RD14 - Debt Capacity Advisory Committee Report to the Governor and the General Assembly - December 19, 2011

Executive Summary:

Concern over the Commonwealth’s increased use of debt prompted Governor Wilder to issue Executive Order 38 (1991) establishing the Debt Capacity Advisory Committee (Committee or DCAC). The DCAC was subsequently codified in Section 2.2-2712 of the Code of Virginia. The Committee was initially comprised of the Secretary of Finance, the State Treasurer, the Auditor of Public Accounts, the Director of Planning and Budget, the Director of the Joint Legislative Audit and Review Commission, and two citizen members appointed by the Governor. Legislation enacted in 2010 added three additional members to the Committee: the staff directors of the Senate Finance and House Appropriations Committees, and the State Comptroller. The Secretary of Finance serves as Chairman.

The Committee is vested with the power and duty to annually review the size and condition of the Commonwealth’s tax-supported debt and to submit to the Governor and the General Assembly, by January 1 each year, an estimate of the maximum amount of new tax-supported debt that prudently may be authorized for the next biennium. The Committee’s recommendations must consider the amount of tax-supported debt that will be outstanding, and the projected debt service requirements over the following nine fiscal years. The Committee must also review annually the amount and condition of obligations for which the Commonwealth has a contingent or limited liability, or for which the Commonwealth is permitted to replenish reserve funds if deficiencies occur (i.e., “Moral Obligation” debt).

Control of debt burden is one of several 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 administrative capabilities of government. The Commonwealth’s triple-A bond rating, which it has held since 1938, helps ensure access to the capital markets at the lowest borrowing cost. But the ability to take on additional debt while maintaining the triple-A ratings is limited, because higher debt service payments (a fixed expense) result in less flexibility to respond to economic cycles and address other budgetary needs. However, because it is viewed in concert with many other variables, there is no precise point at which increased debt levels result in a lower bond rating.

In 1991, after consideration of various alternatives to assess capacity, the Committee decided upon a measure based on tax-supported debt service as a percent of revenues. This measure provides the most direct comparison of the state’s obligations to the resources available. Also, policymakers control and may influence both variables that determine this ratio. In addition, measuring what portion of the State’s resources is committed to debt-related fixed costs, provides a measure of the State’s budgetary flexibility and its ability to respond to economic downturns.

The target level selected by the Committee was five percent (5%) – that is, that debt service on tax-supported debt obligations not exceed 5% of blended revenues. This measure is intended to ensure that annual debt service payments do not consume so much of the state’s annual operating budget as to hinder the Commonwealth’s ability to provide core government services. This measure has been endorsed by the DCAC in each year since.

It is important to note that maintaining debt service at less than 5% of revenues is merely a benchmark of affordability. It is not the only consideration. The cost of debt service must also be considered in light of other budget needs.

2009 Report of the DCAC

In the December 18, 2009 Report to the Governor and the General Assembly, the DCAC for the first time reported that there would be no additional debt capacity for the next two years. Based on the Committee’s model, and the 2009 Official General Fund Revenue Forecast, there would be no additional debt capacity until 2014. This unprecedented finding resulted from (i) a precipitous decline in Virginia’s actual and forecast revenues resulting from a nationwide economic downturn, and (ii) several recent years of significant bonded debt authorizations.

Recognizing that the lack of borrowing capacity and the perceived inability of the Commonwealth to address important capital needs may itself be viewed as a credit weakness, the DCAC requested a study by staff to help determine if the 5% ratio is still the best way to measure the Commonwealth’s capacity, if the Committee should continue to rely on a single ratio tied to revenues, and how results can be smoothed to facilitate capital planning and avoid dramatic changes in capacity, particularly in times of extraordinary fluctuations in revenues. Staff from the House Appropriations Committee and the Senate Finance Committee assisted with the study.

2010 Debt Capacity Study

In September 2010 the draft study was presented to the DCAC, and on November 30, 2010, the Committee, by majority vote, adopted several changes to the debt capacity model. The Committee considered various alternatives, including changing the 5% measure, the use of other measures (e.g., debt per capita) to assess capacity, as well as changes to the treatment of transportation debt in the model. Ultimately, the primary changes adopted by the Committee were the (i) inclusion in the model of the .25% sales tax enacted in 2004 and certain recurring transfers to the general fund from non-general funds, (ii) the reduction of debt service carried in the model for amounts expected to be paid from non-general fund sources, (iii) a change to the interest rate proxy used to estimate the debt service on future borrowings, and (iv) using a ten-year average capacity to arrive at the Committee’s recommendation rather than basing it solely on the next two year period. This latter recommendation is an effort to smooth the effect of dramatic revenue fluctuations, and to facilitate long-term capital planning. The target measure of annual debt service payments to annual blended revenues remains unchanged at 5%.

Debt Capacity Model

The DCAC Report is a tool to enable the Commonwealth to plan the issuance of its future obligations within future resource constraints. The Committee attempts to provide elected officials with information to enable them to balance capital funding needs with maintaining fiscal discipline and budgetary flexibility. The report can guide decision-makers in the development and implementation of the capital budget.

The Committee’s Debt Capacity Model compares annual Blended Revenues from the Official Revenue Forecast to the (i) the scheduled debt service payments on all outstanding tax-supported debt obligations, plus (ii) estimates of the debt service payments on all currently authorized, but unissued tax-supported debt obligations. Then a calculation is made to determine the amount of additional debt that could be authorized and issued without causing total debt service to exceed 5% of Blended Revenues.

Blended Revenues are comprised of general fund revenues, state revenues in the Transportation Trust Fund (TTF), and certain non-general fund transfers including ABC profits. Beginning with the 2010 Report, Blended Revenues also include the .25% sales tax enacted in 2004 and certain recurring non-general fund Appropriation Act transfers.

Tax-supported debt in the model includes general obligation bonds (excluding those general obligation bonds issued pursuant to Article X, Section 9(c) of the Constitution of Virginia for which debt service is paid from project revenues), debt secured by the TTF, obligations issued by the Virginia Public Building Authority (VPBA) and/or Virginia College Building Authority (VCBA) that are repaid from general fund appropriations, obligations payable under regional jail reimbursement agreements, bonded capital lease payments paid from a general fund appropriation, and other capital leases and installment purchases.

The impact of authorized but not yet issued bond programs on future operating budgets is an important element of debt management and assessing debt capacity. Accordingly, estimates for those programs are included in the debt capacity calculations. These estimates are based in part on draw schedules compiled by the Department of Planning and Budget or obtained from agencies on their authorized projects, while staying within the confines of the debt capacity model.

2011 Debt Capacity Recommendations

The debt capacity calculation (Exhibit A) shows that an additional $466.83 million in debt could be authorized and issued in each 2012 and 2013. This amount will cause projections of debt service as a percent of blended revenues to exceed five percent in some years and be below five percent in other years.

Other Recommendations

a) The Committee reiterated recommendations included in past reports for the General Assembly and the Governor to rescind any bond authorizations for projects that are not likely to be issued.

b) The Committee expressed its continued support of the use of traditional financing methods for state projects such as those offered through the issuance of general obligation bonds, or appropriation-supported programs through the VCBA or the VPBA, since capital lease and other conduit borrowings typically result in higher financing costs, and are ultimately still viewed as tax-supported debt.