LOS ANGELES— Moody's Investors Service upgraded more than 90% of the 200 California credits it reviewed as a result of a new methodology for lease revenue bonds and comparable debt.
The rating agency adopted the new methodology in July and just completed a review of all of the lease revenue, appropriation, moral obligation and comparable debt it rates.
The review was conducted nationally, but the changes were more significant for California, because of a change in how abatement and equipment leases are rated, said Eric Hoffmann, who manages Moody's California local government ratings team.
"Most states' contingent obligations were not affected," Hoffmann said. "We did make a few changes at the margins to some of our thinking about lease-revenue credit that results from dedicated revenue changes. We also determined that park assets were less essential."
Historically, Moody's had considered park assets to be essential, so the change resulted in downgrades of lease-revenue bonds that had park assets backing them across the country, he said.
General government contingent debt is the most common form of borrowing by U.S. state and local governments, according to Moody's.
Contingent debt, which includes lease, appropriation and moral obligation, is most commonly used for "construction and renovation of government administration buildings, public safety/correctional facilities, and schools," Moody's analysts wrote in the July report. The debt category is also used to finance hotels, parking garages, sports facilities and theaters.
Moral obligations are usually seen at the state level and are a form of credit enhancement where a highly credit-worthy government pledges its moral obligation to enhance a specific borrowing by a government of lesser credit quality.
The biggest changes in methodology were the removal of an additional notch for abatement risk and the additional notch for essential equipment leases, which were more of a factor in California, Hoffmann said. The change resulted in two-notch upgrades for many equipment leases, because they were typically rated three notches below GOs.
Moody's notches lease-revenue and other contingent obligations off its general-obligation bond ratings.
"It is simply based on our expectation for lease-revenue bonds that there is a higher probability of default relative to general obligation bonds. And, in the event of default, the recovery is not likely to be as good as it would be for a GO," Hoffmann said.
Moody's uses two key factors to determine how far to notch the contingent obligation rating from the issuer's GO rating, according to its July report on the methodology changes. The factors are: the essentiality of the leased asset or finance project, which means how important the asset or project is to the government in fulfilling its core function; and the strength of the clarity and timing of the administrative process to make the annual debt service appropriation decision.
For instance, public safety is considered a core function so debt backed by police stations, courthouses and jails is considered more essential making governments more likely to make payments on debt. Less essential assets would include community centers, theaters and economic development projects.
California is the only state that does an abatement lease where the lease payment is contingent on the use or occupancy of the leased asset, Hoffmann said. Other states primarily use annual appropriation leases, not abatement leases, he said.
"If you have a compromised use or occupancy of the asset, you are forced to abate in proportion to the compromised use," Hoffmann said.
Analysts decided based on the probability of loss that abatement leases no longer needed to be notched one click lower than other lease revenue debt, he said.
The ratings changes were also a combination of market changes as well as the rating agency's methodology changes.
"As expected, some of these credits got two-notch upgrades based on a change in methodology and credit improvement," Hoffmann said. "There is a general trend of improvements in California credits generally and in these credits."
The majority of the upgrades were one-notch, according to data provided by Moody's.
The only downgrade was a one-notch drop to A2 from A1 for pension obligation bonds issued by the Oakland-based Peralta Community College District, Hoffmann said.
The downgrade came because Moody's already was rating POBs two notches below an issuer's GO rating, but Peralta's POBs were only one-notch down from its issuer rating, Hoffmann said.
"What we have seen in the event of fiscal distress or bankruptcy, POBs do not fare as well in terms of recovery as lease-backed obligations that have essential assets," he said.
POBs are unsecured, their recovery is poor and that additional notch reflects that unlikely recovery in the event of fiscal distress, Hoffmann said.
