Fitch Ratings downgrades Philadelphia, Pennsylvania's approximately $1.1 billion general obligation (GO) bonds to 'BBB' from 'BBB+' and removes the rating from Rating Watch Negative. The Rating Outlook is Stable.
The downgrade is based primarily on the city's continued financial deterioration reflected in weaker than originally forecast year-end results for fiscal 2009 and again, for the first quarter of the current fiscal year (2010). Despite significant and proactive spending cuts implemented by management, the city's financial position weakened considerably in fiscal years 2008 and 2009, and based on revenue trends and economic indicators, Fitch remains concerned regarding the city's ability to meet its revised financial projections for the current fiscal year. Fitch believes the operating deficits in recent fiscal years will limit the city's financial flexibility going forward and a return to more stable operations will be difficult to achieve given the current economic environment. The city's tenuous financial position is compounded by the recent expiration of each of the city's four labor contracts, which are expected to be settled before the end of the current fiscal year. The potential for increased labor costs were not budgeted for in the city's fiscal 2010 budget.
Removal of the Negative Watch reflects the recent passage of state legislation allowing the city to impose a temporary sales tax increase and defer a portion of its pension payments over the next two fiscal years. Both measures were delayed due to the late passage of the commonwealth's budget and were heavily relied upon to balance the city's fiscal 2010 budget. The 'BBB' rating on the city's GO debt reflects its exceptionally high debt levels, limited financial flexibility, significantly under-funded pension position, rapidly growing fixed-cost burden related to employee benefits, and below-average economic indicators. Fitch also recognizes the city's strong financial management and solid employment base anchored by its role as a regional economic center, which serves as home to several major health care and higher education institutions. While short-term and long-term concerns remain, Fitch believes the Rating Outlook is Stable at the 'BBB' rating.
Philadelphia, with an estimated population of almost 1.5 million residents, benefits from its role as a regional economic center and a stable employment base weighted in the education and health care sectors led by the University of Pennsylvania and Jefferson Health System as the largest private employers. Despite a slowing economy, commercial and retail development projects have continued, including the transitioning of the city's naval yard into a large private sector business park consisting of approximately 80 companies. In addition, Children's Hospital of Philadelphia, the Fox Chase Cancer Center, and the University of Pennsylvania have each made significant capital investments to expand their respective research facilities. However, despite the size and stability of its employment anchors, the city's unemployment rate, mirroring national trends, has experienced a notable increase over the past year, growing to an above-average 11% in September 2009 from a more moderate 7.4% one year prior. Income levels are also weak; approximately one-fourth of the city's residents live at or below the poverty rate according to the U.S. Census Bureau.
The current economic downturn continues to exert significant pressure on the city's operating budget and overall financial flexibility. Although Fitch believes the city's management team has been proactive to date in making significant budgetary adjustments, a high fixed cost burden, a comparatively high tax burden for residents, and the depletion of general fund balances severely limits the city's ability to absorb further revenue declines.
Following a period of stronger than budgeted growth in several tax sources in fiscal years 2005-2007, the city began fiscal 2008 with a moderately healthy unreserved general fund balance. However, a slowing in the local housing market and overall economy resulted in the economically sensitive business privilege and real estate transfer taxes coming in significantly below budget, resulting in a sizeable operating deficit and reducing the unreserved, undesignated general fund balance to -$24.3 million (on a GAAP basis). Despite notable mid-year expenditure cuts in fiscal year 2009, including significant employee reductions, mostly through attrition and vacancy elimination, a reduction in a portion of several active fire companies, and a decrease in certain city services, general fund tax revenues continued to decline leading to a -$277.4 million operating deficit based on unaudited results. While a portion ($55 million) of the operating deficit is attributable to a late state-aid payment, the deficit is nonetheless $73 million greater than what was expected at the adoption of the fiscal 2010 budget. The current estimated shortfall in fiscal 2009 reduces the total general fund balance (on a budgetary basis) to -$82 million, equal to slightly more than -2% of expenditures.
To help balance the fiscal 2010 budget and provide budgetary relief in fiscal 2011 the city is deferring a portion of its annual pension payments over the next two years, as well as imposing a five-year, one-cent sales tax increase that began in October 2009, about two months later than what was originally budgeted for. According to the multi-year plan, a portion of the expected revenue from the sales tax increase will be used to repay the city's pension fund in fiscal years 2013 and 2014, with interest based on an assumed rate of return on investments of 8.25%. Other measures already enacted include extending the amortization of the city's unfunded pension liability to 30 years from 20 and delaying until fiscal 2015 long-standing annual wage and business privilege tax cuts.
In total, the city's budgetary adjustments were expected to yield a $120.7 million operating surplus that, together with prior-year adjustments, would have left the general fund with a positive fund balance by year-end. However, based on first quarter results for fiscal 2010 that show total tax revenues down $16.1 million and expenditures up about $7.2 million relative to the budget, the city is now projecting a $38.6 million decrease in the year-end surplus that was initially budgeted for. The largest decline in tax revenue through the first quarter of fiscal 2010 was in city's wage tax, which was down approximately 4.6% and is the city's largest source of general fund revenue. While financial projections for the balance of the fiscal year appear more conservative than in past years, Fitch remains concerned over the potential for further declines in tax revenues given current economic trends, particularly related to rising unemployment and its impact on wage tax collections.
The city's overall debt burden remains very high at $5,000 per capita and 17% of market value, although Fitch believes the market value ratio is overstated due to antiquated property assessment practices. Even excluding $1.4 billion in outstanding pension obligation bonds, debt ratios remain well above average. The 2010-2015 capital improvement plan is estimated at $7.9 billion with slightly more than half supported by operating revenues of, and revenue bond issuance by the city's airport and water department. The balance of capital funding will come from state and federal sources as well as from city-supported debt issuance, which Fitch believes will keep debt ratios at a high level for the foreseeable future.
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