Fitch Revises Outlook on State of Washington to Negative; Rates $1.5B GOs 'AA+'

Fitch Ratings assigns an 'AA+' rating to the following State of Washington general obligation (GO) bonds:

--$346,075,000 various purpose GO bonds, series 2012D;

--$188,595,000 motor vehicle fuel tax GO bonds, series 2012E;

--$699,075,000 various purpose GO refunding bonds, series R-2012C;

--$260,140,000 motor vehicle fuel tax GO refunding bonds, series R-2012D.

The bonds are expected to be sold through competitive bid, the refunding bonds on Jan. 31, 2012 and the new money bonds on Feb. 28, 2012.

Fitch also affirms the 'AA+' rating assigned to approximately $17.5 billion of outstanding state GO bonds. Fitch has also revised the Rating Outlook on the state's GO bonds to Negative from Stable.

KEY RATING DRIVERS

OUTLOOK REVISED TO NEGATIVE: The revision of the Rating Outlook to Negative from Stable reflects the challenges faced by the state in addressing a sizable budget gap that developed after the adoption of the current biennial budget. The state is operating in an environment of significantly constrained revenue raising and spending control flexibility. Maintenance of the 'AA+' rating will be contingent upon enactment of sustainable budgeting measures that provide an adequate cushion against future revenue underperformance.

SOLID ECONOMY: Washington's economy is characterized by generally sound performance and increased diversification. The manufacturing sector remains concentrated in the cyclical aerospace industry, although this concentration is sharply reduced. Economic growth prior to the downturn was primarily due to strength in construction, aerospace (Boeing), and technology (Microsoft).

CONCENTRATED REVENUE SYSTEM: The state, with no income tax, relies on consumption-based revenues. This makes Washington particularly vulnerable to reductions in consumer spending and limits the prospects for quick revenue recovery.

RESPONSIVE FINANCIAL MANAGEMENT: Frequent reviews of economic and financial forecasts allow the state to react to changing conditions. Although the economy and revenues have repeatedly underperformed estimates, resulting in significant negative forecast revisions, the state has demonstrated its willingness and ability to take actions to maintain budget balance.

ABOVE-AVERAGE DEBT LEVELS: Debt ratios are in the upper moderate range and expected to remain so, reflecting funding of substantial capital needs, particularly for transportation.

INITIATIVES AND REFERENDA A LIMITED RISK: The state's initiative and referendum environment creates a level of operating and financial uncertainty. However, any law approved by voters in this manner can be amended or repealed by the legislature by a two-thirds vote in the first two years after approval and by a simple majority thereafter.

WHAT COULD TRIGGER A RATING ACTION

Failure to restore and maintain budget balance and an adequate reserve position using primarily recurring gap-closing measures likely would result in a downgrade of the rating.

SECURITY

The bonds are GOs of the state to which its full faith, credit, and taxing power are pledged. Motor vehicle fuel tax GO bonds are first payable from state excise taxes on motor vehicle and special fuels.

CREDIT PROFILE

Washington's 'AA+' GO bond rating reflects a generally solid economy and a demonstrated commitment to fiscal balance even as the state's financial position substantially weakened in the downturn. Credit strengths are offset by a concentrated revenue system that is reliant on the sales tax, with no income tax, as well as above-average debt levels.

The budget gap to be addressed and the continued downside risk to the economic and revenue forecast are currently the main credit issues for Washington. The economy is improving, albeit with a continued drag from construction and government. Revenue results appear to be in line with the November 2011 forecast, suggesting that the February 2012 revenue forecast will not materially change. The long-term prospects for the economy are solid, and key industries are showing strength. Although the repeated and significant underperformance of revenues versus forecast is a concern, Fitch continues to believe that management remains committed to budget balance.

Washington reviews its general fund revenue forecast quarterly, but actual revenue performance has repeatedly underperformed downwardly revised estimates. The revenue system's reliance on a broad-based sales tax makes Washington particularly vulnerable to reductions in consumer spending and limits the prospects for quick revenue recovery. After state general fund revenue declines of 9.6% in fiscal 2009 and 4.1% in fiscal 2010, the November 2011 forecast projects revenues up 7.9% in fiscal 2011, reflecting in part tax increases enacted in April 2010, followed by growth of just 0.3% in fiscal 2012 and 5.4% in 2013. Uncertainty in the forecast remains high, with downside risks outweighing upside potential.

The fiscal 2009-2011 biennium ended on June 30 with a $92 million deficit even after a school payment delay. Following substantial downward revisions to the forecast for the current fiscal 2011-2013 biennium (in June, September, and November 2011), the state faced a $1.4 billion budget shortfall even though the budget enacted in May 2011 included a $723 million cushion against revenue deterioration.

In response, the governor called a special session of the legislature for November 2011 and proposed $2 billion in a combination of recurring and one-time gap-closing actions. As the enacted fiscal 2011-2013 budget already relied on significant spending control, further spending cuts continue to require difficult choices. The governor's proposal includes shortening the school year by four days and eliminating some health services programs. The governor's proposal would leave a projected balance of $601 million at the end of the biennium (4% of fiscal 2013 revenues).

In special session, the legislature enacted $480 million in gap-closing measures, primarily the less controversial of the governor's proposals including fund sweeps and some payment delays. The legislature is now in a 60-day regular session that began on Jan. 9. Fitch expects the legislature to address the remaining $901 million budget gap during the session, although it seems likely that resolution will be delayed until late in the session and after the revenue forecast update is released on Feb. 16.

Given the difficulty of achieving the state's required supermajority legislative vote for tax increases, such measures effectively require voter approval. Tax increases were not part of the governor's $2 billion proposal in November, although she has proposed a public vote on a temporary half cent sales tax to replace some of the cuts.

The enacted budget for the current biennium addressed a projected gap of $4.9 billion. The large gap resulted from relatively weak revenue performance, rising service demands, the roll-off of federal stimulus funds, and the use of some one-time resources in prior budgets; the estimate also assumed compliance with class size and teacher pay initiatives that had been suspended. The budget relied on cuts that in some cases redefined the types of services the state provides as well as about $460 million in fund transfers. Following decisive voter defeats of new taxes with the November 2010 ballot, revenue increases were not part of the gap-closing solution. Savings of $1.2 billion were realized by once again suspending the two education-related voter initiatives and $535 million was cut from higher education, to be partially offset by tuition increases. State employee salaries were reduced by 3% and their share of health insurance premiums increased. Notably, pension changes, specifically the elimination of annual cost of living adjustments (COLAs) for retirees in the closed public employee and teacher plans, resulted in budgetary savings of $344 million for the biennium.

A state Supreme Court decision earlier this month finding state education funding inadequate provides the state flexibility in terms of the timing and amount of remediation, although the decision does generally increase funding demands for education. In 2009, the state passed education funding reform that the court noted positively in its ruling. The state's current six-year financial outlook estimates the cost of implementation of that reform at $317 million in fiscal 2014, rising to $724 million in fiscal 2015, $1.1 billion in fiscal 2016, and $1.3 billion in fiscal 2017.

Washington's economy, which had been performing much more strongly than that of the U.S., entered the recession later than the U.S. overall. Non-farm employment in Washington rose as national employment fell in 2008, then dropped 4.6% in 2009 compared to 4.4% for the U.S. Washington's employment decline of 1.6% in 2010 was twice that of the U.S., although year-over-year growth of 1.4% in December 2011 was slightly above the 1.3% national rate of gain. The state's unemployment rate in December 2011 was 8.5%, matching the U.S. rate. Personal income per capita, at 107% of the U.S. in 2010, ranks 13th among the states.

Washington's debt levels are in the upper moderate range and well above average for a U.S. state, with net tax-supported debt of $17.8 billion equal to 6.2% of personal income. Debt is almost exclusively GO. Capital needs are substantial, particularly for transportation, and tolling is part of the funding solution. The state has increased its focus on debt affordability.

The state administers 13 defined benefit retirement plans, three with hybrid defined benefit/defined contribution options. The closed public employees and teachers plans (PERS and TRS1), which have been closed since 1977, are underfunded, with an unfunded actuarial accrued liability (UAAL) of $4.7 billion as of June 30, 2010, $2.4 billion of which is the responsibility of the state. As noted above, legislation passed this spring with the fiscal 2011-2013 budget eliminated automatic annual COLAs for PERS and TRS1 retirees that had been in place since 1995; this change is now subject to legal challenge.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

In addition to the sources of information identified in Fitch's report 'Tax-Supported Rating Criteria', this action was additionally informed by information from IHS Global Insight.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria', dated Aug. 15, 2011;

--'U.S. State Government Tax-Supported Rating Criteria', dated Aug. 15, 2011.

Applicable Criteria and Related Research:

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=648897

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=648898

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