Fitch Rates California's $2.3B GOs 'A+'; Outlook Stable
Fitch Ratings has assigned an 'A+' rating to the following general obligation (GO) bonds of the state of California:
--$830 million various purpose GO bonds;
--$65 million GO bonds (School Facilities);
--$1.155 billion various purpose GO refunding bonds;
--$250 million GO bonds (mandatory put bonds).
The bonds will be sold via negotiation on March 8, 2016.
At the same time, Fitch has affirmed the rating on $75 billion in outstanding GO bonds of the state of California at 'A+'.
Fitch also has affirmed the ratings on outstanding lease appropriation and other bonds related to the state GO as detailed at the end of this release.
The Rating Outlook is Stable.
The bonds are general obligations, for which the state pledges its full faith and credit, subject to the prior application of moneys to the support of public education; funds for education represent approximately half of state spending.
KEY RATING DRIVERS
IMPROVED FISCAL FUNDAMENTALS: Institutionalized changes to fiscal operations in recent years, when combined with the ongoing economic and revenue recovery, have enabled the state to materially improve its financial position, enhancing its ability to address future fiscal challenges. Progress includes timely, more structurally sound budgets, spending restraint, continued sizable reductions in budgetary debt, and initial funding of reserves.
WEALTHY, DIVERSE ECONOMY: The economy is wealthy and unmatched among U.S. states in its size and diversity. Economic growth continues, with employment growth strong across all sectors and a rebound in California's housing market.
MODERATE DEBT BURDEN: Tax-supported debt is moderate, although combined debt and pension liabilities are above the median for states. Pension funded ratios declined following the downturn and there is a history of inadequate contributions to the teachers' system; however, the state has instituted some benefit reforms and the fiscal 2015 budget provided the first installment of a long-term plan to increase contributions to the teachers' system.
CYCLICAL REVENUES AND CASH FLOWS: With economic recovery and associated strong revenue growth, liquidity has improved significantly and no cash-flow issuance is expected for fiscal 2016 or fiscal 2017. State finances have been subject to periodic, severe budget and cash flow crises due to economic and revenue cyclicality and historical institutional inflexibility. The state expanded its ability to manage cash flow weakness during the last downturn, which Fitch expects will make the effects of future downturns more manageable.
TANGIBLE STRUCTURAL PROGRESS: Deep recurring spending cuts in recent adopted budgets, a restrained approach to restoring past cuts, and healthy revenue growth have eliminated the state's structural imbalance. Further, the state is applying revenue growth to eliminating the heavy burden of budgetary borrowing from the last two fiscal crises, enhancing its fundamental financial flexibility.
INITIATIVES LIMIT FLEXIBILITY: Voter initiatives have reduced the state's discretion to effectively manage budgetary challenges over time. Although more recent initiatives authorizing a simple legislative majority to approve spending and temporarily raising tax revenues have been instrumental to current fiscal progress, the comparatively lower fiscal flexibility remains a credit factor.
CONTINUED FISCAL DISCIPLINE: The rating is sensitive to the continuation of budgetary discipline and the state's ability and willingness to continue progress on reducing budgetary borrowing and maintaining structural balance.
Fitch's 'A+' rating on California's GO bonds incorporates the institutional improvements made by the state in recent years, its disciplined approach to achieving and maintaining structural balance in recent budgets, and the consequent fiscal progress made to date by the state as it recovers from the severe budgetary and cash flow crisis of 2008-2009.
Recent fiscal management improvements remain untested by a severe recessionary event, but in Fitch's view the state is in a materially improved position to address future economic and revenue cyclicality, and the state's finances are likely to further strengthen assuming the current expansion and budgetary discipline continue. However, California's credit standing is likely to remain lower than most states given its comparatively lower fiscal flexibility, driven by revenue limitations, the initiative process, spending formulas for education, and other factors that remain unchanged. Key credit strengths include the state's massive, diverse economy and tax base.
Notable improvements since the fiscal crisis of 2008-2009 have included a voter-approved change that allows simple majority budget approval, various cash flow management tools that contribute to enhanced liquidity, and the passage of a constitutional amendment in November 2014 that strengthens the funding mechanism of the budget stabilization account (BSA) and provides the state with a means to better manage revenue cyclicality. Successive years of timely budgets that have achieved and maintained structural gains primarily through deep, recurring spending cuts and spending restraint in the recovery as well as voter-approved temporary taxes have positioned the state to make steady progress repaying past budgetary borrowing. Fitch believes that these improvements, supported by an expanding economy that is generating revenues at a pace that is exceeding the state's forecasts, have strengthened California's fundamental credit profile.
A key element that will provide future flexibility is the significant reduction in budgetary borrowing that accumulated as the state worked to balance the budget over the course of the two most recent recessions. At its peak, the state's budgetary borrowing totaled approximately $35 billion, including outstanding debt in the form of the Economic Recovery Bonds (ERBs), payment deferrals to schools and local governments, payroll shifts between fiscal years, and interfund borrowing.
The temporarily higher personal income tax (PIT) and sales tax rate changes approved by voters in November 2012, while exposing the state to sharper revenue volatility, provide the state with a margin of cash and revenue flexibility to sustain recent progress, assuming the state continues to exercise spending restraint. The state has utilized these additional revenues to rapidly repay budgetary borrowing, including defeasing the ERBs as of the beginning of the current fiscal year (fiscal 2016). By applying the temporary taxes to debt reduction, Fitch believes the state is better positioned to maintain budgetary balance as the tax increases expire.
Another source of financial flexibility is expected to come from the improved mechanism for funding the BSA. Voters approved a constitutional amendment in November 2014 (Proposition 2) that requires 1.5% of general fund revenues, plus the excess of capital gains tax receipts above 8% of general fund tax revenue not necessary to fund Proposition 98, be set aside at the beginning of each fiscal year in the BSA. Half of each year's deposit for the next 15 years will be used for supplemental payments toward budgetary debt or other long-term liabilities, with the balance retained in the BSA. The provision covering capital gains revenue is likely to contain one of the key drivers of general fund revenue volatility during the last two fiscal crises.
The state deposited $1.6 billion in the BSA at the beginning of fiscal 2015, based on the then existing provisions of Proposition 58, and an additional $1.9 billion at the beginning of the current fiscal year. The governor's budget proposal for fiscal 2017 increases the fiscal 2016 contribution by $1 billion and would set aside $3.6 billion in the state's rainy day fund in fiscal 2017, $2 billion above what would be required by law. This would bring the balance to $8 billion by the end of fiscal 2017, approximately 2/3 of the target 10% of tax revenues detailed in Proposition 2.
ECONOMIC RECOVERY GAINING MOMEMTUM
California's economy is unmatched among U.S. states in size and diversity, and the economy is gaining momentum across most sectors and regions. Although California's job losses during the recession exceeded the U.S. median, its recovery has exceeded the U.S. as well.
As of December 2015, non-farm employment had reached 105.6% of its pre-recession peak, above the U.S. median of 101.8%. Non-farm employment increased 2.9% year-over-year in December 2015, well above the 2% national rate. Employment gains are widespread, particularly in key service sectors, and construction employment is expanding (+7.2% in December) as the housing sector recovers.
California's unemployment rate has fallen considerably, to 5.8% in December 2015 vs. 7.1% one year earlier, although it remains elevated relative to the nation's 5% unemployment rate; this is consistent with historical trends. Personal income growth has generally matched the national and regional averages over the past year and California ranks 11th among the states in terms of per capita personal income at 108.6% of the national average.
The state's latest economic outlook, released with the Governor's budget proposal, foresees continued moderate improvement in the economy; unemployment declining but still higher than the national rate; and continued recovery in the housing market. Personal income is forecast to grow 5.2% in 2016.
IMPROVED BUDGET PERFORMANCE
The state has adopted five consecutive budgets on a timely basis, a marked contrast to historical behavior and one that reflects the benefit of the change to requiring a simple majority to enact a budget. Recent budgets have prioritized shoring up finances, including through prudent control of spending and budgetary debt repayment. Only five years ago, the state faced a cumulative operating gap of $26.6 billion, equivalent to 15.3% of baseline fiscal 2011 and 2012 general fund revenues. Since then, economic and revenue gains, the state's disciplined approach to limiting spending growth, and voter approval in 2012 of temporary personal income and sales tax increases have enabled the state to move to structural budget balance while repaying billions in past budgetary borrowing.
Strong revenue performance continued in fiscal 2015, with general fund revenues $5.5 billion (5.1%, before loans and transfers) above the original forecast upon which the budget was based. Strong PIT and corporate tax receipts offset slightly weaker than anticipated sales and use tax revenues. The additional revenue was applied primarily to increased school spending due to the requirements of Proposition 98. The state repaid $10.4 billion of budgetary debt, deposited $1.6 billion in the state's rainy day fund, and left an estimated $3.7 billion general fund balance.
The enacted budget for fiscal 2016 assumes continued economic growth and steady revenue gains through fiscal 2016. The budget is balanced and continues the emphasis on reducing outstanding budgetary borrowing. It continues to restrain budgetary growth, repays budgetary debt including defeasing the ERBs, and makes a second consecutive deposit to the BSA. Concurrent with the release of the Governor's proposed fiscal 2017 budget in January, the state revised its fiscal 2016 revenue estimate upward by $3.5 billion (3%), permitting the proposal to increase the contribution to the RDF by $1 billion as noted above. Subsequently, January revenues indicated potential weakening in performance with year-to-date tax receipts $193 million below forecast (less than 1%). Both personal income tax and sales tax revenues fell short of forecast, while corporation taxes were above estimate.
The proposed budget for fiscal year 2016-2017, which will begin July 1, 2016, assumes 3% growth in general fund revenues over the current fiscal year to $125.1 billion. Much of the increase in revenue will be automatically allocated to K-14 education under Proposition 98 but will also support increased spending for Medicaid and higher education. The Governor continues his policy of restraining growth in on-going spending while paying down long-term liabilities and funding the rainy day fund. Rather than expanding on-going programs, the governor is proposing an allocation of $2 billion to non-recurring spending for deferred maintenance and state facilities renovations and replacement, in addition to the $2 billion allocated to the rainy day fund.
The budget proposal appears prudent in terms of restraining spending growth in favor of retaining flexibility for future economic weakness. The budget assumes solid economic growth in both fiscal 2016 and 2017, but notes the potential for a future downturn as well as risks associated with slower global growth or a stock market correction. As is the case in the current fiscal year, the state does not anticipate the need to issue cash flow notes in fiscal 2017.
DEBT AND PENSIONS
California has a moderate but above-average debt burden, with net tax-supported debt of approximately $88.6 billion as of Jan. 1, 2016, equal to 4.6% of 2014 personal income. The combined burden of debt and pension liabilities is modestly above the state median.
System-wide funded ratios on a reported basis for the state's two main pension systems, covering public employees and teachers, eroded due to investment losses during the recession. Based on its June 30, 2015 financial report, the public employees' plan reported a 76.3% system-wide actuarial funded ratio. As an agent plan, CalPERS is not required to report a total pension liability (TPL), fiduciary net position (FNP), or net pension liability (NPL) under GASB 67. The teachers' plan, alternatively, reported a 74% system-wide ratio of FNP to TPL as of its June 30, 2015 financial report.
The state adopted a broad package of pension reforms in 2012 that affects most state and local systems, including through benefit reductions for new workers and higher contributions for employees. While changes are expected to generate only modest near-term annual savings for the state and for local governments whose pension plans are subject to the reforms, annual savings are expected to grow considerably over time.
Full actuarial contributions to the public employees' pension system are legally required, but not for the teachers' system, leading to persistent underfunding of the latter. The state addressed teachers' system funding with legislation enacted in June 2014. The legislation gradually increases contribution requirements, in particular from school districts, with the first installment funded in the fiscal 2015 budget, and expects that the plan will be fully funded by 2046.
RELATED RATING ACTIONS
Fitch has affirmed the following bonds that are rated on par with the state GO:
--Cal-Mortgage Loan Insurance Division bonds at 'A+'.
Fitch has also affirmed the following state appropriation-supported bonds of the state issued by the following entities at 'A', one notch below the state's GO rating:
--California Infrastructure and Economic Development Bank state school fund apportionment lease revenue bonds;
--Public Works Board (except for those issued for the Regents of the University of California);
--East Bay State Building Authority;
--Los Angeles State Building Authority;
--Oakland State Building Authority;
--Riverside County Public Financing Authority;
--Sacramento City Financing Authority;
--San Bernardino Joint Powers Financing Authority;
--San Francisco State Building Authority;
--Golden State Tobacco Securitization Corporation (series 2005A, series 2013A, and series 2015A).
All related bonds have Stable Outlooks.
Additional information is available at 'www.fitchratings.com'.
Fitch recently published an exposure draft of state and local government tax-supported criteria (Exposure Draft: U.S. Tax-Supported Rating Criteria, dated Sept. 10, 2015). The draft includes a number of proposed revisions to existing criteria. If applied in the proposed form, Fitch estimates the revised criteria would result in changes to less than 10% of existing tax-supported ratings. Fitch expects that final criteria will be approved and published by the end of the first quarter of 2016. Once approved, the criteria will be applied immediately to any new issue and surveillance rating review. Fitch anticipates the criteria to be applied to all ratings that fall under the criteria within a 12-month period from the final approval date.
Exposure Draft: U.S. Tax-Supported Rating Criteria (pub. 10 Sep 2015)
Tax-Supported Rating Criteria (pub. 14 Aug 2012)
U.S. State Government Tax-Supported Rating Criteria (pub. 14 Aug 2012)
Dodd-Frank Rating Information Disclosure Form
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