Fitch Rates Los Angeles, CA's $1.5B Notes 'F1+'

SAN FRANCISCO--(BUSINESS WIRE)-- Fitch Ratings has assigned an 'F1+' rating to the following Los Angeles, California (the city) tax and revenue anticipation notes:

--$1.475 billion 2016 notes.

The notes are scheduled to sell via negotiation on June 21, 2016. The purpose of the notes is to smooth cash flow management for general fund operations during fiscal 2017 ($400 million) and to prepay the city's fiscal 2017 contributions to the Los Angeles City Employees' Retirement System ($458 million) and the Fire and Police Pension Plan ($618 million), for cumulative savings of approximately $37 million.

SECURITY

The notes are general obligations of the city, payable from unrestricted general fund revenue attributable to fiscal 2017 (projected $8.15 billion which are estimated to cover note principal and interest 5.53x). To the extent these moneys are insufficient to repay the notes in full at their maturity, the notes are repayable from any other legally available unrestricted moneys. Funds for repayment will be set aside in increments of 20% of total principal and interest no later than Jan. 25, Feb. 24, March 24, April 25, and May 25, 2017 respectively. The notes are scheduled to be repaid on June 29, 2017.

KEY RATING DRIVERS

On May 3, 2016 Fitch affirmed the city's Issuer Default Rating (IDR) at 'AA-' based on the city's solid revenue growth, satisfactory expenditure control, a moderate debt burden, and exceptionally strong gap-closing capacity, supported by strengthened general fund liquidity and reserves. The city faces ongoing challenges arising from its limited ability to independently raise revenues, the historically contentious labor environment, multiyear remuneration increases, increasing pension system and other post-employment benefits (OPEB) employer contributions, judicial impediments to benefits reform, and growing service pressures.

Economic Resource Base

The city is the commercial and cultural center of a very large, diverse economy that is benefitting from revenue, employment, and property market improvements. The city's socioeconomic characteristics remain somewhat mixed, as would be expected for such a large urban area. The city is projecting continued slow, steady economic and tax base growth.

Revenue Framework: 'aa' factor assessment

Solid revenue growth has been, and is expected to remain, in line with national GDP growth. This reflects the city's ability to capture revenues from across its wide range of economic activity. However, the city's independent ability to raise revenues is limited by state law.

Expenditure Framework: 'a' factor assessment

Over time, expenditure growth is expected to be roughly in line with revenue growth given rising employee costs and growing service pressures. Labor contract flexibility is counterbalanced by a historically contentious labor environment, judicial impediments to benefits reform, and a competitive environment for sworn personnel. The fixed-cost burden for debt service, pensions, and OPEB is manageable.

Long-Term Liability Burden: 'aa' factor assessment

The long-term liability burden is moderate relative to personal income. However, mixed pension and OPEB funding ratios, plus revised investment return assumptions, will necessitate increased city contributions over time to maintain actuarial funding.

Operating Performance: 'aa' factor assessment

Los Angeles has exceptionally strong gap-closing capacity. Reserves in combination with the city's inherent budget flexibility leave it well positioned to address future downturns. The city has made consistent efforts to retain financial flexibility but remains reliant on one-time funding to achieve annual budgetary balance even at a time of economic recovery.

Short-Term Rating Mapped: The 'F1+' rating on the notes is based on the long-term credit quality characteristics that result in the city's 'AA-' IDR. Other positive features include a sound note repayment structure, good coverage of all note repayment set-asides, and substantial available and borrowable resources relative to the set-aside amounts.

RATING SENSITIVITIES

Sound Financial Management: Fitch expects that the city will continue to exercise sound budget management and maintain solid liquidity and reserves through the economic cycle.

CREDIT PROFILE

The city is currently benefitting from economic expansion characterized by a healthy level of new business registration, increased technology sector investment, strong tourism growth, and numerous new construction projects, particularly downtown. However, the city is also part of a Southern California housing market that, while still growing, has slowed in growth for the second consecutive year. Low wage growth, limited housing inventory, housing affordability barriers, rising mortgage rates, and tight credit are likely contributing to this slow down. Local economists are predicting modest gains in property sales volume and prices in fiscal 2017.

Revenue Framework

A variety of taxes enables the city to translate its active economy into revenue, capitalizing on the city's size and economic diversity. General fund revenues were relatively resilient (particularly property taxes) during the recent recession, with solid post-recessionary growth. The city's multiyear projections indicate ongoing revenue growth.

Historically, the city's general fund revenues have grown in line with national GDP. The city's multiyear projections assume comparable annual revenue growth going forward as a result of ongoing steady growth in employment, income, taxable sales, and tourism.

The city's independent revenue-raising capacity is limited by a variety of voter-approved state propositions. The key revenue flexibility for California cities are fees-for-services and fines. However, the city does not have a good record of expeditiously increasing its fees and charges, and parking fine revenues have underperformed in fiscal 2016 due to diverted staffing and relaxed parking enforcement.

An annual transfer from the power revenue fund represents approximately 5% of annual general fund revenues. This transfer is currently subject to litigation, which is expected to take some years to resolve. A possible ballot measure in November 2016 or March 2017 could clarify the future of this transfer as part of charter and administrative code changes designed to reform Los Angeles Department of Water and Power governance.

Expenditure Framework

The city has demonstrated its ability to control expenditures. Between fiscal years 2009 and 2015, general fund expenditures grew by 10% compared to 15% general fund revenue growth. However, the city recently agreed to multiyear remuneration increases, its employer contributions to the pension system and OPEB are climbing, and it faces growing service pressures. In fiscal 2015, about 60% of general fund expenditures were for public safety.

Moderate baseline spending growth will result from the agreed-upon compensation increases in the city's multiyear labor contracts, additional new positions, and new service priorities. Pension and OPEB contributions will likely increase at a faster rate than other expenditures despite pension reform, a successfully negotiated cap on retiree health benefit costs, and increased employee contributions. Positively, the city is projecting that its pension contributions will plateau in the medium term. To manage its expenditure pressures, the city is focusing on limiting future employee cost increases, making resource allocation decisions based on performance-based budgeting in all departments, and limiting the backfilling of federal grant cuts.

There are three key areas of additional expenditure pressure facing the city. First, addressing homelessness has become a policy priority. The city estimates the need for $1.85 billion for homeless housing over the next 10 years, plus the costs of coordinated case management, prevention programs, and ongoing support services. A possible November 2016 tax measure could provide an additional funding source for that purpose, supplemented by redevelopment or sale of surplus city properties. The city is also considering placing a general obligation bond measure for housing before the voters.

Second, there are unquantifiable but likely significant litigation risks associated with affordable housing compliance with federal disability access laws, health benefits for sworn personnel, and various wrongful incarceration lawsuits. Third, the city is exposed to major costs associated with stormwater regulatory compliance ($1.5 billion capital investment in the next five years, with approximately $2 billion in potential longer-term capital investments, plus increased operations and maintenance costs, and any penalties, fines, and/or lawsuits if the city fails to comply).

Long-Term Liability Burden

The city's long-term liability burden is moderate relative to personal income. The vast majority of the liability burden is generated by overlapping entities (in particular the Los Angeles Unified School District and the Los Angeles Community College District). The city itself has limited debt issuance plans. However, it might need to issue judgment obligation bonds to address future litigation-related costs. In addition, the city faces increased pension and OPEB contributions over time, to reduce net liabilities and to maintain actuarial funding in light of revised investment return assumptions. The city has limited exposure to variable rate exposure debt and no swap agreements are payable from the general fund.

The city's recent agreement with the coalition of major labor unions terminates the coalition's litigation against LACERS pension reform. As a result, more than 2,000 Tier 2 civilian employees are being transferred to Tier 1 at the city's expense, at an estimated one-time cost of $15 million in fiscal 2016 (approximately 0.3% of budgeted general fund revenues) plus the ongoing cost of more generous retirement provisions. New civilian employees are being hired under Tier 3 which will generate fewer savings than the unwound Tier 2. The large police overtime bank liability is gradually reducing as the city appropriates more funding for police overtime each year. The city is planning to use $5 million of fiscal 2016 departmental savings and unappropriated balance to reduce the overtime bank's current $109 million liability.

Operating Performance

The city has exceptionally strong gap-closing capacity. During the economic recovery of fiscal years 2012-2015, the city's general fund saw net operating surpluses after transfers, growing fund balances and reserves, and stronger liquidity. This was achieved despite increasing expenditures.

According to the fiscal 2016 year-end (fifth) financial status report issued on June 3, 2016, the city expects to solve fully its projected $76 million revenue shortfall and $5 million expenditure deficit while maintaining general fund reserves above its policy minimum of 5% of general fund revenues. The city estimates that it will end fiscal 2016 with emergency and contingency reserves at 8%. Adding the budget stabilization fund increases the city's total reserves closer to 10%. The adopted fiscal 2017 general fund budget shows lower reserves that continue to remain above the policy minimum at 6% for the emergency and contingency reserves and 8% when the budget stabilization fund and a reserve for midyear adjustments are included.

The city's recently updated multiyear projections show an ongoing but manageable general fund structural imbalance through fiscal 2021. Previously, the city had projected breakeven operations for fiscal years 2019 and 2020, which Fitch viewed as unlikely given negotiated litigation settlements, increasing pension and OPEB costs, and calls for additional operational spending.

Notes Finance Cash Flow Needs

Note proceeds will be used to smooth cash flow management for general fund operations during fiscal 2017, and to prepay the city's fiscal 2017 contributions to the Los Angeles City Employees' Retirement System and the Fire and Police Pension Plan. The city expects all five note set-asides to occur in months with positive net ending balances, thereby allowing sufficient coverage of between 1.90x-2.85x solely on the basis of each month's net ending balance, without drawing upon $282 million to $1.08 billion in borrowable funds at those set-aside dates. Including borrowable funds increases coverage to 3.05x-6.31x. The repayment deposit structure sets aside 100% of principal and interest more than one month in advance of note maturity.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.

Applicable Criteria

Rating U.S. Public Finance Short-Term Debt (pub. 17 Nov 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=873508

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=879478

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1005920

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1005920

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Fitch Ratings
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Fitch Ratings, Inc.
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Source: Fitch Ratings

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