Fitch Assigns 'A' Rating to $750MM California GOs; Outlook Stable

NEW YORK--()--Fitch Ratings assigns an 'A' rating to $750 million in general obligation (GO) bonds of the state of California, consisting of:

--$575 million various purpose GO bonds (tax-exempt);

--$175 million various purpose GO bonds (federally taxable).

The bonds will be sold via competitive sale on April 22.

Fitch also affirms the 'A' rating on approximately $74.9 billion outstanding state GO bonds.

The Rating Outlook is Stable.

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: Institutionalized changes to fiscal management in recent years, combined with the ongoing economic and revenue recovery have enabled the state to materially improve its overall fiscal standing. Notable progress includes timely, more structurally sound budgets, spending restraint, and sizable reductions in budgetary debt. Fitch upgraded the state's GO rating to 'A', from 'A-', on Aug. 5, 2013.

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, although it has grown in the last decade for infrastructure needs and budgetary borrowing. Pension funded ratios have declined and contributions to the teacher system remain inadequate, but the state has instituted some benefit reforms.

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 progress 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. Nevertheless, the state carries a heavy burden of budgetary borrowing from the last two fiscal crises and 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. Additional material progress on reducing budgetary borrowing, maintenance of structural balance and addressing key fiscal risks could result in rating improvement. Unexpected economic, revenue and cash flow weakness or a return to spending growth without regard to revenue volatility could pressure the rating.

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.

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.

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 state forecasts eliminating budgetary borrowing by fiscal 2018, from $24.9 billion as of June 30, 2014, corresponding to the expiration of temporary tax rates.

Although California's fiscal situation has improved significantly, Fitch views the state as being a long way from a full recovery 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. Despite the institutional reforms of recent years, unmet needs to address unemployment borrowing, underfunding of teacher pensions, and prisons represent material risks.

Additionally, 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, and the budget stabilization account, the state's rainy day fund, remains empty. However, key credit strengths include its massive, diverse economy and tax base and the strengths inherent in a state's broad powers.

ECONOMIC RECOVERY GAINING MOMENTUM

California's economy is unmatched in size and diversity, and the economic recovery is gaining momentum across most sectors and regions. February 2014 employment is up 2.3% year-over-year, well above the 1.5% national rate for the same period. Employment gains are widespread, particularly in key service sectors, and construction employment is expanding rapidly (+6.1% in February) as the housing sector recovers. California's unemployment rate has fallen considerably in the last year, to 8.0% in February 2014 vs. 9.4% one year earlier, although it remains elevated relative to the nation's 6.7% unemployment rate. Personal income, which had strong growth through the first three quarters of 2013, tapered off to 0.7% growth in the last quarter, below regional and national averages.

The state's latest economic outlook, released with the Governor's fiscal 2015 budget proposal in January 2014, foresees continued moderate improvement in the economy, including job growth at approximately a 2% annual growth rate; unemployment declining but still higher than the national rate; and continued recovery in the housing market.

IMPROVED BUDGET OUTLOOK

The state has adopted three consecutive budgets on a timely basis that prioritized shoring up the state's finances, including through prudent control of spending and budgetary debt repayment. Only three 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. Revenues are outpacing the forecast on which the budget was based; the most recent projection, included with the governor's fiscal 2015 budget proposal, estimating revenues to be $2.9 billion higher than assumed in the adopted 2014 budget.

The governor's budget proposal for fiscal 2015 assumes continued slow economic recovery and steady revenue gains through fiscal 2015, while emphasizing the uncertainty that is inherent in California's volatile tax revenue system. The proposal avoids restorations of the deep spending cuts made since fiscal 2011, repays an additional $11.8 billion of budgetary debt, leaves a small, $0.7 billion cumulative general fund balance (after encumbrances and including a $0.3 billion prior period adjustment) and deposits $1.6 billion to the state's rainy day fund, the first deposit since fiscal 2008. Furthermore, a proposed change to the state's rainy day reserve mechanism could enable the state to set aside part of any temporary personal income tax revenue windfalls it receives during good economic times to cushion the inevitable revenue plunges that have precipitated recent fiscal crises; the change would require voter ratification in November 2014.

DEBT AND PENSIONS

California has a moderate but above-average debt burden, with net tax-supported debt of approximately $90.9 billion as of March 1, 2014, equal to 5% of 2013 personal income. The debt burden rose over the last decade 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 issued $5.5 billion in revenue anticipation notes for fiscal 2014 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 are modestly above the median of Fitch-rated states.

Some reforms to pension contribution levels and benefits were adopted with the state's fiscal 2011 budget, and both systems have reduced their discount rate assumptions, to 7.5%. 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 adopted a broad package of pension reforms in September 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.

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=826221

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Contacts

Fitch Ratings
Primary Analyst
Karen Krop, +1-212-908-0661
Senior Director
Fitch Ratings, Inc.
One State Street Plaza
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
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

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Contacts

Fitch Ratings
Primary Analyst
Karen Krop, +1-212-908-0661
Senior Director
Fitch Ratings, Inc.
One State Street Plaza
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
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com