Fitch Rates District of Columbia's $554MM GOs 'AA'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned a 'AA' rating to the following District of Columbia's (DC) general obligation (GO) bonds:

--$373.23 million series 2016D;

--$180.49 million series 2016E.

The bonds are expected to sell via negotiation on Nov. 30, 2016.

The Rating Outlook is Stable.

SECURITY

The bonds are general obligations of the District of Columbia (the District), with its full faith and credit pledged. Also pledged is revenue from a special real property tax, unlimited as to rate or amount and levied in an amount to pay debt service on GO and parity bonds.

KEY RATING DRIVERS

The District's 'AA' GO bonds rating reflects exceptionally strong budget monitoring and controls from an independent Chief Financial Officer with broad fiscal powers, prudent and forward-looking operating performance through both economic downturns and expansions and solid economic prospects. The federal government plays a key role in the District's credit profile given its role as an economic foundation for the District, direct fiscal support, and congressional oversight over local legislation. The large long-term liability burden for the current rating level, made up nearly entirely of debt, is a comparative credit weakness. Statutory caps on debt service should keep the burden relatively stable going forward.

Economic Resource Base

Government employees and spending, particularly federal, comprise a significant portion of the District's economic resource base and provide an important source of stability. The District's economic base has proven resilient to volatility in federally-driven economic activity in recent years including sequestration, a federal government shutdown, and the ongoing risk of federal government contraction. Continued private sector expansion, supported by robust population growth and favorable demographic trends, offsets the risk of federal austerity and Fitch expects it to drive continued economic growth.

Revenue Framework: 'a' factor assessment

The District's revenue growth will likely be in line with or above the level of U.S. economic growth, driven by overall economic expansion. The District has unique and significant limitations in its independent legal ability to raise revenues given the level of congressional oversight, limiting the overall factor assessment.

Expenditure Framework: 'aa' factor assessment

The District has solid flexibility to manage its primary expenditure demands, with workforce challenges common to many highly unionized localities offset by low carrying costs. DC benefits from material federal support in managing its key spending needs including Medicaid and pensions. Federally-mandated reforms also established structural budget management tools that impose spending discipline and limit the natural spending growth rate.

Long-Term Liability Burden: 'a' factor assessment

While pensions and OPEB funded positions are very favorable, the District bears a substantial long-term liability burden due to elevated debt levels. Statutory policies establish clear caps, but DC's extensive capital needs indicate long-term liability levels will remain at elevated levels for the foreseeable future.

Operating Performance: 'aaa' factor assessment

The District is well positioned to address cyclical downturns with robust reserve balances and related statutory funding requirements, midrange inherent budgetary flexibility, and relatively stable general fund revenues. The CFO's office provides extensive budget monitoring and control, supporting the District's operating profile.

RATING SENSITIVITIES

FISCAL MANAGEMENT: The District's 'AA' GO bonds rating is sensitive to shifts in fundamental credit characteristics, including economic stability, proactive and conservative financial management including solid reserve funding, and continued careful management of a sizable long-term liability burden with debt issuance matched to economic and fiscal capacity.

FEDERAL OVERSIGHT AND SUPPORT: The federal government's role is a critical factor in the District's rating. Direct fiscal contributions support the District's strong expenditure framework and temper the long-term liability burden. Congressional oversight limits the revenue framework assessment. Material changes in the federal government's relationship with the district could trigger rating movement. Fitch does not view the 2012 Budget Autonomy Act as a likely trigger.

CREDIT PROFILE

Revenue Framework

The District has diverse tax revenues with real and personal property taxes, personal and corporate income taxes, and a sales and use tax. Combined, these sources account for approximately three-fourths of DC's general fund revenues.

Stability in property taxes offsets volatility in the income and sales taxes; while the growth potential of the latter two taxes supports Fitch's assessment of strong revenue growth going forward. As federal government employment slowly recovers, professional and business services, and education and health services are the most robust sectors. Strong revenue growth over the last decade, well above the rate of national GDP, indicates fundamental resilience despite federal government contraction. Fitch's assessment incorporates the fact that the growth rate is somewhat overstated given revenue policy actions the District implemented during this period.

Given federal engagement and oversight, the District has no truly independent legal revenue raising capability. The federal Home Rule Act subjects all enacted non-budget local legislation, including revenue raising measures, to a 30- (for civil matters) or 60-(for criminal matters) legislative days congressional review period. Congress can void the legislation during the review period with a joint resolution of both houses, signed by the President. This represents a significant political hurdle, but locally approved legislation has been voided occasionally in the past.

Local budget bills, including authority to spend revenues generated under separate local legislation, are subject to even more federal scrutiny. The Home Rule Act established the District as essentially a federal agency for budgeting purposes, requiring explicit congressional approval as part of appropriations bills before local budget bills become effective. Under a local Budget Autonomy Act enacted by the District council in 2012, and a recent local court decision upholding it, the District believes its local funds budget is now only subject to the 30-day congressional review period. Some members of Congress have challenged this assertion and the final outcome is not yet clear. The inherent ability of Congress to block any revenue changes (through non-approval of local budgets bills or voiding local legislation) is a limiting factor for DC's revenue framework assessment.

Expenditure Framework

The District's responsibilities are very broad, as it provides city, county, and education services to its population. In addition, DC also functions as a state government sharing the most significant expenditure challenge facing most state governments, Medicaid. An enhanced Federal Medical Assistance Percentage (FMAP) match provides the District with a level of federal support exceeding that provided to most states, offsetting some of the burden.

Overall spending should continue to grow in line with revenues. The District faces a wide range of expenditure pressures, but benefits from a resilient revenue stream primed for continued growth.

Carrying costs (debt service, pension actuarially determined contribution [ADC] and OPEB actual contribution) are low at about 8% of spending and should be fairly stable as the District consistently pays full actuarial amounts for both pensions and OPEB. Federal support plays a key role in minimizing carrying costs. District employees except police, firefighters, and teachers participate in either the federal Civil Service Retirement System (for those hired before Oct. 1, 1987), with the district making percentage of payroll contributions as a participating employer; or a District-managed defined contribution system.

Police, firefighters, and teachers participate in single employer defined benefit plans managed by the District. Under the federal Revitalization Act, the federal government took on the liabilities and annual contribution requirements for police, firefighters and teachers up through June 30, 1997; funding of actuarial liabilities accrued since then is very strong.

The District's workforce is highly unionized with approximately 75% of the workforce subject to collective bargaining, and Fitch views the workforce environment as a neutral to weaker factor in the District's overall expenditure flexibility assessment. Employees are not permitted to strike but all collective bargaining units are eligible for binding arbitration to resolve contract negotiations.

Many contracts have been settled through June 30, 2017 with a relatively consistent pattern of annual wage increases at a moderately high 3%. The teachers union, one of the largest individual bargaining units, has been without a contract since June 30, 2012, and the firefighters unit has been without a contract since July 1, 2015. The unsettled contracts create some uncertainty and risk, which Fitch incorporates into the expenditure framework assessment.

The Washington Metropolitan Area Transit Authority (WMATA, the local public transit operator) presents an additional expenditure pressure for the District. WMATA receives annual operating and capital support from the District and surrounding states (Maryland and Virginia, collectively with DC, the contributing jurisdictions), as well as ongoing federal support. DC's operating contributions have consumed between 4% to 5% of the District's general fund operating expenditures in recent years.

A recent surge in safety incidents and renewed attention to the system's overall reliability raises the possibility WMATA's operating and capital needs could increase significantly in future years. Fitch anticipates any increase would be shared across the contributing jurisdictions. A substantial increase in the District's ongoing financial support for WMATA, without a commensurate increase in resources available for meeting those demands, could increase the pace of expected spending growth and/or reduce the District's flexibility to reduce spending in an economic downturn. WMATA currently has no dedicated funding source other than its operating revenues and appropriated support from contributing jurisdictions and the federal government.

Long-Term Liability Burden

Pensions and OPEB liabilities are very low with both essentially fully funded, setting the district apart from the vast majority of U.S. tax-supported governments. Federal support described earlier plays a key role in this extremely strong funded position. However, the debt burden is sizable, leading to an elevated long-term liability burden with combined debt and pension liabilities of approximately $10 billion at the end of fiscal 2015, or 20.7% of the District's 2015 personal income (debt represents 20.3%). Relative to fiscal 2016 market value of nearly $177 billion, the ratio is 5.6%.

Fitch expects debt to increase in line with local revenue growth given a statutory cap on debt service to general fund revenues tax revenues. The District's infrastructure demands, particularly given the breadth of its service responsibilities, will drive a steady flow of capital needs. However, Fitch anticipates that the District will continue to keep a close eye on affordability and would alter its capital spending plans if conditions made debt more of a burden on resources.

As with the expenditure framework, WMATA poses a potential risk for the District's long-term liability profile; however, Fitch similarly anticipates any burden for additional capital investment well beyond current levels will be shared across the contributing jurisdictions, and possibly the federal government. The District's annual share of WMATA's capital budget is approximately $130 million or 10% of the District's capital spending. In addition to the other contributing jurisdictions, the federal government has also made regular capital contributions to WMATA.

Earlier this month the District released its first long-range capital financial report providing an assessment of capital needs and its ability to fund them. Fitch views the report as an important tool to manage its sizable long-term liability burden. Regular reviews and updates to the plan will foster a stable debt burden while strategically addressing infrastructure needs.

Operating Performance

The District's resilient revenue base, adequate spending flexibility, and sizable reserves leave it very well positioned to manage a moderate economic downturn. The District maintained budget balance through the Great Recession with a variety of expenditure and revenue adjustments, as well as use of its unrestricted general fund balance. Fitch calculates the available fund balance was nearly 20% of spending at the end of fiscal 2015 and likely improved with another surplus in fiscal 2016.

Fitch includes in available general fund balance all unreserved fund balance (including the cash flow reserve and fiscal stabilization reserve accounts) and two components of the reserved general fund balance - the contingency cash reserve fund and emergency reserve fund. Both were established under federal statute to provide the District with fiscal flexibility. Both are available for intra-year cash flow purposes, further supporting the notion that the funds are part of the District's available financial cushion.

Fitch views the extensive powers and responsibilities of the independent CFO and other federally established mechanisms as key strengths of the District's operating environment. Fiscal discipline instilled following the District's financial crisis in the 1990s is institutionalized, largely in the form of the CFO's office. The CFO establishes the official binding revenue forecast used for budgeting and regularly updates it; monitors annual revenue and expenditure trends to ensure budget compliance and to flag any unanticipated shortfalls; scores all local legislation with potential fiscal consequences and can essentially block legislation that leads to a projected budget deficit; and develops annual multi-year revenue estimates.

Under the Federal Home Rule Act, the District's annual budget also includes a detailed multi-year outlook for operating and capital revenues and spending. Revenues in particular (presented by the CFO) tend to be based on conservative assumptions. While the federal financial control board is dormant, federal law establishes clear guidelines for its automatic reinstatement (namely, signs of significant District fiscal distress).

During the current economic expansion, the District made rapid progress in restoring fiscal flexibility with measures like steady rebuilding of its general fund balance (including establishing the cash flow reserve and fiscal stabilization reserve accounts in fiscal 2011) and rolling back temporary personal income and sales and use tax increases implemented to address effects of the Great Recession.

The District's local Budget Autonomy Act, passed by the District council in 2012, could streamline its budgeting process by limiting congressional intervention. The act essentially shifts the congressional oversight process for the locally-funded portion of the District's budget to a requirement for passive congressional review versus a requirement for active congressional appropriation in a spending bill. Earlier this year, the House of Representatives passed legislation overturning the Budget Autonomy Act but the Senate did not act on the bill. The District is complying with a DC Superior Court order upholding the act and requiring that the District implement it for the fiscal 2017 budget.

The validity of the Budget Autonomy Act is not a key credit consideration for Fitch. The District's previous requirement for its local budget to be annually appropriated by Congress left the District exposed to federal political brinksmanship but did not directly lead to rating pressure, even during federal shutdowns. Debt service on district bonds must be paid under the Home Rule act, regardless of whether a budget has been approved by Congress or locally.

CURRENT DEVELOPMENTS

Fitch anticipates the District ended fiscal 2016 (on Sept. 30) with a sizable surplus with revenues ahead of the enacted budget estimate and expenditures reportedly below budget. The September 2016 CFO revenue estimate projected the District's fiscal 2016 revenues at $7.1 billion, or $180 million above the February 2016 estimate used to enact the budget. For fiscal 2017 through 2020, the CFO projects moderate and steady growth of 1.1% this year and then approximately 3% annually in out-years. These estimates incorporate the implementation of tax cuts triggered under a statutory plan enacted by the District council several years ago.

City council and the Mayor approved the District's fiscal 2017 budget in June and forwarded the local funds portion to Congress pursuant to the local Budget Autonomy Act. The budget includes less than 1% growth in general fund spending versus the final revised fiscal 2016 budget.

Date of Relevant Rating Committee: May 25, 2016

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

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/site/re/879478

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Contacts

Fitch Ratings
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Eric Kim
Director
+1-212-908--0241
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Karen Krop
Senior Director
+1-212-908-0661
or
Committee Chairperson
Douglas Offerman
Senior Director
+1-212-908-0889
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Eric Kim
Director
+1-212-908--0241
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Karen Krop
Senior Director
+1-212-908-0661
or
Committee Chairperson
Douglas Offerman
Senior Director
+1-212-908-0889
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com