Fitch Affirms California Dept. of Veterans Affairs GO & Rev Bonds at 'AA-'; Outlook Remains Negative

NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the 'AA-' rating on $799.5 million outstanding State of California Veterans general obligation (GO) bonds and $546.7 outstanding California Department of Veterans Affairs (Cal Vets, or the Department) home purchase revenue bonds. The Outlook for the GO and revenue bonds remains Negative.

RATING RATIONALE:

--The Negative Outlook is based on credit concerns regarding the declining financial performance of the program as it experienced a $37.8 million loss in fiscal year (FY) 2010 and a $22.3 million loss in FY 2009. There is still the potential for further erosion of retained earnings due to foreclosure losses and management reports that it expects a loss for FY 2011.

--The 'AA-' rating is based on the program's retained earnings in 2010 which are still equal to 9.7% of total bonds outstanding and 10.8% of contracts outstanding (down from 10.7% and 11.7% respectively in 2009) despite net annual operating losses.

--While cash flow projections which incorporate Fitch's loan loss assumptions demonstrate retained earnings declining until 2017, the asset parity position never falls below 1.01% under a loan loss stress scenario which is adequate for current rating level.

--Approximately 27% of existing loans in the portfolio have a VA guarantee and eligible new loans will either be VA guaranteed, FHA insured or may be uninsured if below 80% loan to value (LTV).

--Approximately 36% of the program's portfolio was originated from 2005 to the present (26% in years 2006 & 2007), making these loans vulnerable to significant LTV volatility given pronounced declines in single-family housing valuations within the state of California.

--The program also has the potential for loss exposure since there is only one PMI provider for 33% of the existing portfolio which is Radian. Fitch withdrew its rating on Radian in May 2008 and there are concerns about Radian's creditworthiness and claims paying ability.

--There is still a high level of program loans in REO status (154 loans as of May 2011).

WHAT COULD TRIGGER A DOWNGRADE?

--Future program operating losses which will necessitate additional draws on the program's retained earnings;

--Increases in program delinquencies and foreclosures which may trigger increased program losses;

Additional credit concerns which could impact the performance of the underlying contract portfolio focus on the state of California and the following:

--Pronounced declines in single-family housing valuations;

--High levels of delinquencies and foreclosures;

--The state's high unemployment levels and broad economic weakness.

SECURITY:

Veterans General Obligation bonds of the State of California are payable in accordance with the various veterans bond acts by the state general fund. The full faith and credit of the state of California is pledged for the payment of both principal and interest. All general obligation bonds have an equal claim against the general fund of the State of California. While the GO Veterans bonds carry the full faith and credit of the State of California, their source of payment are monies from the 1943 Fund.

Home Purchase Revenue Bonds are special obligations of the department payable solely from, and by a pledge of, an undivided interest in the assets of the Fund and the Veterans Debenture Revenue Fund, a separate fund of the department. The undivided interest in the net revenues of the fund is secondary and subordinate to any interest or right in the fund of the people of the state of California and the holders of general obligation veterans bonds. There is also a bond reserve account in the Veterans Debenture Revenue Fund (as required by the revenue bond resolution) which was funded and is maintained in an amount equal to at least 3% of the outstanding revenue bonds. This reserve shall be used solely for the purpose of paying principal and interest on the revenue bonds.

CREDIT SUMMARY:

The GO and revenue bonds are secured by a $1.4 billion contract loan portfolio that has demonstrated weakening performance over the last year. As of May 2011, 7.6% of the portfolio in dollar terms was more than 60 days delinquent (including in foreclosure) which translates to 5.3% of the portfolio based on number of loans. The 2010 - 2011 delinquency statistics for the portfolio have remained generally level on a monthly basis, but did increase since May 2009 when delinquencies were 6.6% by dollar amount and 4.2% by number.

From 2003 to 2010 the program experienced seven fiscal years of loss (with FY 2007 being the only exception). Despite the fact that the program's retained earnings diminished during seven of the last eight fiscal years, the surplus funds still remain a centerpiece of the program's security; however, the amount has been further compromised given the large losses of $22.3 million in 2009 and $37.9 million in 2010.

At June 30, 2010, the fund's retained earnings were approximately $162 million, or 9.6% of bonds outstanding and 10.7% of loans/contracts outstanding. The availability of surplus funds does provide a cushion against potential loan losses and potential liquidity stresses from varying prepayment activity. While the current amount of retained earnings is currently sufficient to support the 'AA-' rating currently assigned, the Negative Outlook is further supported by Fitch's expectation that there will be additional losses to retained earnings (of a lesser magnitude than 2009 and 2010) in FY 2011 given short-term interest rates and contract performance over the last 12 months. Fitch expects that the program will be able to absorb current loan losses; however, if retained earnings are further diminished in the future, it is highly likely that the remaining amount will not be able to adequately address 'AA-' stress scenarios and maintain appropriate asset parity ratios for an 'AA-' rating. Fitch expects to review the ratings once the FY 2011 audit is released and new cash flows are run.

Approximately 36% of the program's portfolio was originated from 2005 to the present, making these loans vulnerable to significant loan-to-value volatility given pronounced declines in single-family housing valuations within the state of California since 2005 to the present. Program cash flows provided by the department incorporate current actual REO losses and an aggregate loan loss assumption of 14.1% to address the portion of the portfolio that is most vulnerable to future losses. Despite the incorporation of the assumed losses, the cash flows just maintain asset parity coverage of no less than 1.01x under all stress and prepayment scenarios.

As of May 31, 2011, 33% of the contract portfolio (by loan balance) carried primary mortgage insurance from Radian, 40% of the loans were uninsured, and 27% of the portfolio was VA-guaranteed. The Radian insured portion of the portfolio requires that a 2% deductible be satisfied by the program before any losses are covered. In May 2008, Fitch withdrew its rating on Radian Guaranty Inc. While the presence of primary mortgage insurance on outstanding contracts within the portfolio typically mitigates the fund's exposure to loan losses, Fitch is unable to comment on Radian's creditworthiness and ability to pay, therefore adding to the dilution of this historically positive credit factor. For the 40% of the contract portfolio which is uninsured, all of those loans have loan-to-value percentages under 80%, demonstrating deep owner equity in the property.

The recent passage of legislation revised the mechanics of how veterans GO bond debt service is paid. Under the new law, veterans GO bonds are payable first from moneys required under the Veterans Code to be deposited from the 1943 Fund into the newly created Veterans Bond Payment Fund which is held in the State Treasury and segregated from State General Fund moneys. The veterans GO bond debt service payment is now paid from the Veterans Bond Payment Fund to GO bondholders. The establishment and segregation of this fund eliminated the risk that the veterans GO debt service funds could be used by the state for other purposes. Prior to the passage of the legislation funds to pay the veterans GO bonds were transferred from the 1943 Fund to the General Fund. The new law still provides for the contingency that if the moneys deposited into the Veterans Bond Payment Fund are insufficient to make the veterans GO bond debt service payment, the State of California (rated 'A-' with a Stable Outlook by Fitch) will make up the deficiency.

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

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria' (Oct. 8, 2010);

--'State Housing Finance Agencies - Single Family Mortgage Program Rating Guidelines' (Nov. 26, 2008).

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=637130

State Housing Finance Agencies - Single-Family Mortgage Program Rating Guidelines

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=416066

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