Standard & Poor's Ratings Services said it has revised its outlook on Michigan's general obligation bonds and appropriation-backed debt outstanding to stable from positive.
At the same time, it affirmed the AA-minus rating on the state's GO debt and its A-plus rating on the state's appropriation-backed debt. S&P also assigned a AA-minus rating to Michigan's series 2016A GO bonds. The outlook is stable.
"The revised outlook reflects our view that rising costs tied to the Flint water crisis and Detroit Public Schools' (DPS) distressed financial position will limit the state's ability to build reserves over the next two fiscal years," said Standard & Poor's credit analyst Carol Spain.
While the governor's budget proposal does not draw on budget stabilization fund (BSF) reserves in fiscal years 2016-2018, planned deposits are minimal, which represents a reversal of a what S&P previously viewed as a commitment to significantly build reserves.
Furthermore, the governor has proposed the use of general fund reserves in fiscal 2016 to finance supplemental expenditures for the Flint water crisis, Michigan Infrastructure Fund, and DPS. Given projections of minimal general fund balances to end the next two fiscal years, should costs tied to the Flint water crisis or assistance to distressed local governments exceed proposed amounts, S&P believes there is strong potential that BSF funds could be tapped.
Although many of the governor's budget proposals are pending legislative approval, the agency believes, there is significant political pressure for the state to contribute funds toward both Flint and DPS. It is likely that costs related to the Flint water crisis over the next two years will surpass the executive budget's projections.
"Michigan currently has the wherewithal to support projected additional costs and maintain the current rating," said Spain, "but if costs related to the Flint water crisis or distressed local credits escalate, there could be credit pressure."
The series 2016A GO bonds will be used to finance the Great Lakes Water Quality Bond Fund.
"The stable outlook reflects our view of the state's currently projected structural balance over the two-year outlook horizon and slow projected economic growth," added Spain. It also reflects recent improvement in state pension contributions and the state's expressed commitment to funding the full annually determined contribution.
Building reserves during good economic times, such as now, is of particular importance to state credit quality due to the cyclical nature of Michigan's economy and finances, S&P said. Despite additions to the BSF budgeted for 2016, the agency still view balances as being at only adequate levels.
If Michigan builds and maintains higher reserves, the rater could consider an upgrade; however, it believes recent challenges related to the Flint water crisis and other assistance to local governments could constrain the state's ability to build reserves in the medium term.
Currently projected reserves provide Michigan with flexibility to address a degree of unforeseen expenses, S&P said. However, a significant decline in reserves could leave the state more vulnerable in the event of a potential downturn in the economy. While currently unlikely, structural imbalance over time, further weakening of state economic conditions compared with peers, or a significant use of BSF reserves could lead the rating agency to consider a downgrade.
