News Column

Fitch Affirms 'A' Rating on California GOs; Outlook Stable

August 26, 2014

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings affirms the 'A' rating on $75.7 billion in outstanding general obligation (GO) bonds of the state of California.

The Rating Outlook is Stable.

Fitch also affirms the ratings on outstanding lease appropriation and other bonds related to the state GO as detailed at the end of this release.

SECURITY

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 MANAGEMENT: The state has benefitted from institutionalized changes to fiscal management in recent years, which, when combined with the ongoing economic and revenue recovery, have enabled it to materially improve its overall fiscal standing. Progress includes timely, more structurally sound budgets, spending restraint, and continued sizable reductions in budgetary debt.

WEALTHY, DIVERSE ECONOMY: The economy is wealthy and unmatched among U.S. states in its size and diversity. After severe, widespread recessionary conditions, growth has resumed, including in California's housing market.

MODERATE DEBT BURDEN: Tax-supported debt is moderate, but has grown for infrastructure needs and budgetary borrowing. Pension funded ratios have declined and there is a history of inadequate contributions to the teacher system; however, the state has instituted some benefit reforms and the fiscal 2015 enacted budget provides the first installment of a long-term plan to increase funding of the teacher pension system.

CYCLICAL REVENUES AND CASH FLOWS: State finances are subject to periodic, severe budget and cash flow stress due to economic cyclicality, revenue volatility tied to personal income taxes, carried over structural imbalances, a lack of reserves and institutional inflexibility. The state expanded its ability to manage cash flow weakness during the last downturn, and other fiscal management reforms made to date can be expected to make the effects of future downturns more manageable.

TANGIBLE STRUCTURAL PROGRESS: Deep recurring spending cuts in recent adopted budgets and a restrained approach to restoring past cuts have significantly lowered the state's structural imbalance. The state has made significant progress in reducing the burden of budgetary borrowing from the last two fiscal crises; however, its historical difficulty achieving and sustaining budgetary solutions poses an ongoing risk.

INITIATIVES LIMIT FLEXIBILITY: Voter initiatives have reduced the state's discretion to effectively manage budgetary challenges over time. However, more recent initiatives authorizing a simple legislative majority to approve spending and temporarily raising tax revenues have been instrumental to current fiscal progress.

RATING SENSITIVITIES

CONTINUED FISCAL DISCIPLINE: The rating is sensitive to the continuation of the state's recent fiscal discipline and its ability and willingness to continue addressing numerous fiscal challenges. Continued progress on reducing budgetary borrowing, maintenance of structural balance and addressing key fiscal risks could result in rating improvement.

CREDIT PROFILE

California's GO bond rating reflects 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. Fitch believes that these gains provide the state with a greater capacity to address future fiscal and budgetary cyclicality. However, California's credit standing is likely to remain lower than most states for the foreseeable future given the magnitude of the state's budgetary and financial challenges despite its key credit strengths. These include its massive, diverse economy and tax base.

FISCAL IMPROVEMENT

Notable fiscal management improvements since the fiscal crisis of 2008 - 2009 have included a voter-approved change that allows simple majority budget approval as well as various cash flow management tools. Successive years of timely budgets that achieved structural gains primarily through deep, recurring spending cuts have also positioned the state to make steady progress repaying past budgetary borrowing under the state's current forecast.

Although California's fiscal situation has improved significantly, Fitch views the state as not yet having fully recovered from the effects of two fiscal crises over a little more than a decade. Budgetary borrowing, which has included deferrals, internal loans and deficit bonds, will remain a drag on current resources for several years even under optimistic scenarios. 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 and repay budgetary borrowing, assuming the state continues to exercise spending restraint. The balance of budgetary debt outstanding is expected to be reduced to $15.5 billion by the end of fiscal 2015. The state forecasts eliminating budgetary borrowing by fiscal 2018, corresponding to the expiration of temporary tax rates.

The state's longstanding challenges to achieving and maintaining budgetary gains -- often due to lawsuits, federal objections, or allowing spending to grow at a pace in excess of sustainable revenues -- could continue to weigh on the state's finances. California has limited sources of flexibility to confront the inevitable future downturn; although it is making a deposit to the budget stabilization account (BSA) for the first time in several years in fiscal 2015.

A proposed constitutional amendment on the ballot this November would strengthen the funding mechanism of the BSA and provide the state with a means to better manage revenue cyclicality. The amendment would require that 1.5% of general fund revenues be set aside in the BSA and would require additional deposits whenever capital gains rise to more than 8% of general fund tax revenues. Half of each year's deposit for the next 15 years would be used for supplemental payments toward budgetary debt or other long-term liabilities. In Fitch's view, passage of the proposed measure could position the state for additional fiscal improvement and could be viewed as a credit positive.

ECONOMIC RECOVERY GAINING MOMENTUM

California's economy is unmatched in size and diversity, and the economy is gaining momentum across most sectors and regions. Non-farm employment is up 2.2% year-over-year in July 2014, above the 1.9% national rate for the same period. Employment gains are widespread, particularly in key service sectors, and construction employment is expanding (+3.8% in July) as the housing sector recovers. California's unemployment rate has fallen considerably in the last year, to 7.4% in July 2014 vs. 9.0% one year earlier, although it remains elevated relative to the nation's 6.2% unemployment rate. Personal income growth has generally matched the national and regional averages over the past year and ranks 12th among the states in terms of per capita personal income at 106.4% of the national average.

The state's latest economic outlook, released in May 2014, foresees continued moderate improvement in the economy, including job growth at approximately a 2.5% annual growth rate; unemployment declining but still higher than the national rate; and continued recovery in the housing market. Personal income is forecast to grow 5.1% in 2015.

IMPROVED BUDGET OUTLOOK

The state has adopted four consecutive budgets on a timely basis that prioritize shoring up the state's finances, including through prudent control of spending and budgetary debt repayment. Only four 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, gradual 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 toward structural budget balance while repaying billions in past budgetary borrowing.

The adopted budget for fiscal 2014 did not require gap-closing measures to achieve balance, although the plan trimmed some spending, funded modest service restorations and included notable structural changes to school funding and to health care delivery in preparation for federal health reform. Revenue performance in fiscal 2014 was strong, outpacing the conservative forecast on which the budget was based by $5.1 billion (5.2%).

The enacted budget for fiscal 2015 assumes continued economic recovery and steady revenue gains through fiscal 2015, while emphasizing the uncertainty that is inherent in California's volatile tax revenue system. The budget avoids restorations of the deep spending cuts made since fiscal 2011, repays an additional $10.4 billion of budgetary debt ($5.1 billion as a supplemental to fiscal 2014), leaves a $1.4 billion cumulative general fund balance, of which $449 million is reserved in the special fund for economic uncertainties, and deposits $1.6 billion to the state's rainy day fund, the first deposit since fiscal 2008. Another $1.6 billion would accelerate pay off the economic recovery bonds, first issued in response to California's 2003 - 2004 budgetary crisis.

DEBT AND PENSIONS

California has a moderate but above-average debt burden, with net tax-supported debt of approximately $91.2 billion as of July 1, 2014, equal to 5.0% of 2013 personal income. The debt burden rose due primarily to substantial GO bond issuance for infrastructure and borrowing to cover budget gaps. Net tax-supported debt excludes cash flow borrowing; the state is issuing $2.8 billion in revenue anticipation notes for fiscal 2015 cash flow needs, well below that of prior years, reflecting the state's substantially improved fiscal position.

System-wide funded ratios on a reported basis for the state's two main pension systems, covering public employees and teachers, have eroded due to investment losses. Based on their June 30, 2013 financial reports, the public employees' plan reported an 83.1% system-wide funded ratio, and the teachers' plan reported a 67% system-wide funded ratio.

Using Fitch's more conservative 7% discount rate assumption, funded ratios for the two systems fall to 78.8% for public employees and 63.5% for teachers. On a combined basis, net tax-supported debt and pension liabilities attributable to the state at 8.3% are above the state median of 6.1%, ranking the state 31st.

The state adopted a broad package of pension reforms in 2012 that affect 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' 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 that will increase statutorily required contributions to the system from the state, school districts, and teachers beginning in the current fiscal year. The legislation gradually increases funding requirements, with the first installment funded in the fiscal 2015 budget, and expects that it will be fully funded by 2046.

RELATED RATING ACTIONS

Fitch also affirms the 'A' rating and Stable Outlook on the following bonds, which are rated on par with the state GO:

--Cal-Mortgage Loan Insurance Division bonds.

State appropriation-supported bonds of the state issued by the following entities are affirmed at 'A-' with a Stable Outlook, 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 and series 2013A).

Appropriation bonds of the state issued by the following entities are affirmed at 'BBB+', two notches below the state's GO rating; the Rating Outlook remains Stable:

--California Judgment Trust;

--Shafter Joint Powers Financing Authority;

--Taft Public Finance Authority.

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

In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from IHS Global Insight.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=857914

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.



Fitch Ratings

Primary Analyst:

Karen Krop, +1-212-908-0661

Senior Director

Fitch Ratings, Inc.

33 Whitehall Street

New York, NY 10004

or

Secondary Analyst:

Douglas Offerman, +1-212-908-0889

Senior Director

or

Committee Chairperson:

Laura Porter, +1-212-908-0575

Managing Director

or

Elizabeth Fogerty, +1-212-908-0526

Media Relations, New York

elizabeth.fogerty@fitchratings.com


Source: Fitch Ratings


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