Moody's Investors Service said it has downgraded to Baa1 from A1 the rating of the California Statewide Communities Development Authority's taxable pension obligation bonds, Series 2004 A-1 (pooled issue).

The rating action affects approximately $155 million in debt.

The downgrade is driven by two primary factors. The first is the weakened economic and financial position of some of the participants, particularly the city of Riverside, which represents 50% of the debt service payments to bond holders, and the city of Merced, with only 4%.

While Riverside has managed to weather the now slowly improving financial and real-estate crisis that hit the state in 2007, its overall financial position has weakened. Though the city's reserves remain consistent with investment-grade credits, the city faces significant economic hurdles.

Most significantly, unemployment remains above both the state and national averages and median housing prices remain stagnant and well below their peak. One positive economic indicator is that foreclosure rates have come down relative to the state average, though they remain high.

Like Riverside, Merced's balance sheet remains fairly healthy, but the city's overall credit profile has weakened significantly following five consecutive annual operating deficits, back-to-back declines in assessed value, a more than 60% decline in home prices, and persistently high unemployment that exceeds both the state and U.S. averages.

The second factor is Moody's changed view of the pledge supporting the underlying payments by the pool participants. The agency said it believes this pledge is relatively less secure than its prior estimates, both in terms of probability of default and likely losses in the event of default.

Security for the underlying bond payments for these pension obligation bonds is a contractual pledge of each of the participants backed by all of their available financial resources. This promise is notably in contrast to the stronger, voter approved general obligation pledge that provides a baseline for our estimate of the credit quality of pension obligation bonds.

Under California law, a city's GO pledge is an unlimited ad valorem property tax pledge.

The city must raise property taxes by whatever amount necessary to repay the obligation, irrespective of the city's general financial position. A pledge to repay a debt issued to refinance pension liabilities, however, is a contractual obligation, on parity with a city's other unsecured obligations.

The relative performance of California cities' property tax bases and their financial profiles through the recent economic cycle, and likely continued divergence going forward, has resulted in Moody's creating a greater distinction between these different types of pledges than we had previously.

The bonds are secured by local agency obligations purchased with bond proceeds, namely taxable pension obligations of the pool participants, which are unconditional obligations. Prior to issuance, each of the participating municipalities filed a complaint in the Superior Court of California and received a default judgment stating that the promise to pay debt service on the Series 2004 A-1 bonds was a valid, legal, and binding obligation. Proceeds of the 2004 A-1 bonds were used by the pool participants to finance all or a portion of their unfunded pension liability.

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