RD449 - 2009 Annual Report of the Debt Capacity Advisory Committee - December 18, 2009


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

The concept of debt capacity management was introduced in "An Assessment of Debt Management in Virginia," a report issued by the Secretary of Finance in December 1990. Control of debt burden is one of the key factors evaluated by rating agencies in their assessment of a state's credit quality. Other factors include economic vitality and diversity, fiscal performance and flexibility, and general administration of government. The three bond rating agencies affirmed the Commonwealth's triple-A bond ratings in October 2009. The reports noted:

"The commonwealth's 'AAA' rating reflects its substantial economic resources, conservative approach to financial operations, which include periodic revenue forecast updates, and careful attention to the level of its debt obligations." Fitch June 8, 2009

"The rating reflects Virginia's long history of proactive and conservative fiscal practices, an economy that has slowed significantly but still fares better than the nation, the significant fiscal challenges the commonwealth continues to face amid weakened revenues; and a strongly-managed debt structure." Moody's September 29, 2009

"The commonwealth's overall performance is slowing, but we believe it remains favorable relative to the U. S." "We also believe that, despite feeling the effects of the national slowdown..., in the long term Virginia's overall economic strength, employment diversity, and good income levels will likely offset the near-term effects of the recession." Standard & Poor's October 6, 2009

In this report, we have used the Debt Capacity Model as the means of calculating the Commonwealth's tax-supported debt affordability. The Model calculates the maximum amount of additional debt, beyond the amount currently authorized, that may prudently be authorized and issued by the Commonwealth each year over the next ten years. The Model is based on the premise that tax-supported debt service payments should be no greater than 5% of general tax revenues. The Debt Capacity Advisory Committee adopted the 5% maximum measure in 1991 and has fully endorsed this ratio every year since that time. The Model incorporates the official revenue estimates contained in the Governor's proposed budget submitted December 18, 2009, and assumptions for the issuance of currently authorized bonds. The result of the Debt Capacity Model is attached as Exhibit A.

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 Virginia Resources Authority, which is the only issuer that currently has outstanding debt backed by the Commonwealth's moral obligation pledge. The Virginia Housing Development Authority, which has not issued moral obligation bonds since 1999, paid off all previously outstanding moral obligation bonds during fiscal year 2009.

The Virginia Resources 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. Due to increased demand for its financing programs, the 2009 General Assembly approved an increase to the Authority's moral obligation debt limit from $900 million to $1.5 billion.

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. However, conversion would only occur if the General Assembly appropriated funds to replenish a debt service reserve fund shortfall upon request by a moral obligation issuer. Further, if any such debt were ever converted, it would be only the amount necessary to cure the default of an underlying revenue stream (e.g., a locality participating in a pooled bond issue).

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.

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

The Committee notes that the period of time between the authorization of capital projects and permanent financing can vary greatly, usually spanning several years. Cash flows used for our analysis were based on project timelines and construction schedules provided by agencies. These needs could be modified due to shifting priorities, construction delays and other factors. Therefore, the projected timing of the issuance may lessen the immediate impact on the Model. The Committee recommends the following:

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, 2009, there is no additional debt capacity for 2010 or 2011.

The Model results are sensitive to changes in interest rates and revenues. Specifically, a one percent increase in general fund revenues in each and every year of the Model solution horizon will change the amount of average debt capacity by approximately $11.2 million. An increase in general fund revenues of$100 million in each and every year of the Model solution horizon will change the amount of average debt capacity by approximately $5.3 million. More details on the Model's sensitivity to changes in interest rates and revenues can be found in Exhibit B.

The average interest rates used in the Debt Capacity Model have increased by two basis points since the December 17, 2008 Report. The Bond Buyer II Index is the benchmark index used in the Model. The Model uses the average of the Bond Buyer II 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 anyone 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. Exhibit B provides sensitivity analyses that demonstrate the impact on average debt capacity resulting from 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.

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. However, the Committee is not aware of any such authorizations as this time.

3. Alternative Financing of State Projects:

We continue to support the use of traditional financing methods such as those used by the Virginia Public Building Authority and the Virginia College Building Authority for financing state projects. Capital lease and other more complex structures 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, yet the structure still creates obligations that must be treated as tax-supported debt.

4. Moral Obligation and Contingent Liability Debt:

We make no specific recommendation on the programs or levels of the statutory caps for the single issuer currently utilizing the moral obligation pledge of the Commonwealth.

Conclusion

The significant decline in fiscal year 2009 actual revenues and further decline in forecasted revenues has resulted in an unprecedented Model solution of zero. This solution, while in accordance with established policies, has prompted the Committee to consider whether the current ratio is still appropriate, and whether reliance on a single ratio tied to revenues is the best way to assess the Commonwealth's debt capacity, particularly in times of extraordinary fluctuations in revenues. Accordingly, we have requested that staff conduct a study and provide recommendations· for consideration by the Committee prior to the December 2010 meeting. The study will consider several key issues, such as whether 5% continues to be an appropriate measure, if additional measures should be incorporated in the Model, whether the composition of debt included in the Model should be changed. We have further requested that staff from the House Appropriations and Senate Finance Committees participate in the study.

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 2010 Session of the General Assembly.