RD452 - 2008 Annual Report of the Debt Capacity Advisory Committee - December 17, 2008


Executive Summary:
The Debt Capacity Advisory Committee (the "Committee") is required to annually review the size and condition of the Commonwealth's tax-supported debt and submit to the Governor and General Assembly an estimate of the maximum amount of new tax-supported debt that prudently may be authorized for the next two years. In addition, the Committee is required to review annually the Commonwealth's moral obligation debt and other debt for which the Commonwealth has a contingent or limited liability. We are pleased to present our annual report.

The Debt Capacity Model

In this report, we reaffirm our use of the Debt Capacity Model as the means of calculating the Commonwealth's tax-supported debt affordability. The Model calculates the maximum amount of incremental debt that may prudently be issued by the Commonwealth over the next ten years, while maintaining an additional two years of debt issuance capacity as a reserve beyond the end of the ten-year issuance period. The reserve is used as a hedge against variations in other assumptions used in the Model, such as interest rates and revenue growth. The Model uses the ratio of tax-supported debt service as a percentage of revenues as its base calculation. The ratio of debt service as a percentage of revenues should be no greater than 5%. In our view, 5% is the maximum ratio consistent with maintaining the premier credit ratings on the Commonwealth's debt. The Model incorporates the official revenue estimates contained in the Governor’s proposed budget submitted December 18, 2008. The Debt Capacity Model is attached as Exhibit A.

The concept of debt capacity management and the 5% maximum ratio were introduced in An Assessment of Debt Management in Virginia, a report issued by the Secretary of Finance in December 1990. The Debt Capacity Advisory Committee adopted the 5% maximum measure in 1991 and has fully endorsed this ratio every year since that time. The credit ratings assigned to the Commonwealth’s obligations are, in part, based upon its sound debt management policies. Moody’s Investors Service, in a report issued this fall, specifically referenced the Commonwealth’s conservative policies, as follows:

“The highest rating reflects the Commonwealth’s long history of proactive and conservative fiscal practices, an economy that has slowed but still outperforms the nation, the significant fiscal challenges the commonwealth faces amid a weaker economy, and its good management of a complex debt structure. The rating outlook is stable.” (Moody’s Investors Service, New Issue report, November 7, 2008.)

Moral Obligation or Contingent Liability Debt and Other Findings

The Committee also reviewed outstanding moral obligation debt and other debt for which the Commonwealth has a contingent or limited liability. The Committee reviewed the types of programs, statutory caps, outstanding amounts, and other financial data for the two issuers that currently have debt outstanding that is backed by the Commonwealth’s moral obligation pledge. The two issuers are the Virginia Housing Development Authority and the Virginia Resources Authority. Each of these issuers’ outstanding moral obligation debt is currently within its statutory limit. The Virginia Resources Authority intends to request additional moral obligation debt authorization in the 2009 Session as discussed below.

The Virginia Resources Authority is authorized to issue up to $900 million of moral obligation debt. The Authority issues moral obligation bonds under its programs to provide low-cost financing to localities for water, wastewater, solid waste, storm water, public safety, brownfields remediation, public transportation and airport projects. The Authority has experienced unprecedented demand for its financing programs due to changes in market conditions that have restricted market access for local governments. The Authority plans to request additional moral obligation debt authorization in the 2009 Session that would increase the statutory limit from $900 million to $1.5 billion.

The Virginia Housing Development Authority established a new multi-family housing program in 1999 that does not carry the Commonwealth’s moral obligation pledge. Since 1999 that authority has issued all of its multi-family housing bonds under that program and discontinued the issuance of moral obligation bonds.

The Virginia Public School Authority is the only issuer of non-tax-supported debt that utilizes a sum sufficient appropriation as an additional credit enhancement. This represents a contingent liability for the Commonwealth. The Virginia Public School Authority issued its first series of bonds under this structure in 1997. In 2001, its Equipment Technology Notes were brought under this structure. The bonds and notes are rated “double A plus” by each of the three major rating agencies.

Information on the amount of outstanding debt, statutory limits and debt ratings for moral obligation debt and other debt for which the Commonwealth has a contingent or limited liability is shown in Exhibit D. Sensitivity analyses are also included which demonstrate the impact on tax-supported debt capacity resulting from the conversion of moral obligation debt to tax-supported debt. The sensitivity analyses are prepared using worst-case scenarios showing the impact of the conversion of all moral obligation debt. If any such debt were ever converted, however, it would occur on an issue-by-issue basis. Conversion would occur if the General Assembly appropriated funds to replenish a debt service reserve fund shortfall if requested by a moral obligation issuer. For example, an issuer would request that the Governor and General Assembly replenish the debt service reserve fund if, in the event of a default on the underlying revenue stream, the issuer was forced to draw on the debt service reserve fund to pay debt service.

The Committee also reviewed the current and historical debt position of the Commonwealth. Part of this review included other authority debt not supported by taxes. Data included in Exhibit C summarizes information considered by the Committee.

Recommendations

Historically, Virginia has followed a capital budgeting and approval process in which projects and the financing thereof have been approved during the even-year General Assembly Session during which a new biennial budget is adopted. The budget is amended, if necessary, during the odd- or second year. The Committee therefore has provided the following amounts for the current biennium since this report coincides with the 2009 General Assembly Session during which the amended biennial budget for the 2009-10 budget biennium will be considered.

The Committee notes that the period of time between the inception of capital projects and permanent financing can vary greatly, usually spanning several years. Therefore the Committee continues to consider scheduled projected issuance when making its recommendations.

1. Model Results – Tax-Supported Debt Authorization

The Committee believes that based upon the Debt Capacity Model and the Governor’s Official Revenue Forecast of December 18, 2008:

• A maximum of $369.99 million of tax-supported debt could prudently be authorized by the 2009 Session of the General Assembly; and

• A maximum of $369.99 million of tax-supported debt could prudently be authorized by the 2010 Session of the General Assembly.

This maximum amount of authorization is above and beyond the tax-supported debt that is currently authorized but unissued. The decrease in debt issuance capacity from the amounts recommended in the February 25, 2008 Report is mainly attributable to significant decrease in projected revenues along with the debt authorizations during the 2008 session of the General Assembly and an increase in interest rates.

The Model results are sensitive to changes in interest rates and revenues. Specifically, a one percent change in general fund revenues in each and every year of the Model solution horizon will change the amount of average debt capacity by approximately $7.70 million. A change in general fund revenues of $100 million in each and every year of the Model solution horizon will produce approximately $5.66 million of incremental average debt capacity change. More detail on the Model’s sensitivity to changes in interest rates and revenues can be found in Exhibit B.

The Committee notes that the average interest rates used in the Debt Capacity Model have increased by 20 basis points since the February 25, 2008 Report. The Bond Buyer 11 Index is the benchmark index used in the Model. The Model uses average of the Bond Buyer 11 Index for the last eight quarters as its base interest rate for authorized but unissued general obligation bonds and adds an additional fifty basis points for non-general obligation bonds. The Committee notes that the effect of interest rate movements over any one year is mitigated since the base rate is an average of the last eight quarters.

The Committee recognizes that it cannot predict the future level of interest rates or the pace of revenue growth and recognizes the sensitivity of the Model results to such factors. Attached as Exhibit B are sensitivity analyses that demonstrate the impact on the Model of changes in external factors such as interest rates and revenues, or internal factors such as excess capacity. The Model calculates the maximum amount of tax-supported debt that could be prudently authorized and issued based on the assumptions incorporated in the Model. It does not constitute a recommendation of the Committee that such amount actually be authorized. In the opinion of the Committee, debt issuance in excess of the recommended amounts could result in the Commonwealth exceeding the maximum ratio of 5%. See Exhibit C for further narrative.

The Committee makes no recommendations as to which projects, if any, should be chosen for debt financing or how they should be prioritized. These decisions are most appropriately made through the budgetary and legislative processes.

2. Consider Eliminating Authorizations Not Likely to be Issued:

The Committee endorses the efforts of the General Assembly and the Governor to continue to rescind authorizations for projects that are not likely to be used. The Committee recommends that unnecessary authorizations continue to be identified and rescinded, as appropriate.

3. Alternative Financing of State Projects:

We continue to support the use of traditional financing vehicles such as the Virginia Public Building Authority and the Virginia College Building Authority for financing state projects as opposed to capital lease-supported transactions. Certain state projects have been financed in the past using local and special purpose authorities, such as industrial development authorities or redevelopment and regional housing authorities. Due to the structure of such financings, they often result in higher financing costs than if the financing had been completed through an established state program. In such cases, the Commonwealth has limited control of the process, however such bonds are normally considered tax-supported debt and are included in the Model because the Commonwealth is responsible for debt service payments over the life of the bonds.

4. Moral Obligation and Contingent Liability Debt:

We make no specific recommendation on the programs or levels of the statutory caps for the two issuers currently utilizing the moral obligation pledge of the Commonwealth. If the Virginia Resources Authority is successful in obtaining an increase in their moral obligation cap, the proposed increase would not negatively impact the Commonwealth’s general obligation credit ratings.

Conclusion

The Commonwealth of Virginia has become an acknowledged leader among states in the area of debt capacity management, and is repeatedly held out as an example of how the process should work. It has been our pleasure to advise you on the concepts of debt affordability and debt capacity management. We trust this report and our recommendations are useful as we move forward together into the 2009 Session of the General Assembly.