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Fitch Rates $550MM California GO Bonds 'A-'; Outlook Stable

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings assigns an 'A-' rating to $549.8 million in various purpose general obligation (GO) refunding bonds of the state of California.

The bonds are expected to sell via competitive bid on Oct. 23. The par amount is approximate and will be determined upon final sale.

In addition, Fitch affirms the 'A-' rating on approximately $72.6 billion in outstanding GO bonds of the state.

The Rating Outlook is Stable.

SECURITY

General obligations, for which the state pledges its full faith and credit, subject to the prior application of moneys to the support of public education; funds for education represent approximately half of state spending.

KEY RATING DRIVERS

WEALTHY, DIVERSE ECONOMY: The economy is wealthy and unmatched among U.S. states in its diversity and breadth. Growth has resumed after severe, widespread recessionary conditions.

HISTORY OF BUDGET AND CASH STRESS: State finances are subject to periodic, severe budget and cash flow crises due to structural imbalances, revenue cyclicality and institutional inflexibility.

VOLATILE REVENUES: Revenues are volatile, notably the component tied to personal income. Modest revenue growth has resumed since the downturn although the course of future collections is uncertain.

TANGIBLE STRUCTURAL PROGRESS: Deep spending cuts in the last two adopted budgets have significantly lowered the state's structural imbalance. Among many challenges to maintaining structural progress is the state's historical inability to achieve and sustain budgeted expenditure reductions.

VOTER INITIATIVES LIMIT FLEXIBILITY: Constraints imposed by voter initiatives and a partisan policy-making environment have repeatedly hindered timely, effective action on fiscal challenges.

MODERATE DEBT BURDEN: Tax-supported debt is moderate, but has grown in the last decade for infrastructure needs and budgetary borrowing.

CREDIT PROFILE

California's 'A-' GO bond rating and Stable Outlook reflect its persistent budgetary and cash challenges and limited fiscal flexibility tied to ongoing structural deficits and institutional constraints to sustainable budget-making. These credit weaknesses are offset in part by the size and breadth of the state's economy and tax base and the strengths inherent in a state's broad powers.

Fiscal uncertainty has diminished as California's economic recovery has strengthened and the state has taken repeated, material steps to narrow structural gaps. Despite clear progress, credit uncertainties remain considerable, including the strength of the state's nascent economic and revenue recovery, whether voters consent to budgeted temporary tax rate increases or reject them, triggering offsetting cuts, and the state's ability to fully achieve and sustain budgeted gap-closing solutions. Voter consent on the tax package in November could leave the state poised for further structural gains, allowing it to begin repaying the sizable budgetary borrowing accrued in the last decade, but would likewise expose the state to further tax revenue volatility.

ECONOMY

California's economy is unmatched in diversity among U.S. states. Recovery is taking hold after a particularly deep and protracted recession, although economic recovery remains uneven. August 2012 employment is up 2.2% from August 2011, higher than the 1.4% national rate for the same period. Employment gains are widespread, particularly in key service sectors, and construction employment has returned to growth. However, California's unemployment rate remains well above the national average, at 10.6% in August 2012 vs. 8.1% nationally. Personal income is also growing, with the second quarter of 2012 rising 3.7% year-over-year, compared to 3.3% nationally. The state's latest economic outlook, released in May 2012, foresees economic activity in 2012 and 2013 accelerating after generally sluggish growth in 2011, although the unemployment rate is expected to remain at historically elevated levels.

FINANCES

California fiscal performance in recent decades has been marked by cyclical revenue collections and periodic, severe budgetary and cash flow crises. Resolution of the state's fiscal challenges has often been delayed, reliant on non-recurring solutions, and constrained by restrictive voter initiatives. The state's uncertain economic and revenue recovery, in contrast to the much stronger post-recessionary experience after prior downturns, has resulted in persistent fiscal strain. To date this has left the state with little flexibility to begin making progress on paying down past budgetary borrowing.

Positively, the state's last two budgets were adopted on a timely basis and incorporated sizable recurring spending reductions, narrowing its structural imbalance. The fiscal 2012 budget closed a cumulative gap estimated in January 2011 at $26.6 billion (equal to 15.3% of baseline general fund revenues). The plan relied on $15 billion in spending reductions along with an optimistic revenue forecast and non-recurring items to achieve balance. Given underperformance of actual revenues in the course of the year, spending cuts of approximately $880 million were triggered mid-year, enabling the state to quickly offset a portion of the revenue underperformance. Nonetheless, the combination of revenue erosion and an inability to achieve certain enacted solutions required the controller to implement $3.3 billion in measures to augment cash resources. The state estimates that fiscal 2012 closed with a negative fund balance of $2.9 billion.

The adopted budget for fiscal 2013, which began on July 1, closed a gap of $15.7 billion (equal to 17.8% of general fund revenues and transfers) and leaves a forecast year-end available reserve of $948 million. The $16.6 billion in adopted solutions includes recurring and non-recurring spending reductions ($8.1 billion), revenue measures ($6 billion) and other transfers and loans ($2.5 billion). The state's revenue outlook assumes voter consent in November to temporary personal income and sales tax rate increases, which would generate $8.5 billion in gross revenues and $5.6 billion in net revenue for the general fund. Voter rejection of the measure would trigger $6 billion in automatic spending reductions, the vast majority of which would affect K-12 education.

Despite recent structural gains, considerable budgetary uncertainty remains through fiscal 2013 and beyond. Enactment of the temporary tax package could enable the state to make progress toward repaying the sizable budgetary borrowing built up over the last decade, but would also leave the state more reliant on volatile personal income tax receipts. If the tax package is rejected by voters, triggered cuts would absorb most, but not all, of the foregone revenues. Beyond the achievability of the voter initiative, the state has consistently faced challenges implementing and sustaining planned spending cuts due to litigation, federal rejection of program changes, or other obstacles.

DEBT AND PENSIONS

California has a moderate but above-average debt burden, with net tax-supported debt of approximately $91.8 billion as of Sept. 1, 2012, equal to 5.5% of 2011 personal income. The debt burden has risen over the last decade due primarily to substantial GO bond issuance for infrastructure and borrowing to cover budget gaps. Net tax-supported debt excludes cash flow borrowing; in August 2012 the state issued $10 billion in revenue anticipation notes for FY 2013 cash flow, higher than in fiscal 2012 but generally consistent with recent experience.

System-wide funded ratios on a reported basis for the state's two main pension systems, covering public employees and teachers, have eroded due to investment losses. Based on their June 30, 2010 actuarial valuations, the public employees' plan reported an 83.4% system-wide funded ratio and the teachers' plan reported a 71.5% system-wide funded ratio.

Using Fitch's more conservative 7% discount rate assumption, funded ratios for the two systems fall to 77% for public employees and 66% for teachers. On a combined basis, net tax-supported debt and pension liabilities attributable to the state are estimated by Fitch at 8.4% of 2011 personal income, above the 6.6% median of Fitch-rated states.

Some reforms to pension contribution levels and benefits were adopted with the state's fiscal 2011 budget, and both systems have reduced their discount rate assumptions. Full actuarial contributions to the public employees' system are legally required, but not for the teachers' system, leading to persistent underfunding of the latter. The governor and legislature agreed in August 2012 to a broad package of pension reforms that would affect most state and local systems, including through benefit reductions for new workers and higher contributions for employees. While changes are expected to generate only modest near-term annual savings for the state and for local governments whose pension plans are subject to the reforms, annual savings are expected to grow considerably over time.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from IHS Global Insight.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

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Fitch Ratings
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Douglas Offerman
Senior Director
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Fitch Inc.
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Secondary Analyst
Karen Krop
Senior Director
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elizabeth.fogerty@fitchratings.com

Source: Fitch Ratings

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