Fitch Downgrades West Virginia's IDR to 'AA'; Outlook Negative
--The state's Issuer Default Rating (IDR) to 'AA' from 'AA+';
--$393.6 million outstanding general obligation (GO) bonds to 'AA' from 'AA+';
--$441.6 million outstanding lease revenue bonds issued by the Economic Development Authority (EDA) and the School Building Authority (SBA) to 'AA-' from 'AA';
--$133 million outstanding West Virginia Water Development Authority (WDA) revenue bonds to 'A+' from 'AA-'.
The Rating Outlook is Negative.
GO bonds issued by West Virginia are backed by the state's full faith and credit. Special limited obligations of the EDA and SBA are payable from lease revenue payments from the state, subject to annual appropriation.
The bonds issued by the WDA are supported by multiple layers of security for bond repayment, with the strongest support, and the basis for the rating, provided by the state's moral obligation pledge to replenish the authority's debt service reserve funds, set at maximum annual debt service under each loan program, should any be utilized due to a borrower default.
KEY RATING DRIVERS
The downgrade of the state's IDR and GO bonds to 'AA' from 'AA+' reflects the state's economic and fiscal challenges that have reduced its financial flexibility and are expected by Fitch to continue over the next several years. Fitch believes long-term headwinds are significant, as coal production remains a key input to the state's economy and there is significant domestic and international momentum to reduce coal utilization. Fitch expects that financial stress will persist until such time as the decline in coal production bottoms out and is replaced by an expansion of the state's other natural resources or another positive development. The 'AA' IDR reflects the still sizable level of reserves at the state's disposal to provide cushion through this transition; however, the Negative Outlook reflects uncertainty as to the time frame by which the state will achieve budgetary equilibrium and the magnitude of the economic turmoil resulting from these trends.
The 'AA-' rating on the EDA and SBA bonds, at one notch below the state's IDR, reflects the requirement for annual state budget appropriations to pay debt service. EDA and SBA bonds have been issued to fund various capital projects at state office buildings and school facilities throughout the state. The 'A+' rating on the WDA bonds, which have been issued to support clean water projects in the state, at two notches below the state's IDR, reflects WDA's pledge to seek a state appropriation for reserve replenishment should the reserve fund be tapped due to a borrower default.
Economic Resource Base
West Virginia's economy has had a significant foundation in the development of its large coal reserves over at least the past century. A steep decline in demand for coal over the past two years, following varying declines that began in 2008, has slashed production and resulted in shuttered mines, substantial employment loss in the mining sector and contractions in the construction and manufacturing sectors, and increased unemployment. Development of the state's crude oil and natural gas reserves in the Marcellus and Utica Shales, which began in 2010, has increased substantially over this time period, but the substantial drop in crude oil and natural gas prices as well as a lack of transmission capacity have also hampered the state's economy and financial performance.
Bright spots in the state's economy have been the steady growth in the services professions as well as transportation, trade, and warehousing, with a particular focus on the areas located in the state's eastern panhandle that are near to Washington D. C. and its surrounding suburbs. Yet, the state's demographic profile remains comparatively weak and the state has steadily lost population to other states and regions.
Revenue Framework: 'a' factor assessment
Fitch expects West Virginia's revenues, which are supported by broad-based sources, to continue to reflect the economic volatility associated with its extensive natural resources sector. Revenues attributable to coal production are expected to exhibit persistent losses as the industry continues its long-term contraction, significantly inhibiting growth prospects for revenues overall. Although West Virginia has complete legal control over revenue-raising, Fitch believes realizing more healthy revenue growth will be challenging absent measures to capture revenue from other economic sectors or increased stability in the crude oil and natural gas sectors.
Expenditure Framework: 'aa' factor assessment
The state maintains ample expenditure flexibility with a low burden of carrying costs for liabilities and the broad expense-cutting ability common to most U. S. states. However, the state's expenditure profile is challenged by the stagnant to declining revenue trend that is expected to push the natural pace of spending growth above the state's expected revenues.
Long-Term Liability Burden: 'aa' factor assessment
West Virginia's outstanding debt is low and equal to the U. S. states median at 2.4% of personal income. The more significant unfunded pension obligation, however, notably increases the overall liability burden. The state has aggressively addressed many of its outstanding liabilities through the dedication of specific tax revenues to both workers' compensation and other post-employment benefits (OPEB).
Operating Performance: 'aa' factor assessment
Revenue declines tied to the steep drop in coal production and low natural gas and crude oil prices have stressed the state's financial operations over the past several fiscal years. Financial operations benefit from the maintenance of a sizable, separate rainy day fund (RDF) but the state has applied significant reserves in fiscal years 2015 through 2017 to offset these revenue losses and to fund unexpected costs from floods that impacted the state in June 2016. There is a consistent history of rebuilding reserves as the economy strengthens; however, the subdued natural resource markets may impede that momentum.
Economy and Financial Operations: The Negative Outlook reflects Fitch's assessment of the risks associated with the state's weakened natural resource markets and Fitch's concern that the state will be challenged in providing a durable response to its current economic and financial challenges, further diluting its financial flexibility.
West Virginia coal production is expected to continue its steady decline as both U. S. and global purchasers revamp their energy portfolios, with accelerating declines a potential outcome of additional environmental regulations. West Virginia is particularly challenged by the focus on more stringent clean air standards as 95% of the electric power that is generated in the state comes from coal-fired plants that could require costly retrofits or be subject to lower dispatch to achieve compliance with proposed U. S. requirements. Additionally, the state exports more than three-fourths of the coal that it produces to other states and internationally, and is exposed to efforts by those entities to improve their carbon dioxide emissions regardless of changing regulations. Global coal markets have also been affected by the strong dollar that has increased the price of West Virginia coal and increased competition from other international mining producers. Decreased external demand for the state's coal, which accounted for 41% of the state's total exports in 2014, has had significant economic and financial repercussions for West Virginia. The National Mining Association, an advocacy group for mining interests, estimates that coal production in 2015 contributed $7.5 billion (11%) to the state's GDP that year through direct, indirect, and induced effects.
The state's crude oil and natural gas industries have grown tremendously in the current decade as the state lies on both the Marcellus and Utica Shales. The potential for developing these resources has been impeded by the drop in crude oil and natural gas prices as well as insufficient pipeline capacity for natural gas transmission. As capacity improves and crude oil prices stabilize, natural gas development is expected to increase and provide for economic growth in the state's northern region. The West Virginia University College of Business and Economics forecasts total GDP from natural gas production will equal that of coal in the near future.
The state's General Revenue Fund (GRF) is supported by a broad mix of revenue sources with the personal income tax (PIT) and sales tax the largest revenue contributors at 46% and 31%, respectively. Severance taxes account for a modest 6% of revenues expected in fiscal 2017; this resource to the GRF has been halved since fiscal 2014 due to the weakness in coal production and low prices for crude oil and natural gas. Actions taken in the 2016 legislative session boosted the PIT in the GRF beginning in fiscal 2017 as PIT revenue that had been dedicated to eliminating the state's workers' compensation liability has halted as the state wants to avoid significant overfunding of the liability. For fiscal 2017, other revenue sources to the GRF will increase as the state increased taxes on tobacco products, suspended the sales tax exemption for purchases of medical equipment, and returned previously allocated revenues to the GRF as a means of closing an identified budget gap for that year.
Historical growth in the state's revenues, after adjusting for the estimated impact of tax policy changes, was ahead of national GDP growth over the 10 years through 2014 with solid growth in most years reflecting growing natural gas development and strong exports for the state's coal. The state's economy has weakened since 2014 and economic growth is expected to be modest over the medium term, incorporating unemployment rates that are higher than the national average and employment and income growth below national rates. Combined with expected continued population declines, these factors will pressure the state's economy and constrain growth in revenue sources, in Fitch's view.
The state has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.
As in most states, education and health and human services spending are the state's largest operating expenses. Education is the larger line item, including for higher education, as the state provides significant funding for local school districts and the public university and college system. Health and human services spending is the second largest area of spending, with Medicaid being the primary driver.
Fitch expects that spending growth, absent policy actions, will be ahead of natural revenue growth, driven primarily by Medicaid, and require regular budget adjustments to ensure ongoing balance. The fiscal challenge of Medicaid is common to all U. S. states and the nature of the program as well as federal government rules limit the states' options in managing the pace of spending growth. Managing the state's budget is expected to be particularly challenging due to a stagnant revenue trend that Fitch expects will keep spending growth above the state's expected revenues.
West Virginia retains ample ability to adjust expenditures to meet changing fiscal circumstances. While Medicaid remains a notable cost pressure, spending requirements for debt service and pension obligations are low. From 2005 until fiscal 2016, the state statutorily dedicated specific taxes to the elimination of its liability for workers' compensation, which is expected to be extinguished within the next two fiscal years. Commencing in fiscal 2017, the state has statutorily dedicated $30 million per year from the PIT toward its liability for OPEB; the OPEB funded ratio was almost 20% in fiscal 2015. Based on the state's actual contributions for OPEB, debt service, and pensions, carrying costs accounted for 9% of expenditures in fiscal 2015; that ratio is expected to modestly increase in fiscal 2017.
Long-Term Liability Burden
As of June 30, 2016, the state's debt burden at 2.4% of 2015 personal income equals the U. S. states median and remains a low burden on resources; Fitch calculates outstanding net tax supported debt of $1.6 billion as of this date. Per Fitch's October 2015 State Pension Update report, the state's total net tax-supported debt and unfunded pension liabilities represented a much higher 11.5% of 2014 personal income, reflecting the combined, Fitch-adjusted unfunded liability for the state public employees retirement system (PERS) and the teachers' retirement system (TRS) of almost $6 billion in fiscal 2015. PERS reported a 91.3% fiduciary net position to total pension liability ratio in fiscal 2015 while the TRS reported a lower 66.3% ratio. The prior unfunded liability reported by the systems of $5.2 billion improved to $4.4 billion as of July 1, 2015. The state has consistently overfunded its ARC for TRS in recent years while ARC funding for PERS has been more variable.
The state is a very modest issuer of debt; 42% of debt issuance is backed by the state's lottery and excess lottery revenue pledge (lottery and excess lottery bonds rated 'A+') with almost equal amounts of GO and annual appropriation debt providing for most of the balance of outstanding debt. As of June 30, 2016, there was $394 million in outstanding GO debt out of a total of $1.6 billion outstanding. The state reports modest future debt issuance plans that include a $25 million lottery-backed obligation for school capital projects and a tentative $100 million federal highway grant anticipation note, as well as potential refinancings for debt service savings.
While the state fared better than the nation through the Great Recession, current soft natural resource markets have caused a multi-year period of fiscal stress in the state. State employment has declined in three consecutive years, from 2013 through 2015, with employment losses continuing into 2016. The employment situation has somewhat stabilized beginning in May, but Fitch believes it is uncertain if this trend will continue and what impact it will have on the state's stressed financial operations.
The state has responded to the economic downturn and related serial revenue losses through a multi-prong approach: reducing expenditures, increasing and reallocating revenues, and through consecutive applications of reserves from its RDF. Conservative financial operations provided for a RDF that reached a recent peak of $956 million, 23% of GRF revenues in fiscal 2014. Multiple appropriations from this reserve, including a $70 million appropriation to fund the fiscal 2017 budget and a $55 million appropriation to fund state costs related to devastating floods that impacted the state in June 2016, have reduced the RDF to a still sizable $687 million (16% of GRF revenues) expected at the end of fiscal 2017. Additional balances that the state held in other reserves, including those of the state lottery, have also been applied to closing recent revenue shortfalls as they arose. Fitch believes the continued appropriations from the RDF highlight the difficulty in achieving structural solutions to the currently underperforming revenue sources, despite a strong gap closing capacity.
The current administration reports a minimum balance target for the RDF of 15% of GRF spending. Fitch believes the current administration is committed to that goal, however, this base may prove difficult to sustain as reaching fiscal 2017 revenue projections may prove difficult, in Fitch's view. Further, a new administration entering office in January 2017, following the November 2016 elections, may not articulate the same goals.
The state closely tracks monthly revenue collections and proactively monitors its revenue forecast, important practices given the cyclicality in the state's revenue sources. Conservative fiscal practices provided for both the accumulation of a sizable RDF that the state is now accessing during this time of fiscal stress as well as the dedication of specific revenues to address its liabilities. Fitch expects the state to continue to adhere to these conservative practices and rebuild its reserves as economic performance allows. Given the reduced availability of reserves, Fitch believes that in a future moderate economic downturn the state may need to take more extensive measures to maintain balance.
Recent Operating Performance
Financial operations in fiscal year 2016 were challenged by revenue underperformance that required an additional $83.8 million intra-year appropriation from the RDF to achieve balance in addition to expenditure cuts and appropriation revisions, following an appropriation of $14.8 million that was included in the enacted budget. Overall, revenues to the GRF were $426 million (9.9%) below the state's revenue forecast used to enact the 2016 budget. The draws on the RDF followed a $100 million draw on reserves in fiscal 2015 to address revenue shortfalls and fund Medicaid expense. The RDF balance of $778.7 million at the end of fiscal 2016 is equal to 20% of GRF revenues.
Following the enactment of the almost $4.2 billion GRF budget for fiscal 2017 that included a $70 million appropriation from the RDF, the state was impacted by significant flooding in mid-June that caused extensive damage in the state. To match the aid provided by the Federal Emergency Management Agency (FEMA), the state allocated $55 million from the RDF in addition to other funding sources; the total direct state cost of the floods is estimated at $85 million. Including this additional allocation, the RDF balance at the end of fiscal 2017 is estimated at $687 million, equal to 16.4% of GRF revenues. The state forecast for 3.3% natural revenue growth supports the enacted budget in addition to actions taken in the 2016 legislature to increase tobacco taxes, eliminate the tax exemption on medical devices, and reduce appropriations. While the forecast is for moderate growth in the state's revenues, Fitch believes the state may be challenged in achieving this forecast due to continued soft natural resource markets that may require mid-year action to rebalance the budget.