Fitch Upgrades California GO to 'A '; Outlook Stable
--\$790 million various purpose GO bonds;
--\$1.11 billion various purpose GO refunding bonds.
The bonds will be sold via negotiation on March 5, 2015.
At the same time, Fitch Ratings upgrades the rating on \$76.4 billion in outstanding GO bonds of the state of California to 'A+' from 'A'.
The Rating Outlook is Stable.
Fitch also takes rating action on outstanding lease appropriation and other bonds related to the state GO as detailed at the end of this release.
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 FUNDAMENTALS: The upgrade is based on continued improvement in the state's fundamental fiscal position. Institutionalized changes to fiscal operations in recent years, 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. Progress includes timely, more structurally sound budgets, spending restraint, continued sizable reductions in budgetary debt, and initial funding of reserves.
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 combined debt and pension liabilities are above the median for states. Pension funded ratios declined following the downturn and 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 provides the first installment of a long-term plan to increase contributions to the teacher's system.
CYCLICAL REVENUES AND CASH FLOWS: With economic recovery and associated revenue growth, liquidity has improved significantly and no cash-flow issuance is currently expected for fiscal 2016. State finances have been subject to periodic, severe budget and cash flow crises due to economic and revenue cyclicality and historical institutional inflexibility. The state expanded its ability to manage cash flow weakness during the last downturn, which can be expected to make the effects of future downturns more manageable.
TANGIBLE STRUCTURAL PROGRESS: Deep recurring spending cuts in recent adopted budgets, a restrained approach to restoring past cuts, and healthy revenue growth have eliminated the state's structural imbalance. Further, the state is applying revenue growth to eliminating the heavy burden of budgetary borrowing from the last two fiscal crises, enhancing its fundamental financial flexibility.
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 budgetary discipline and its ability and willingness to continue progress on reducing budgetary borrowing and maintaining structural balance.
CREDIT PROFILE
Fitch's upgrade of California's GO bond rating to 'A+' from 'A' 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.
Recent fiscal management improvements remain untested by a severe recessionary event, but in Fitch's view the state is in a materially improved position to address future economic and revenue cyclicality, and the state's finances are likely to further strengthen assuming the current expansion and budgetary discipline continue. However, California's credit standing is likely to remain lower than most states given its comparatively lower fiscal flexibility, driven by revenue limitations, the initiative process, spending formulas for education, and other factors that remain unchanged. Key credit strengths include the state's massive, diverse economy and tax base.
UPGRADE REFLECTS FISCAL IMPROVEMENT
Notable improvements since the fiscal crisis of 2008-2009 have included a voter-approved change that allows simple majority budget approval, 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. Successive years of timely budgets that have achieved and maintained structural gains primarily through deep, recurring spending cuts as well as voter-approved temporary taxes have positioned the state to make steady progress repaying past budgetary borrowing. Fitch believes that these improvements, supported by an expanding economy that is generating revenues at a pace exceeding the state's forecasts, have strengthened California's fundamental credit profile.
INCREASED FLEXIBILITY
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 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 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, assuming the state continues to exercise spending restraint. The state has utilized these additional revenues to rapidly repay budgetary borrowing, including effectively retiring the ERBs at the beginning of the next fiscal year (fiscal 2016). It is important to note that by focusing the use of temporary taxes on debt reduction, the state is better positioned to maintain budgetary balance as the tax increases expire.
Another source of financial flexibility is expected to come from the improved mechanism for funding the BSA. Voters approved a constitutional amendment in November 2014 that requires 1.5% of general fund revenues, plus the excess of capital gains tax receipts above 8% of general fund tax revenue, not necessary to fund Proposition 98, be set aside at the beginning of each fiscal year in the BSA. Half of each year's deposit for the next 15 years will be used for supplemental payments toward budgetary debt or other long-term liabilities, with the balance retained in the BSA. This latter provision is likely to contain one of the key drivers of general fund revenue volatility during the last two fiscal crises. The state deposited \$1.6 billion in the BSA at the beginning of the current fiscal year, based on the existing provisions of Proposition 58.
ECONOMIC RECOVERY GAINING MOMEMTUM
California's economy is unmatched in size and diversity, and the economy is gaining momentum across most sectors and regions. Non-farm employment is up 2.1% year-over-year in December 2014, just below the 2.3% national rate for the same period. Employment gains are widespread, particularly in key service sectors, and construction employment is expanding (+4.0% in December) as the housing sector recovers. Although California's job losses during the recession exceeded the U.S. median, its recovery has exceeded the U.S. as well. As of December 2014, non-farm employment had reached 101.3% of its pre-recession peak, above the U.S. median of 100.4%.
California's unemployment rate has fallen considerably in the last year, to 7% in December 2014 vs. 8.3% one year earlier, although it remains elevated relative to the nation's 5.6% unemployment rate; this is consistent with historical trend. Personal income growth has generally matched the national and regional averages over the past year and California ranks 11th among the states in terms of per capita personal income at 108.2% of the national average.
The state's latest economic outlook, released with the governor's budget proposal in January 2015, foresees continued moderate improvement in the economy, unemployment declining but still higher than the national rate, and continued recovery in the housing market. Personal income is forecast to grow 5.3% in 2016.
IMPROVED BUDGET OUTLOOK
The state has adopted four 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. Only four 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, 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 the current year, fiscal 2015, avoided restoring the deep spending cuts, repaid an additional \$10.4 billion of budgetary debt, was expected to leave a \$1.4 billion cumulative general fund balance, and deposits \$1.6 billion to the state's rainy day fund, the first deposit since fiscal 2008. Another \$1.6 billion was expected to reduce budgetary borrowing, including deferred payments to school districts and local governments.
Strong revenue performance is continuing in fiscal 2015, with general fund revenues through January \$472 million above even the upwardly revised November 2014 forecast used for the governor's fiscal 2016 budget proposal, although this is in part due to timing of receipt of sales tax revenues. Strong PIT and corporate tax receipts offset slightly weaker than anticipated sales and use tax revenues during the first half of the fiscal year. The governor's budget proposal for fiscal 2016 assumes that fiscal 2015 revenues will ultimately be \$2.6 billion higher than originally assumed in the fiscal 2015 adopted budget, with these increased revenues absorbed by additional payments to schools and higher costs of Medi-Cal.
The governor's budget proposal for fiscal 2016 assumes continued economic growth and steady revenue gains through fiscal 2016. The budget as proposed is balanced and continues the emphasis on reducing outstanding budgetary borrowing. It continues to restrain budgetary growth, repays budgetary debt including making the final payment for the economic recovery bonds (ERBs), and makes a second consecutive deposit to the BSF. A revised budget proposal is expected in May.
DEBT AND PENSIONS
California has a moderate but above-average debt burden, with net tax-supported debt of approximately \$90 billion as of Jan. 1, 2015 (not including the current issuance), equal to 4.9% of 2013 personal income. Debt and pension liabilities combined at 8.3% are above the state median of 6.1%, ranking the state 31st.
System-wide funded ratios on a reported basis for the state's two main pension systems, covering public employees and teachers, eroded due to investment losses during the recession. Based on its June 30, 2013 financial report, the public employees' plan reported an 83.1% system-wide actuarial funded ratio. As of its June 30, 2014 financial report, the teachers' plan reported a 76.5% system-wide ratio of assets to liabilities (reflecting GASB 67 requirements). Using Fitch's more conservative 7% discount rate assumption, the most recent ratios for the two systems fall to 78.8% for public employees and 72.5% for teachers.
The state adopted a broad package of pension reforms in 2012 that affect most state and local systems, including 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' system are legally required, but not for the teachers' system, leading to persistent underfunding of the latter. The state addressed teachers' system funding 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 it will be fully funded by 2046.
Net tax-supported debt excludes cash flow borrowing; the state issued \$2.8 billion in revenue anticipation notes for fiscal 2015 cash flow needs, well below that of prior years, reflecting the state's substantially improved fiscal position. The governor's budget proposal does not anticipate the need for cash flow issuance during fiscal 2016.
RELATED RATING ACTIONS
Today's upgrade of the state's GO rating to 'A+' also applies to the following bonds which are rated on par with the state GO:
--Cal-Mortgage Loan Insurance Division bonds.
State appropriation-supported bonds of the state issued by the following entities are upgraded to 'A' with a Stable Outlook, one notch below the state's GO rating:
--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);
--East Bay State Building Authority;
--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).
Appropriation bonds of the state issued by the following entities are upgraded to 'A-', two notches below the state GO rating; the Rating Outlook remains Stable:
--California Judgment Trust;
--Shafter Joint Powers Financing Authority;
--Taft Public Finance Authority.
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