Understanding California's Fiscal Recovery

Primary Credit Analyst: Gabriel J Petek, CFA, San Francisco (1) 415-371-5042; gabriel.petek@standardandpoors.com Secondary Contact: David G Hitchcock, New York (1) 212-438-2022; david.hitchcock@standardandpoors.com

SAN FRANCISCO (Standard & Poor's) Jan. 14, 2014--In Standard & Poor's Ratings Services' view, California's credit quality has been strengthening since 2011. But we trace the origins of its fiscal recovery to just before that -November 2010. That's when voters passed Proposition 25, amending the state constitution to allow a majority of the legislature to pass the state budget. Since Proposition 25 was passed, the state has not begun a fiscal year without its budget in place. And it's not just because ever since the measure passed, the state's fiscal condition has made budgeting easier. Indeed, the first two budgets following passage required the state to first close projected deficits of $26.6 billion and $15.7 billion, respectively. The earlier two-thirds requirement meant that a minority block of legislators could effectively shut down the budget process rather than concede to budget provisions they disagreed with. In our view, budget negotiations are inherently political, but as the legislative caucuses grew increasingly polarized throughout the 2000s, common ground became harder to find. Increasingly volatile revenue trends only exacerbated the fiscal implications of the standoffs. But when revenue collections began plummeting following the onset of the 2008 financial crisis, the need for structurally significant and potentially politically unpalatable budgets solutions became more urgent. And yet even in the face of widening deficits and intensifying liquidity pressures, the legislature struggled to reach the supermajority consensus necessary to pass budgets. The stalemates seemed to be getting more intractable with each passing year. For fiscal 2011, the budget wasn't passed and enacted until Oct. 8, 2010, a record 100 days after the fiscal year had begun. LATE BUDGETS COMPLICATED CASH MANAGEMENT

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Periodic liquidity pressures were bound to occur given the state's underlying fiscal misalignment. But the perennially delayed budgets made these episodes more acute and complicated the controller's ability to manage the state's cash. Without its budget in place, which had become common early in the fiscal year, the state couldn't access the capital markets to sell its revenue anticipation notes (RANs). In most fiscal years, the state issues RANs, typically as a routine but critical method of ensuring that its general fund maintains sufficient liquidity throughout the year. The RANs are used because the state's cash outflows are evenly disbursed, or are even frontloaded in the fiscal year. In contrast, the state doesn't receive a majority of its tax receipts until late in the year, which is also when it repays the RANs. Somewhat counterintuitively, we believe the absence of an enacted budget has sometimes helped the state conserve cash, at least in the short run. When it would begin the fiscal year without a budget, some of the state's payment obligations lacked an appropriation and would go unpaid, causing the state to conserve cash. The situation, therefore, temporarily strengthened the state's ability to pay its priority payments. The state's priority payments include those that are required by the constitution, such as for the schools. Debt service is also among the priority payments, and importantly, continues to be paid even in the absence of an enacted budget. But even if it wasn't paying its nonpriority obligations, soon enough the state would deplete its available cash. The controller expressed just this concern in July 2009 and said that, without an enacted budget, the state's priority payments would be in jeopardy by the end of the month. Unable to issue the RANs, the controller began issuing registered warrants ("IOUs") in order to preserve cash for priority payments. The state would go on to pay $2.6 billion of its nonpriority obligations with IOUs it issued through Sept. 4, 2009. The strategy bought time, but the controller warned that a more genuine remedy was necessary and that, by October, priority payments would again be in jeopardy despite the IOUs. Use of the IOUs was among the more aggressive types of extraordinary cash management tools deployed by the state throughout the 2008-2011 timeframe. But there were others. Some were administrative, such as when the controller temporarily deferred the payment of some obligations, including tax returns. Other actions -- including deferring the payment of certain obligations on an intra-year basis -- required legislative approval. The legislature also periodically expanded the list of internal state funds from which the general fund may temporarily borrow for cash flow purposes. In contrast with the budget, where larger fiscal policy issues get debated, the legislature retained a less politicized posture when it came to cash management. It was even able to assemble a supermajority in a timely manner when necessary. Although it was under financially stressful conditions, the state was willing and able to engage in nontraditional cash management, which, in turn, displayed its fundamental creditworthiness. It also explains, in part, why our rating on the state's GO bonds never went to below the 'A' category. While these actions proved crucial to the state when it was most financially

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vulnerable, they amounted to emergency measures in our view, not solutions to the state's underlying fiscal problems. STRUCTURAL DEFICIT WAS AT THE ROOT OF THE STATE'S CASH PROBLEMS The state's structural deficit was at the root of its liquidity problems. By repeatedly assuming higher revenues than would actually materialize throughout much of the 2000s, the state had established an unaffordable expenditure baseline. Between January 2008 and January 2011, the state's three main taxes -- personal income, sales and use, and corporate -- had come in more than 25% below the state's forecasts. In its fiscal 2010 budget, for example, the state initially assumed $97.7 billion of general fund revenue but ultimately would only collect $87 billion. But once enacted, budgets dictate spending as a matter of law, regardless of whether actual revenues materialize in accordance with what the state has forecasted. And unlike with some states, in California the governor has minimal authority to unilaterally adjust appropriations in times of budget stress. As revenue collections repeatedly fell short of what the budgets had assumed, the state funded an increasing share of its operational expenditures with borrowed cash. As a result, the general fund cash deficit that began on July 13, 2007 deepened. By June 30, 2009, the general fund cash deficit stood at $11.9 billion, up from $1.5 billion at the same point in 2008. RELIANCE ON ONE-TIME FIXES PERPETUATED FISCAL STRESS The state's fiscal problems were not just the result of revenue weakness and late budgets, however. Lawmakers had come to rely heavily on one-time or temporary deficit closing measures. In our view, the two-thirds legislative vote requirement for budget passage put a premium on political expedience and contributed to the difficulty in reaching agreement on more sustainable budget fixes. But whatever the cause, few of the steps taken to bridge the deficits in those years offered recurring benefit for future budgets. And in fact, many of them involved borrowing, either in the form of payment deferrals or making loans to the general fund from other internal funds of the state. The Department of Finance estimates that about 80% of the gap-closing measures adopted in the three fiscal years from 2009 through 2011 were nonstructural. And the reliance on temporary gap-closing measures -- or ones that faltered altogether -- perpetuated the state's budget crisis. Due to the failure to address the underlying structural gap, the deficits continued to reappear and cumulatively topped $100 billion in just the three fiscal years from 2009 through 2011. A NEW APPROACH Shortly after taking office, and only about three months since the fiscal 2011 budget had been enacted, Governor Jerry Brown's administration identified a nearly $27 billion projected budget deficit for fiscal 2012. In May, with the state still facing a large shortfall, the governor for the first time also highlighted that the state had amassed $34.7 billion in budgetary liabilities. The governor was pointing out that, by having repeatedly failed to confront its structural budget misalignment and by relying on borrowing, the state had created a second problem. He termed the backlog of budget liabilities the "wall of debt." Budget liabilities interfere with the state's ability to build

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a fiscal cushion during periods of economic and revenue growth. Paying for the budget liabilities also siphons away current-year revenue to, in effect, pay for prior-year budgets. From a credit perspective, we have consistently asserted that there is some urgency to retiring the budget liabilities while the temporary tax increases of Proposition 30 are in effect. Once the tax increases expire, paying off the budgetary debt would require starker policy tradeoffs and would also likely be politically more difficult. In our view, the governor's budget proposal to prioritize the repayment of these debts has favorable implications for the state's credit quality. PLANNING FOR THE FUTURE With a more sustainable fiscal alignment now in place, the governor's proposal would begin laying a foundation for better preserving financial stability going forward. First, taking advantage of currently strong revenues to accelerate the payment schedule, the governor presents a realistic path for retiring the balance of the budget liabilities by the close of fiscal 2018. Second, and with the resolution of the budget liabilities now in sight, the governor's plan turns to confronting the state's fiscal volatility. But rather than attempt to transform its revenue structure, the governor would establish a rainy day fund specifically designed to dampen the effect of the state's revenue cyclicality and spending inflexibility on its financial position. To this end, the governor proposes to scrap and replace the current rainy day fund concept currently scheduled to go before voters as a constitutional amendment on the November 2014 ballot. Although the governor's rainy day fund proposal has several provisions, we believe there are three that stand out from a credit perspective: It would increase the maximum size of the rainy day fund to 10% of revenues from 5%. In our view, a reserve of up to 10% could go a long way in helping to cushion the negative effect the state's revenue volatility has on its finances. Deposits into the fund would be tied to a key source of the revenue volatility -- capital gains. Specifically, the rainy day fund would capture the increment of capitals gains-related tax revenue above 6.5% of general fund revenue, a threshold that has been topped in eight of the past 10 years. Also, to the extent the state owed them, the state could make supplemental payments to retire any budgetary or other long-term liabilities in lieu of making a deposit. The governor proposes establishing a Proposition 98 reserve. We believe this could be beneficial for the state's credit quality because, Proposition 98 has been a source of spending-side volatility that has periodically strained state finances. Proposition 98 was a voter initiative and a constitutional amendment passed in 1988 that sets the annual minimum amount of funding for California school districts and community colleges (K-14). The precise amount of funding is determined through the applications of several tests that weigh enrollment and general fund revenue growth and inflation in relation to one another.

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Depending upon the interaction of these variables, the minimum funding guarantee can sometimes surge upward. Alternatively, in years of relatively weak general fund revenue growth, one of the Proposition 98 tests (Test 3) allows the legislature to appropriate less K-14 education funding than if growth were not as slow. The legislature can also suspend the minimum guarantee outright with a two-thirds vote. However, in either case, the state must track the actual level of funding to what would have been provided absent the slow growth. In future years, when the state's revenue growth accelerates, it's required to make extra payments to restore the funding level to where it would have been. As we interpret it, the governor's proposal, which is an outline at this point, would set aside a portion of the funds that would normally go to the schools in the years during which the guarantee surges upward. Presumably, it would then release all or a portion of the funds in Test 3 years or other fiscal years when the funding is not sufficient to fund enrollment growth and a cost of living adjustment, thereby somewhat smoothing out the funding trend. Taken together, we believe these rainy day fund provisions could help stabilize the state's budget performance and partially mitigate the effects of the state's tax structure on its fiscal position.

RELATED CRITERIA AND RESEARCH Related Research California, Jan. 14, 2014

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