DALLAS — Moody’s Investors Service yesterday downgraded Arizona’s issuer credit rating to Aa3 from Aa2 as the state faces continuing financial stress and diminished borrowing capacity.

In addition to the issuer downgrade, Moody’s lowered the rating on appropriation debt to A1 from Aa3. The A1 rating also applies to about $62 million of refunding certificates of participation expected to be priced next week for the Arizona School Facilities Board.

The downgrade comes after Arizona took extraordinary measures to overcome a $3 billion budget deficit in the fiscal year that began July 1, including mortgaging state office buildings to raise $1 billion for operating expenses and issuing $450 million of bonds backed by state lottery revenues.

The issuer credit rating affects about $2.4 billion of outstanding debt.

While Standard & Poor’s maintained its AA-minus issuer credit rating and its A-plus on the School Facilities Board COPs, it also retained a negative outlook.

While Moody’s provided a stable outlook on the new rating, analysts anticipate another fiscal year of steep challenges.

“We expect that the state will lag in the economic recovery as it will take some time to rebound from the severe housing market downturn, which has led to weakening in state finances and economy that is more significant than other states,” wrote lead analyst Maria Coritsidis. “Until the economy rebounds, the state will continue to experience fiscal pressure, which will be difficult to address given constraints on the state’s financial flexibility.”

The state’s lack of flexibility includes the loss of a $700 million line of credit from Bank of America that was tapped several times in the previous fiscal year. Treasurer Dean Martin has said that the state may not make it to October without needing more short-term borrowing. Martin, who this month dropped out of the Republican primary against Gov. Jan Brewer, killed the line of credit at a meeting of the State Loan Commission at which Brewer was absent. Martin blamed the loss of the lending facility on Brewer, one of three members of the commission.

“While fiscal 2010 year-end operating cash balances were positive (over $1 billion), initial cash-flow projections for fiscal 2011 indicated that the state could face cash deficits starting in October 2010 that would increase to a maximum low point of about $800 million in April 2011,” Coritsidis wrote.

The School Facilities Board certificates are payable from semiannual lease payments by the board under lease agreements. The lease payments are subject to annual appropriation from the state general fund and allocation of the funds for debt service by the board. Much of the borrowing of the past fiscal year was for lease payments for the schools. There are no conditions on the obligation to make lease payments, including no requirement regarding use and occupancy of the facilities.

Next week’s refunding ASF COPs are part of the budget-balancing maneuvers. The refunding is structured to push out maturities in order to achieve budgetary relief for the current fiscal year 2011.

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