Fitch Rates Louisiana's $212MM GO Bonds 'AA-'; Outlook Stable
The Rating Outlook is Stable.
SECURITY
The bonds are general obligations of the state of Louisiana, whose full faith and credit are pledged. The bonds are payable from the bond security and redemption fund, on parity with outstanding GO debt, and have a first lien on the fund, which receives all money deposited in the state treasury not otherwise dedicated.
KEY RATING DRIVERS
Louisiana's 'AA-' IDR reflects the state's broad though somewhat concentrated economic base, strong ability to control revenue and spending policy, and above average but still moderate liability burden. The rating also reflects the state's persistently imbalanced financial operations, and a reliance on one-time measures for immediate gap-closing, which along with overly optimistic revenue projections have resulted in the need for successive years of mid-year budget corrections. Although the state recently approved recurring measures in the 2016 legislative session to close identified budget gaps in fiscal years 2016 and 2017, a large portion of the newly enacted revenue rolls off after fiscal 2018. Absent substantially improved economic growth, replacement revenues, additional expenditure controls, or other proactive measures, the state is likely to be confronted with a large structural gap in fiscal 2019, in Fitch's view.
Economic Resource Base
Louisiana's economy is resource-based as a major producer of oil and gas, and much of its manufacturing is dominated by petroleum and chemical production; combined, the state's mining, petroleum and coal products manufacturing, and chemical products manufacturing contributed $57.7 billion (23.5%) to the state's GDP in 2014. Given the concentration in the development and processing of crude oil, the state's economy is particularly exposed to the impact of a long-term downward price trend. Tourism is also important, and the port system is among the largest in the world.
Revenue Framework: 'aa' factor assessment
Fitch expects Louisiana's revenues, which are supported by broad-based sources, to continue to reflect the economic volatility tied to the extensive natural resources sector. The current economic slowdown is expected to extend over the medium term and will continue to challenge revenue growth. The state has complete control over its revenues, with an unlimited legal ability to raise operating revenues as needed.
Expenditure Framework: 'aa' factor assessment
The state has a low burden of carrying costs for liabilities and maintains the broad expense-cutting ability common to most U. S. states; however, state actions over the past several years, such as under-appropriating for formula expenditures such as Medicaid, have somewhat reduced the state's budgetary flexibility in responding to revenue shortfalls. Given continued, expected challenges in the state's economy, expenditure growth is expected to be ahead of future revenues, requiring ongoing active budget management.
Long-Term Liability Burden: 'aa' factor assessment
Louisiana's overall liabilities represent a moderate burden on resources but are well above the U. S. state median. The burden of the state's unfunded pension obligations is particularly high for a state, incorporating 100% of the liability for the state employee and teachers' pension systems.
Operating Performance: 'aa' factor assessment
Louisiana's financial operations have been characterized by continual budget stress in the last decade, with recurring budget gaps that the state has closed through both structural and non-recurring actions. While the state has recently enacted recurring measures to close identified budget gaps, a large portion of the new revenue rolls off after fiscal 2018 and many solutions remain one-time in nature. Nevertheless, Fitch believes that the state retains very strong gap-closing capacity as a result of the flexibility inherent in a state's powers. In addition, the state's financial operations benefit from the maintenance of a separate rainy day fund despite a sizable appropriation from this resource in fiscal 2016.
RATING SENSITIVITIES
Movement in the state's IDR is sensitive to shifts in key fundamental credit characteristics including continued proactive management of its challenged financial operations. The Stable Outlook incorporates Fitch's expectation that the state will proactively respond to its fiscal and economic challenges.
CREDIT PROFILE
Energy production and processing dominate Louisiana's economy. In 2015 the state was ranked ninth highest for crude oil production excluding federal offshore production and fourth for natural gas production and the state's 19 operating refineries process 20% of the nation's crude.
The state's economy has suffered from the downward energy price trend that began in 2014. Baker Hughes, a large oilfield service company, reports an average of 42 rotary rigs in the state in August 2016, down from a peak average of 115 in September 2014 and continuing to trend lower in recent months. The cutbacks have significantly dampened employment gains while the unemployment rate, at 6.3% in July 2016, approximates 129% of the nation's.
Beyond the energy sector, tourism in New Orleans remains a significant sector, and that city's port system is among the largest in the world. Flood protection in the New Orleans area has been enhanced since the hurricanes in 2005, but Louisiana remains vulnerable to severe storm activity, as recently demonstrated by the severe floods in the state's capital region in August 2016.
Revenue Framework
Sales taxes and personal income taxes (PIT) have provided almost equal support of GF operations, together totaling about 70% of fiscal 2016 GF revenues, with additional revenue flowing from lottery and gaming, reflecting the sizable casino and riverboat gaming presence in the state, as well as corporate income and severance taxes. A temporary boost in the sales tax rate to close a fiscal 2017 budget gap is expected to increase the share of sales taxes support to 37% of GF revenue. The state is directed by its constitution and statutes to dedicate certain revenues for specific purposes, such as transportation revenues, lottery revenue, and tobacco settlement monies. Dedications diverted approximately 30% of revenues from the GF in fiscal 2016 although the proportion is expected to drop to 23% in fiscal 2017 following the expected increase in gross revenues that year.
Historical growth in revenues, after adjusting for the estimated impact of tax policy changes, was below the pace of national GDP growth over the 10 years through 2014 and essentially matched inflation. Over that period, modest growth was notable in sales and income taxes, as well as in severance taxes from natural resource development, despite the robust growth in crude oil and natural gas markets during this time; trends were affected by the devastating impacts of Hurricanes Katrina and Rita as well as the national recession despite solid economic growth as the state recovered from the hurricanes. The slump in crude oil prices, beginning in late 2014, was a primary contributor to significant revenue underperformance relative to forecast in fiscal years 2015 and 2016 and as projected for fiscal 2017. Fitch believes slow revenue growth will continue over the medium term as crude oil and natural gas prices are expected to remain subdued and affect overall economic performance.
The state has no legal limitations on its independent ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees. A two-thirds vote of each house of the legislature is required to impose a law that levies a new tax or increases an existing tax, but a majority vote is sufficient to suspend an existing tax exemption.
Expenditure Framework
As in most states, education and health and human services are Louisiana's largest operating expenditures. Education is the larger line item, including for higher education, as the state provides significant funding for local school districts and the public university and college system. Health and human services is the second largest area of spending, with Medicaid being the primary driver.
Fitch expects that spending growth, absent policy actions, will be ahead of natural revenue growth, driven primarily by Medicaid, and require regular budget adjustments to ensure ongoing balance. The fiscal challenge of Medicaid is common to all U. S. states and the nature of the program as well as federal government rules that limit the states' options in managing the pace of spending growth. However, Fitch expects Louisiana to be particularly challenged as the state has reduced many programs over the past several years, shrinking its cost-cutting options. The state anticipates that its recent expansion of Medicaid under ACA will reduce some of the state's financial burden in upcoming years. In other major areas of spending such as education, Louisiana is able to more easily adjust the trajectory of growth.
Overall, Louisiana retains ample ability to adjust expenditures to meet changing fiscal circumstances. While Medicaid remains a notable cost pressure, fixed spending requirements for debt service, pension (ARC), and OPEB (actual) are low; carrying costs accounted for only 5.9% of governmental expenditures in fiscal 2015 as compared to the 5.8% U. S. state median. Pension contributions over the past several years have generally fallen below the ARC as state contributions are based on statutory guidelines, although the state has made recent contributions above the ARC. The pensions' funded ratio has remained fairly constant as a result of successful reforms on cost of living increases.
Long-Term Liability Burden
As of June 30, 2016, the state's debt burden at 3.5% of 2015 personal income remains a low, but above average burden on the state's resources and debt issuance is well controlled by policy measures. Funding of the two largest pension systems is below average and the state has initiated various reform measures to improve their sustainability. Under GASB 67 standards for pension systems, the state employees' retirement system (LASERS) reported a 62.7% ratio of pension assets to liabilities in fiscal 2015; the teachers' retirement system (TRS) reported a ratio of 62.5%.
Reform efforts in 2014 included changing how cost of living increases are granted and how excess investment earnings are applied to address the unfunded liabilities, as well as re-amortizing unfunded liabilities. The reforms modestly improved the systems' ratios in fiscal 2015. Pension and OPEB benefits for state employees and teachers are otherwise constitutionally protected, reducing the state's flexibility to make benefit changes.
On a combined basis, the burden of the state's net tax-supported debt and adjusted unfunded pension (UAAL) obligations approximates 16% of 2015 personal income, well above the 5.8% median for U. S. states as calculated by Fitch in its October 2015 pension report. The calculations include 100% of the liability for both LASERS and TRS, which are both the responsibility of the state although it is not required to make 100% of the annual payments. The state's accrued OPEB obligations are guaranteed by its constitution, similar to accrued pension benefits, and the state made 44% of the ARC payment for OPEB in fiscal 2016. The OPEB UAAL stood at $5 billion as of the end of fiscal 2015.
Operating Performance
The state's revenue monitoring and forecast updates are an important tool that the state applies to monitor financial operations, particularly given the stress under which operations have functioned over the past several years, with consecutive years of recurring budget gaps that the state has closed through both structural and non-recurring actions. In the period following hurricanes Katrina and Rita, in 2005, the state has been affected by steep cuts in its federal Medicaid reimbursement rates given increases in the state's income and the ending of disaster-related federal reimbursements.
The sharp drop in crude oil prices since late 2014 further affected budgetary performance. Although the state's revenue estimating conference (REC) repeatedly reduced GF revenue expectations for fiscal years 2015 and 2016, actual collections underperformed even as higher needs emerged in K-12 education, Medicaid, higher education tuition assistance, and corrections. The state responded with reduced agency expenditures, fund sweeps, revenue reallocations, a series of tax increases and enhancements, an appropriation from the budget stabilization fund (BSF), and an allocation from settlement proceeds from BP.
The BSF continues to be an important backup resource for the state. The state is able to access up to one-third of the balance for current fiscal year operations or a prospective revenue shortfall. The state estimates fiscal 2016 ended with a BSF balance of $358 million or 4.4% of GF revenues.
Louisiana's budget management during the national economic recovery has been influenced by the state-specific challenges discussed above. The state's reliance on one-time measures for budget-balancing, along with overly optimistic revenue projections and insufficient budgeting of formulaic expenditures, have resulted in the need for successive years of mid-year budget corrections during a period of economic growth.
GF cash position has narrowed in recent years and the state is currently considering the issuance of cash flow notes to fund operations, although accessible cash in other operating funds remains and the state's BSF, expected to equal 4.4% of General Fund (GF) revenues at the end of fiscal 2016, can be applied to financial shortfalls under certain guidelines and with legislative consent.
Current Developments
The new administration which took office in January 2016 estimated a $750 million current year budget gap for fiscal 2016, later expanded to $940 million, with a $2 billion gap forecast for fiscal 2017. The legislature responded in two special sessions to the forecast gaps through the approval of a series of tax increases and enhancements and changes to tax exemptions and credits. Actions included increasing taxes on sales, tobacco, alcohol, and health maintenance organizations. While most tax initiatives are permanent, the one-cent sales tax increase, which provides $214 million in revenue in fiscal 2016 and $881 million in fiscals 2017 and 2018, respectively, will sunset on June 30, 2018 after which the state will have to address the resulting structural gaps in the absence of faster economic growth.
In addition to the tax increases, which are estimated to have contributed $300 million to closing the fiscal 2016 gap and almost $1.4 billion to the closing of the fiscal 2017 gap, the state approved a $128.5 million BSF draw for fiscal 2016, redirected $200 million of BP settlement monies for economic damages to the GF, and authorized a debt refunding to provide approximately $81.6 million in relief to the GF in fiscal 2016 and about $30 million in relief for fiscal 2017.
The state still anticipates an ending deficit for fiscal 2016 despite these actions. The amount of the deficit is uncertain, but Fitch believes the state will proactively strive to reduce operations expense in fiscal 2017 to eliminate it, as required by the state's constitution. This task had been expected to be challenged by the need to trim appropriations in fiscal 2017 from an already identified, estimated $300 million funding gap, and Fitch now expects this challenge will be compounded by additional, unanticipated expenditures and possible revenue losses related to the August 2016 floods.
The August floods resulted in considerable damage to homes and businesses in nine parishes in the state's capital region. The ultimate cost for damages in the state will take time to finalize, but significant federal reimbursement through FEMA is already occurring; through Aug. 31, 2016, $394 million had been approved by FEMA's individual assistance program. The state currently estimates its direct operating expense related to the floods at $52 million, an estimate that Fitch believes could be augmented by flood-related infrastructure requirements. How the state will fund these costs prior to receiving FEMA reimbursements given its narrow cash balances is yet to be decided, and already-contemplated cash flow borrowing this fiscal year, currently authorized up to a maximum of $500 million, is now more likely, in Fitch's view.
Fitch expects the state's financial position will deviate from earlier forecasts due to the adverse economic and revenue impact of the floods and increase in related expenditures, with offsets provided by the gradual receipt of federal disaster reimbursement and rebuilding efforts. Fitch expects the state will proactively respond to these challenges and will continue to monitor the state's progress.
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