous budget solutions and revenue underperformance early in the fiscal year to date have opened a $6.6 billion gap in fiscal year (FY) 2009-2010, which ends June 30, reaching $19.9 billion through FY 2010-2011, the budget year. Moreover, although forecast cash weakness in March and April of this year appears manageable, cash flows in the budget year present a near-term challenge in the absence of timely legislative action.

The Stable Outlook reflects that the current long-term rating, well below that of other states, incorporates the extensive financial pressures confronting the state as it seeks solutions for balance. Fitch's view is that budgetary and cash pressures will continue through fiscal 2010-2011 and beyond, even as the state's range of options to address those pressures remains limited. The governor's proposed budget relied on $8.5 billion in spending cuts, $6.9 billion in extraordinary federal assistance, and $4.5 billion in fund shifts and other measures to close the budget gap and alleviate cash flow strain. Despite some progress to date, the prospect of achieving the entire $6.9 billion of extraordinary federal aid is remote, raising the likelihood the state will have to rely on solutions within its control. However, enacted cuts to date already have been severe or subject to court action and additional recourse to broad tax revenue solutions continues to be unlikely. These factors and the state's history of contentious and prolonged budget stalemate make quick achievement of sustainable solutions unlikely.

The state's revenue forecast, released with the governor's budget, incorporates the underperformance of revenues late in FY 2008-2009 and into the first half of FY 2009-2010. The governor's budget lowers forecast revenues $4.7 billion in the three fiscal years ending June 30, 2011, including $1.3 billion from FY 2008-2009 and $1.5 billion from FY 2009-2010. The declines reflect actual and forecast economic weakness and the recognition that $1 billion expected from the partial sale of the State Compensation Insurance Fund (SCIF) in FY 2009-2010 is now unlikely to be achieved. After declining 19.3% in FY 2008-2009 from FY 2007-2008, to $82.8 billion, the state anticipates general fund revenues and transfers rising 6.4% in FY 2009-2010, to $88.1 billion, partly due to temporary personal income and sales tax rate increases enacted last year. FY 2010-2011 revenues and transfers rise 1.4%, to $89.3 billion, with the return of economic growth. The controller reports that year-to-date revenues through February were 3.9%, or $2 billion, over the governor's budget forecast levels, with year-over-year growth in personal income, corporation and sales taxes.

Much of the budget challenge now faced by the state is linked to its repeated inability to achieve and sustain the solutions from previously enacted budgets, including one-shot revenues. The FY 2009-2010 budget revision, enacted in July 2009, closed a forecast $24.2 billion gap through the end of the fiscal year. The state now considers solutions totaling $7.2 billion through FY 2010-2011 to be unachievable, either due to litigation or erosion of assumptions. These include $3.7 billion in FY 2009-2010 solutions, such as the $1 billion SCIF sale and the use of $958 million in transportation spillover funds for general fund needs, both of which are subject to litigation. Measures contemplated to replace previously failed solutions may likewise prove unachievable, underscoring the limited flexibility the state now has given the extent of actions taken to date.

The state anticipated that FY 2009-2010 cash resources would be exhausted during a three-week period in late March and April absent corrective measures. Better cash flow performance since then and the enactment of payment deferrals appear to have alleviated projected cash stress; the receipt of PIT collections after the April 15, 2010 filing date would further replenish general fund cash through fiscal year-end. Cash flows in the budget year are a greater concern, although legislation passed in February 2010 grants the controller, treasurer and director of finance greater flexibility to determine payment delays for certain appropriations, notably K-12 education. These new powers would provide the state with up to $5 billion in cash flow flexibility, most importantly in the early months of the fiscal year. However, without consensus on the budget, cash resources again would be depleted by September. Over the last two years, the controller has demonstrated a willingness to use several strategies, including payment deferrals and IOUs, to ensure continuation of priority payments and has expressed his commitment to take such actions again as necessary. Priority payments include debt service.

The state's economy continues to face severe stress despite gradual easing of job losses in recent months. February 2010 employment was down 4.3% from February 2009, compared to a 2.5% decline nationwide. Unemployment remains persistently high, most recently at 12.5% in February 2010, versus 9.7% nationwide. Job losses continue to be widespread both geographically and across sectors, with key construction, manufacturing, and professional and business services sectors particularly hard hit. Preliminary personal income fell 2.5% in California in 2009, steeper than the 1.7% decline nationwide. The state's economic forecast released with the governor's budget anticipates gradual improvement in 2010, with rising personal income but continued job market weakness.

The state has a moderate but above-average and rapidly rising debt burden, with net tax-supported debt of approximately $84.5 billion as of March 1, 2010, equal to 5.4% of preliminary 2009 personal income. The state's debt level will continue to rise with issuance for capital under recently authorized GO bond measures. A large proportion of outstanding debt, notably economic recovery and tobacco settlement bonds, was issued to address operating gaps over the last decade.

Applicable criteria available on Fitch's web site at 'www.fitchratings.com' include:

--'Tax-Supported Rating Criteria', dated Dec. 21, 2009.

--'U.S. State Government Tax-Supported Rating Criteria', dated Dec. 28, 2009.

Considerations for Taxable/Build America Bonds Investors

The following sector credit profile is provided as background for investors new to the municipal market.

State Appropriation-Backed Bonds: A U.S. state government's overall credit quality is reflected in the rating for its general obligation (GO) full faith and credit pledge, the broadest security that a state can provide to the repayment of its long-term borrowing. In cases where bond payment requires annual or biennial legislative appropriation, this lesser long-term commitment to repayment is reflected in a lower rating than the GO rating. Such debt is typically rated one notch below the GO rating. If concerns about non-appropriation are heightened, for example in cases where there is not clear essentiality for the project being funded, such debt can be rated two or more notches below the GO rating. Conversely, if the risk of non-appropriation is judged to be effectively eliminated, for example through a mechanism that traps substantial operating funds if appropriation is not made, the appropriation debt can be rated on par with the GO credit. State GO ratings generally fall within the two highest rating categories of 'AAA' or 'AA', with a few outliers. The top tier ratings reflect states' inherent strengths: states generally have broad economic and tax base resources and all possess sovereign powers under a federal government system, with substantial, although varying, control over revenue raising and spending. Given these inherent strengths, in only a few instances have economic concentration and long-term structural decline or the inability or unwillingness to address large financial challenges led to ratings below the 'AA' category. For additional information on State ratings, see U.S. State General Obligation Bond Rating Criteria dated Dec. 28, 2009.

Additional information is available at 'www.fitchratings.com'.

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