N.Y. Downgrade Risk Not Being Priced

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The risk of a downgrade to New York’s general obligation debt isn’t being priced into the state’s bonds, an investment management firm said in a report released Friday.

The state’s fiscal problems and “dysfunctional political process” could lead to a downgrade despite stable credit ratings according to a report by Evercore Wealth Management, an investment management firm.

A confluence of factors make this year particular difficult for the state to put its fiscal house in order, said Howard Cure, director of municipal research at Evercore and author of the report. Not only does Gov. David Paterson need to close a $6.8 billion budget gap next week when he proposes his fiscal 2011 budget. The budget also needs to be balanced without the benefit of federal stimulus funds, which largely expire in calendar 2010.

But 2010 is both an election year and a Census year. With Democrats holding a slim majority in the U.S. Senate, a change in power could affect the redistricting process, thus providing a strong disincentive to make unpopular choices, Cure said.

“It’s going to be very difficult to negotiate some viable long-term budgetary solutions in this type of environment,” Cure said. “We’re just concerned about the downgrade risk.”

A downgrade would make the bonds less liquid in the secondary market, he added.

“If there are problems in balancing the budget and getting a budget passed and meeting basic bills without having to delay certain payment then the we would be concerned about the liquidity,” Cure said. “There will always be a market but I think it could be a money losing proposition.”

The state sells debt on several different credits and GO debt is a relatively small portion of its $53.6 billion of outstanding debt. The state has $3.3 billion of GO bonds outstanding. Concern about the credit relates to lease-backed debt as well, of which New York has $26.1 billion outstanding, Cure said.

The state’s main vehicle for selling bonds in recent years has been its personal income tax credit, secured by a 25% pledge of state income tax receipts. Last year the state sold $5.71 billion of new-money PIT bonds compared to $804.1 million of GOs.

Evercore has sold some of its New York GO bonds and replaced them the personal income tax bonds. Evercore views that credit more favorably because of legal requirements that the income tax funds cannot be used for other purposes until debt service has been paid.

Evercore is not alone in their assessment of the credit.

“We think the state has significant challenges and could potentially get downgraded somewhere down the line,” said Evan Rourke, portfolio manager at Eaton Vance. “Most of that’s tied into our assessment of the economic risk given that so much revenue comes from the financial sector.”

The three major ratings agencies have stable outlooks on New York’s GOs. Moody’s Investors Service rates the credit Aa3, Standard & Poor’s rates it AA and Fitch Ratings rates it AA-minus.

In November, Moody’s cautioned that it could take ratings action if the state did not address its budget problems or relied too heavily on non-recurring actions.

“We are just waiting to see what New York State does,” said Moody’s analyst Emily Raimes. “What kind of budget they propose and what the Legislature comes up with.”

The state Division of Budget has not responded to repeated requests for clarification.

A debt trade last week showed that ­investors still see the state GO as ­expensive relative to 30-year

­double-A ­Municipal Market Data ­index. On Thursday, a ­customer bought $35,000 of Series 2009A state 30-year tax-­exempt GO debt at a yield of 4.25% on the ­secondary market, according to ­Municipal Securities ­Rulemaking Board trade data. That trade was five basis points more expensive than the ­double-A MMD.

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