More than $1 billion of bond-financed projects planned by Virginia could be delayed as the state’s new governor confronts billion-dollar deficits for fiscal 2010 and 2011.

The triple-A rated state also is waiting to see if Congress will pass legislation to convert qualified school construction bonds into direct-pay subsidy bonds, like Build America Bonds, before issuing a second round of tax-credit QSCBs next year.

Virginia’s newly elected governor, Republican Bob McDonnell, must deal with a $1.8 billion mid-year budget gap for fiscal 2010 as he prepares to tackle the fiscal 2011 and 2012 budgets. The state faces a $1.3 billion deficit for fiscal 2011.

Virginia’s outgoing governor, Democrat Tim Kaine, had to slash spending to cope with plunging revenue and this month announced a biennial budget plan that includes a 1% income tax increase to generate about $1.6 billion. In September, Kaine announced spending cuts to compensate for a $1.35 billion general fund shortfall.

McDonnell, who has the option to write a new budget or propose amendments to Kaine’s, has said he disagrees with the tax increase.

The governor-elect reiterated his predecessor’s commitment to preserve the state’s triple-A credit rating, but campaigned against any tax increases. The decision leaves the new governor to find $1.6 billion in additional spending cuts. The state’s fiscal year starts July 1 and the General Assembly convenes on Jan. 13.

Even before any changes, the budget as it stands now “is a substantially more austere budget than in recent years,” said Nicholas Samuels, an analyst with Moody’s Investors Service. “What we’re most focused on is that the budget includes structurally balanced solutions that align ongoing revenues with ongoing expenditures.”

Samuels noted that the budget does not extend the maturities on Virginia’s outstanding bonds.

Kaine’s budget includes $1.2 billion of debt-financed projects for the next two fiscal years, mostly for state colleges and building projects. The state has a bond covenant that limits debt service to 5% of revenues. As revenues decrease, the government has less room under the 5% cap to issue debt.

The limited revenue “puts those projects on a time line that they would not get issued right away,” said Evelyn Whitley, Virginia’s director of debt management. She said the Virginia Public Building Authority expects to issue $340 million in February for projects that have already been approved.

Budget problems have not dimmed investors’ appetite for the state’s debt, according to market participants.

“We have not had people questioning [Virginia’s] credit worthiness at this point,” said Joseph W. Paucke, senior vice president at Davenport & Co.

Neighboring Maryland also is rated triple-A and the District of Columbia has a AAA rating from Standard & Poor’s on its income-tax revenue bonds.

Investors nationwide have shown limited interest in the tax-credit qualified school construction bonds created by the American Recovery and Reinvestment Act. The QSCB market has languished even as investors have embraced Build America Bonds, also spawned by the ARRA. BABs offer a direct-interest subsidy from the federal government. As of Dec. 11, state and local governments have issued more than $63 billion of direct-pay BABs compared with $2.46 billion of tax-credit bonds, according to Thomson Reuters.

This month, the House passed legislation as part of a jobs bill that would offer municipalities a direct-pay subsidy from the U.S. Treasury for QSCBs and qualified zone academy bonds instead of a tax credit. The Senate has not yet considered the bill.

Virginia expects to delay issuing its second tranche of QSCBs until there is more clarity from Congress.

“We certainly don’t want to leap into them the old way if this new way might be a possibility,” Whitley said. Though she said the state was pleased with its initial pricing on a $61 million QSCB deal from November, the direct-pay subsidy would be “an easier execution.”

The limited number of QSCB buyers means that issuers have had to offer supplemental coupons or sell them at a significant discount, said Arthur Anderson, an attorney with McGuireWoods LLP who worked with Virginia on its initial QSCB deal.

QSCBs are “just not what was advertised,” Anderson said. “They were supposed to be par instruments.” The conversion to direct-pay BABs will help achieve that result for localities, he said.

Counties in Virginia also face similar budget difficulties.

Triple-A rated Fairfax County is the largest debt issuer among the state’s counties. It faces a 7.0% revenue decline in fiscal 2011. The county’s real estate tax base, which accounts for about 70% of its tax base, is forecast to decrease 12% in fiscal 2011, compared to growth above 20% in fiscal 2006 and 2007. Fairfax has lost $13.5 million it expected to receive from the state. An 11-cent increase in the real estate tax rate is expected to raise $199.1 million in fiscal 2011.

Fairfax will not need to issue new-money general obligation debt until October, according to Leonard Wales, the county debt manager.

Fairfax expects to issue $100 million of bonds for the Metrorail extension to Dulles International Airport this summer. However, the deal could be threatened by a legal challenge to the county’s special taxing district established to pay for the project. The case is pending before the state Supreme Court.

Construction on the Metrorail extension is already underway and the first phase is on schedule to be finished by December 2013. The second phase, which will reach the airport, is scheduled to be finished by December 2016.

The Metropolitan Washington Airports Authority, which oversees the Dulles extension project, expects to issue between $250 million and $600 million of new-money toll revenue bonds by May. The deal is likely to be primarily BABs, said Lynn Hampton, vice president and chief financial officer at the MWAA. The authority also expects to issue about $500 million by June for aviation projects, including new-money, refunding and commercial paper, she said.

Airport authorities will be watching Congress next year for an extension of the exemption of airport bonds from the alternative minimum tax. The exemption helped airports issue debt this year, according to Hampton.

Virginia’s local governments that have found themselves frozen out of the bond insurance market may be able to access the Virginia Resources Authority’s pooled loan program for financing. As Virginia’s third-largest issuer in 2008, the VRA expects to expand its pool of eligible borrowers in 2010, said Sheryl Bailey, the the agency’s executive director.

The VRA, which has $3.3 billion of loans outstanding to 81 local governments and agencies, expects to issue about $140 million of clean water bonds in March for eight projects, Bailey said.

The collapse of the bond insurance market “has greatly increased demand” for the authority’s services among local governments, according to Anderson.

“It does offer localities credit enhancement,” he said.

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