NEW YORK--(BUSINESS WIRE)--(This is a correction of a release originally published on Aug. 12, 2016. It adds additional rating upgrades for certain VRDO long-term ratings that were missing from the original release.)
Fitch Ratings has assigned an 'AA-' rating to the following general obligation (GO) bonds of the state of California:
--$615 million various purpose GO bonds;
--$2.085 billion various purpose GO refunding bonds.
The bonds will be solid via negotiation on Aug. 30, 2016.
Fitch has also upgraded the following ratings:
--The state's Issuer Default Rating (IDR) to 'AA-' from 'A+';
--$74.9 billion in outstanding GO bonds to 'AA-' from 'A+';
The Rating Outlook is Stable.
Fitch has also upgraded outstanding lease obligations and other bonds related to the state IDR as detailed at the end of this release.
In addition, Fitch has upgraded certain VRDO long-term ratings that now qualify for the application of the 'higher of' or 'dual-party pay' approach pursuant to the criteria 'Rating Criteria for Letter of Credit-Supported Bonds and Commercial Paper' (April 5, 2016) and 'U.S. Municipal Structured Finance Criteria' (Feb. 23, 2015) as follows:
--GO variable-rate bonds series 2003B-1, 2, 3, 4 (LOC: Bank of America, N.A.) to 'AA-' from 'A+', Stable Outlook;
--GO variable-rate bonds series 2005A3, 2005B1 (LOC: Mizuho Bank, Ltd.) to 'AA-' from 'A+', Stable Outlook;
--GO variable-rate bonds series 2005A2-1, 2005B3 (LOC: Sumitomo Mitsui Banking Corporation) to 'AA+' from 'AA', Negative Outlook;
--California, State of (CA) GO variable-rate bonds series 2005B2 (LOC: Bank of Tokyo-Mitsubishi UFJ, Ltd.) to 'AA-', Stable Outlook.
Note: The 2005A2-1 and 2005B3 bonds were subsequently downgraded to 'AA-'; Stable Outlook on Oct. 24, 2016 to reflect the correction of an error in Fitch's application of its VRDO criteria when both the issuer's and LOC provider's long-term rating may be considered when assigning the VRDO's long-term rating. For more information, see Fitch release 'Fitch Takes Various Actions on LOC-Supported VRDOs'.
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.
KEY RATING DRIVERS
The upgrade to California's IDR and GO rating to 'AA-' from 'A+' reflects a combination of positive credit developments and application of Fitch's revised criteria for U.S. state and local governments, which was released on April 18. 2016. The 'AA-' rating reflects California's large and diverse economy that supports strong, albeit cyclical revenue growth prospects, solid ability to manage expenses through the economic cycle, and a moderate level of liabilities. California is fundamentally better positioned to withstand a future economic downturn than has been the case in prior recessions due to numerous institutional improvements. The state has demonstrated strong budget management during this period of economic recovery and expansion, using temporary tax revenues to eliminate the overhang of budgetary borrowing that had accumulated through two recessions.
Economic Resource Base
California's economy is unmatched among U.S. states in its size and diversity and is generally stable despite a considerable presence in industries prone to cyclicality. Population and employment growth levels approximate the U.S. medians over time, but the state remains a magnet, including for immigrants. After severe, widespread recessionary conditions, growth in the recovery has been strong, including in California's housing market.
Revenue Framework: 'aaa' factor assessment
Tax revenues are dominated by personal income taxes, which are economically sensitive, particularly those related to capital gains. Growth prospects are strong, driven by the state's strong economic fundamentals. As with most states, California's legal ability to raise taxes is unlimited, although subject to legislative super-majority voting requirements.
Expenditure Framework: 'aa' factor assessment
California has a solid ability to reduce spending through the economic cycle although its flexibility is somewhat restricted than is true for most states due to constitutional requirements for funding education and voter initiatives that limit state discretion.
Long-Term Liability Burden: 'aa' factor assessment
Long-term liabilities, while above the median for U.S. states, are moderate. Pension funded ratios declined following the downturn; however, the state has instituted some benefit reforms and implemented a long-term plan to increase contributions to the teachers' system.
Operating Performance: 'aa' factor assessment
Institutionalized changes to fiscal operations, 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.
In cases where Fitch's criteria permits both the borrower's and LOC provider's long-term credit rating to be considered when assigning the VRDO's long-term rating, the long-term rating is based on the higher of the underlying long-term rating assigned to the bonds by Fitch and the long-term rating assigned by Fitch to the bank providing the irrevocable direct-pay LOC securing the bonds.
In cases where Fitch's criteria permits the application of Fitch's dual-party pay approach, the long-term rating is based jointly on the underlying rating assigned to those bonds by Fitch and the rating assigned by Fitch to the Bank, which provides the irrevocable direct-pay LOC supporting the bonds.
RATING SENSITIVITIES - IDR
Continued Fiscal Discipline: The rating is sensitive to the state's ability and willingness, both within the legislative and executive branches, to maintain fiscal discipline throughout the economic cycle.
RATING SENSITIVITIES -Qualifying VRDOs
Certain long-term VRDO ratings are tied to the respective long-term rating assigned to the obligor and the respective long-term rating that Fitch maintains on the bank providing the LOC. Changes to one or both of these ratings may affect the long-term ratings assigned to the bonds. Additionally, in cases where either the underlying bond rating or the bank rating were downgraded to 'A-' or lower, the dual-party pay criteria could no longer be applied, and the long-term rating assigned to the bonds would then be adjusted to the higher of the respective bank rating and the respective underlying bond rating.
CREDIT PROFILE
California's 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. The state's latest economic outlook, released with the May 2016 revision to 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.
Revenue Framework
General Fund resources are derived primarily from personal income tax (PIT) and sales tax (SUT): two-thirds of general fund revenues are from the PIT and another 21% from sales tax as of fiscal 2016. The PIT is structured with progressive rates, with capital gains a significant and notably volatile component. SUT is levied on goods but not services at a combined state and local uniform rate of 7.5%. Voter approved Proposition 30 temporarily increased PIT and SUT rates beginning in fiscal 2013, to permit increased spending for education while reducing accumulated budgetary borrowing. The sales tax portion expires on Dec. 31, 2016 while the PIT portion extends to Dec. 31, 2018. Voters will consider extending these taxes with a measure on the November ballot.
California's revenues have been notably volatile, particularly PIT receipts from capital gains. The state has in recent years attempted to cap the impact of volatility on the general fund, with capital gain-related tax revenues above 8% of general fund revenues not necessary to fund Proposition 98 being allocated to the rainy day fund.
Strong economic fundamentals are the basis for a revenue profile that is likely to grow at or above the national average over time. California's tax revenues, adjusted for the estimated impact of tax policy changes, grew at a pace that exceeds national GDP growth over the 10 year period ending in 2014. Fitch expects continuation of this trend.
California does not have legal limitations on its ability to raise revenues. While not a legal limitation, it is noted that there is a requirement for a super-majority legislative vote to raise tax revenues.
Expenditure Framework
General fund spending is focused on education and health and human social services, as is typical of most states. Education, which comprises more than half of state general fund spending, is the largest category of state spending and has a constitutional first claim on revenues. Having opted into the optional expansion of Medicaid under the Affordable Care Act (ACA), California's program (Medi-Cal) is a significant and growing part of the budget.
Spending is expected to be in line with, to marginally above, expected revenue growth, driven by health and human social services, particularly Medi-Cal. Most education spending falls under Proposition 98, a constitutional requirement with a complex formula that links spending to longer-term trends in state personal income and revenue. As such, spending on education is relatively inflexible both in terms of annual spending and multi-year impacts of the funding formula. However, Proposition 98 also results in lower required spending for education when revenue declines. Beyond education spending, the state retains considerable ability to reduce or defer spending. Carrying costs for long-term liabilities are above the state median but remain low.
Long-Term Liability Burden
Long-term liabilities are a low burden on resources, although combined debt and pension liabilities are above the median for states at 9% of 2015 personal income. The state has approximately $85.6 billion in net tax supported debt (prior to the current issuance), a level that has declined in recent years. There is a history of inadequate contributions to the teachers' system; however, the state has instituted some benefit reforms and the fiscal 2015 enacted budget provided the first installment of a long-term plan to increase contributions to the teacher's system.
Based on its June 30, 2015 financial report, the public employees' plan reported a 69.4% actuarial funded ratio for state employees. The teachers' plan reported a 68.5% actuarial funded ratio (system-wide) as of June 30, 2015. Fitch estimates that the systems' funded ratios, adjusted to a 7% return assumption, would measure 65.8% (state employees) and 64.9% (teachers). The state is responsible for about 38% of the teachers' system liability.
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 contribution shortfalls 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.
Operating Performance
In Fitch's view, the state is in a materially improved position to address future economic and revenue cyclicality, although recent fiscal management improvements remain untested by a recessionary event. Notable improvements since the fiscal crisis of 2008-2009 have included a voter-approved change that allows simple majority budget approval, significantly reducing the risk of budget impasses that had plagued the state; 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. Fitch believes these changes make it unlikely that the state would experience a similar liquidity crisis to that of the Great Recession, as it was in part caused by the inability to enact a timely budget and subsequent inability to borrow for cash flow purposes. Cash balances, including borrowable resources outside the general fund, have recovered and the state has not borrowed for cash flow purposes since fiscal 2015.
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 output of the Fitch Analytical Scenario Tool (FAST) demonstrates California's economically sensitive revenue structure, with revenues potentially falling 8% in the first year of a moderate downturn (1% decline in national GDP) based on the state's historical experience adjusted for tax policy changes. During the most recent recession, California needed to use extraordinary measures to adjust to a sharp decline in revenues and the resulting liquidity crisis, including payment deferrals to schools and local governments, payroll shifts between fiscal years, and interfund borrowing. The changes instituted by the state since leave it better positioned to address future downturns.
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. As the economy has recovered, 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. By applying the temporary taxes to debt reduction, Fitch believes the state is better positioned to maintain budgetary balance as the tax increases expire.
The enacted budget for fiscal 2017, which began July 1, 2016, is balanced and continues the emphasis on reducing outstanding budgetary borrowing. It is based on continued economic growth and a forecast of 4% growth in general fund revenues to $123.6 billion. A portion of the increase in revenue will be automatically allocated to K-14 education under Proposition 98 but it will also support increased spending for Medicaid and higher education. The budget continues to a large extent the governor's 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 budget allocates $1.9 billion to non-recurring spending for deferred maintenance, state facilities renovations and replacement, and affordable housing and allocates $3.3 billion to the rainy day fund, bringing its total to $6.7 billion (5.4% of revenues) from $3.4 billion as of fiscal 2016. The budget appears prudent in terms of restraining spending growth in favor of retaining flexibility for future economic weakness. The budget assumes solid economic growth in fiscal 2017, but notes the potential for a future downturn as well as risks associated with slower global growth or a stock market correction.
RELATED RATING ACTIONS
Today's upgrade of the state's IDR to 'AA-' also applies to the following bonds, which are rated on par with the IDR, reflecting enhancement provided in the form of a requirement to issue GO parity debentures to make up depleted reserves:
--Cal-Mortgage Loan Insurance Division bonds to 'AA-' from A+'.
State appropriation-supported bonds issued by the following entities have been upgraded to 'A+', one notch below the state's IDR, from 'A', reflecting the slightly higher degree of optionality associated with payments that are subject to appropriation. The upgrade on these bonds reflects the upgrade of the state's IDR.
--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);
--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).
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.
Applicable Criteria
Rating Criteria for Letter of Credit-Supported Bonds and Commercial
Paper (pub. 05 Apr 2016)
https://www.fitchratings.com/site/re/878782
U.S. Municipal Structured Finance Criteria (pub. 23 Feb 2015)
https://www.fitchratings.com/site/re/862222
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
https://www.fitchratings.com/site/re/879478
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1013850
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1013850
Endorsement Policy
https://www.fitchratings.com/regulatory
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