Moody's Investors Service has assigned an Aa2 rating to $689.6 million of Commonwealth of Pennsylvania general obligation bonds, Second Refunding Series of 2009. The bonds are secured by the full faith and credit of the commonwealth and are expected to sell as early as August 25. Concurrently, the rating outlook has been revised to negative from stable, reflecting the state's declining available fund balances and the challenge it faces in rebuilding those balances. Additionally, the outlook reflects delays in resolving budget gaps due to falling revenues.
The outlook change also affects $911 million of appropriation-backed debt issued through the Commonwealth Financing Authority, the Philadelphia Regional Port Authority, and the Harristown Development Authority.
Credit Strengths:
-- State debt position is moderate and well-controlled with tax-supported debt ratios roughly at national average levels, and a comparatively well-funded state pension system.
--Diverse, broad, and relatively stable economy; with wealth levels are slightly above the national average. While the state is in recession, the large health and higher education sectors have moderated employment losses.
--The commonwealth's established record of good financial management and willingness to take actions to balance its budget.
Credit Challenges:
--The commonwealth's pattern of declining operating balances in recent years.
--The need to rebuild the budget reserve fund which is likely to be entirely drawn down to fill revenue shortfalls.
--Anticipated declines in liquidity, expected to cause first short-term borrowing during fiscal 2010
--A long trend of below-average growth in population, employment, and personal income, and the continuing loss of manufacturing jobs that reflects the mature nature of the state's economy.
--Capital funding pressures to replace aging infrastructure.
REVENUE SHORTFALL LEAVES $2.7 BILLION OPERATING DEFICIT IN FISCAL 2009; FISCAL 2010 BUDGET NOT PASSED IN FULL
Commonwealth revenues fell significantly short in fiscal 2009, which ended on June 30, leaving a large unresolved deficit. General Fund revenues ended the year $3.25 billion-or 11.3%-below the certified estimate and about 10% below those received in 2008. The shortfall occurred in all three major revenue sources of personal income tax, sales tax, and corporate taxes, with particularly steep drops in the non-withholding portion of the income tax (down 27%) and the portion of the sales tax attributed to vehicle purchases (down 13%).
As the shortfall opened during fiscal 2009, the Governor unilaterally made approximately $500 million of mid-year budget cuts. He proposed filling the remainder of the shortfall with $1.1 billion of federal stimulus funds and use of the rainy day fund and other balances. The legislature however, did not act to approve or replace these measures, and so the commonwealth ended the fiscal year with an unappropriated balance of negative $2.74 billion, essentially rolling the shortfall forward into fiscal 2010.
A complete fiscal 2010 budget has not been approved, and continues to be debated. The governor generally favors increasing revenues and use of balances and federal stimulus, while many legislators-particularly in the State Senate-prefer broader spending cuts to reduce the need for new revenues and rapid use of federal stimulus and balances. The resolution of the fiscal 2009 shortfall has effectively been included in this negotiation.
On August 5, the governor signed a partial budget, which provided for 1) essential operations including employee wages and benefits, 2) general obligation and lease/appropriation debt service, 3) operations for prisons, state police, and mandated costs for health and welfare systems. The budget did not include other core spending items such as basic education funding, grants and aid to local governments, and other health and welfare programs. The partial budget certified a revenue estimate of $25.6 billion, and appropriated just $10.9 billion.
Delays in state budget adoption, while not new or unique to Pennsylvania, have become chronic in this decade, which Moody's views with concern because it has reduced the commonwealth's ability to respond quickly to shortfalls. It has also added instability and made financial planning more difficult for both the commonwealth as well as its local governments.
Despite the stubborn nature of the dispute, Moody's believes that the challenge the commonwealth's policy makers face is manageable. The $2.7 billion gap is about 10% of the state's budget, and the current general fund balance is approximately $2.9 billion, or when other funds are included-such as the $750 million rainy day fund and the $700 million health care provider retention account-the state has total of $5.5 billion in surplus funds available for operations, if needed. Further, policy makers have a wide variety of options available, including several proposed new ongoing revenue sources such as temporary income tax increases, suspending the phase out of the capital stock and franchise tax, and increasing various tobacco taxes. All key parties to the budget negotiation have also reportedly expressed willingness to consider significant ongoing spending reductions. Finally, the state also has access to federal fiscal stimulus funds. The August 5 partial budget uses $1.1 billion of those monies, and the governor had previously proposed utilizing $2.5 billion in fiscal 2010 and $1.9 billion in fiscal 2011.
STRAINED LIQUIDITY EXPECTED TO LEAD TO FIRST SHORT-TERM BORROWING IN OVER 10 YEARS
Sturdy liquidity has been a credit strength of the commonwealth, and while this is still evident, balances are expected to be drawn down during the upcoming fiscal year as they are used to support operations. The commonwealth is authorized to borrow up to 20% of expected revenues for cash flow purposes during a fiscal year and the notes must mature during the fiscal year in which they are issued. While the commonwealth has not borrowed for cash flow since fiscal 1998, it is anticipated to execute such a borrowing this year, with the size, timing, and nature of the borrowing dependent on the result of the budget negotiations. While it is not unusual for states to make use of cash flow borrowing, Moody's does consider an increase in cash flow borrowing size from year to year to be a sign of stress.
Currently, the commonwealth has a $2.9 billion general fund balance. When all funds-including the $750 million budget reserve and $700 million in a health care providers retention account-the commonwealth has access to $5.5 billion, if needed, for operations.
EMPLOYEE RETIREMENT AND OPEB COSTS CREATE OUT-YEAR BUDGET PRESSURE; UPDATED OPEB VALUATION REFLECTS LOWER LIABILITY
The State Employee's Retirement Fund (SERS) and the Public School Employees Retirement Fund (PSERS) are relatively well-funded. SERS was funded at 89% on December 31, 2008, while PSERS was funded at 84.1% as of December 31, 2007. Fiscal 2009 combined contributions are budgeted at $585 million. Fiscal 2008 and 2007 combined contributions were $684 million and $602 million, respectively. Pension contributions are expected to rise sharply starting in 2013, when the effect of a 2003 law that loosened the amortization schedule expires. The 2013 contribution was estimated at $1.5 billion in June of 2008, but is now expected to be higher due to negative investment returns.
Based on a February 2008 updated valuation, the commonwealth's other post-employment benefits (OPEB) liability was lowered from $13.8 billion, with an actuarially annual required contribution (ARC) of $1.1 billion, to $8.5 billion with a lower ARC of $705 million. This was the result of collective bargaining agreements that resulted in significant increases in annuitant share contributions. These agreements affect roughly 73% of all commonwealth employees and increase the employee contribution in the retiree health program from 1.0% of final gross salary to 3.0%, phased-in through 2011. The fiscal years 2008 and 2009 ARCs were fully funded. While Pennsylvania's liability remains sizeable, Moody's considers its actions to reduce the liability and its full funding of the ARC to be positive.
RECESSION EVIDENT IN STATE ECONOMY
Pennsylvania began to lose jobs on a year-over-year basis in October 2008, well after national declines began, and the job losses have accelerated quickly since then. July 2009 non-farm employment of 5.7 million was down 3.2% from June 2008, a steep decline that was nonetheless more favorable than the nation's 4.2% loss. Manufacturing, 11% of Pennsylvania's total employment, was down a steep 11.3% in July over the prior year. Unemployment in June rose to 8.3%, the highest since 1985, but again below than the nation as well as neighboring states. Job losses in Pennsylvania have been moderated by the modest growth in its large health and higher education sectors, which include Pennsylvania's three largest private employers: the University of Pittsburgh Medical Center (Aa3, Negative Outlook), and Jefferson Health System (Aa3, Stable) and the University of Pennsylvania (Aa2, Stable), the latter two of which are both in Philadelphia.
Per capita personal income levels in Pennsylvania have closely tracked the nation for decades. In 2008, per capita personal income of $40,265 was 101.3% of the U.S. The commonwealth does face some impediments to long-term economic growth, including slow population growth and an aging population, large infrastructure needs, and continued exposure to a still-sizeable traditional manufacturing base.
MODERATE DEBT LEVELS EXPECTED TO BE MAINTAINED
Pennsylvania has a strong debt position, although the growth of the commonwealth's net tax-supported debt in recent years has been slightly quicker than its growth in personal income. The ratio of debt to personal income is 2.5%, on par with Moody's 2009 50-state median. The commonwealth's debt issuance is expected to increase modestly in the coming years as the result of bond authorizations for economic stimulus and environmental improvements. Even so, the ratio of annual debt service (including lease payments) to annual revenue in both the General Fund and Motor Vehicle License Fund has been consistently below 4%. Tax-supported debt is nearly 90% general obligations and debt amortizes rapidly, with general obligations fully retired in 20 years. The commonwealth's general obligations and lease appropriation debt is entirely fixed rate, with no outstanding interest rate swaps. Moody's views this as a conservative approach and a credit positive.
MOST RECENT RATING ACTION
The last rating action with respect to the Commonwealth of Pennsylvania was on May 14, 2009, when a Aa2 rating with a stable outlook was assigned to the Commonwealth of Pennsylvania General Obligation Bonds First Refunding Series of 2009.
The principal methodology used in rating this issue was Moody's State Rating Methodology, which can be found at
OUTLOOK:
The outlook for the Commonwealth of Pennsylvania is negative, reflecting the state's declining available fund balances and the challenge it faces in rebuilding those balances. Additionally, the outlook reflects delays in resolving budget gaps due to falling revenues. Liquidity, while strong, is expected to decline.
What could change the rating - UP?
-- Significant improvement in the commonwealth's trend of economic growth, accompanied by continued good budgetary and financial management, including reserve replenishment and a return to structural balance.
What could change the rating - DOWN?
-- Further economic deterioration leading to worsening revenue performance and a reduction in liquidity. Additionally, failure to adopt a fiscal plan that will restore structural budget balance, particularly when federal fiscal stimulus dollars are no longer available may pressure the rating.
