COMMONWEALTH DEBT RATING DOWNGRADE
On September 2, 2017, S&P Global Ratings downgraded the credit rating of the Commonwealth of Pennsylvania from AA‑ to A+, thus making our state its fourth lowest rated state in the United States of America. S&P Global Ratings has applied lower ratings only to Kentucky (A+), New Jersey (A‑) and Illinois (BBB). This action is significant because it could cost Pennsylvania more to borrow money by general obligation bonds at a time when our unresolved pension deficit, structural imbalance and legislation for funding the 2017‑2018 budget leave Pennsylvania few alternatives to pay its debts as they become due.
A credit rating from any of the big three rating agencies, Fitch Ratings, S&P Global Ratings and Moody’s Investors Services, is a third‑party assessment of (1) the debtor’s ability to repay its debt and (2) the likelihood of timely repayment of the debt (the “Repayment Assessment”). Any bond issued on a lower credit rating will be riskier in Repayment Assessment and therefore will require the debtor to pay more interest to attract the required investment. Risk must be rewarded in the market place.
The Commonwealth’s credit rating is important also because it reflects the Repayment Assessment of Pennsylvania debt without other collateral securing that repayment. In a financing structured without collateral to support repayment of state debt, Pennsylvania issues general obligation bonds (“GO Bonds”). Those GO Bonds are secured by the Commonwealth’s taxing power. Pennsylvania taxpayers, not the value of or the cash flow from collateral owned and pledged by the Commonwealth, bear the ultimate cost of repaying GO Bonds.
Why did S&P Global Ratings downgrade Pennsylvania? “The downgrade largely reflects the Commonwealth’s chronic structural imbalance dating back nearly a decade, a history of late budget adoption and our opinion that this pattern could continue,” said S&P Global Rating’s credit analyst Carol Spain. Structural imbalance occurs as a function of a successively diminished state workforce while Pennsylvania steadily owes more debt each year. See, “Economic and Budget Outlook: Commonwealth of Pennsylvania – Fiscal Years 2016-2017 to 2021- 2022,” by the Pennsylvania Independent Fiscal Office (“IFO”). According to Matthew Knittel, Director of the IFO, the shortfall is recognized at a present $1.5 billion related to Fiscal Year 2016-2017 that must be paid in Fiscal Year 2017-2018. The second issue is a $700 to $800 million deficit in the 2017-2018 Fiscal Year, due in part to the $32 billion budget of the General Assembly containing at least $600 million of new spending. That second deficit could carry forward as a structural imbalance in Fiscal Year 2018‑2019 due in part to increased pension obligations and health care costs according to Mr. Knittel. These deficits are the subject of a present debate between the Senate and the House of Representatives that was due to be resolved by June 30, 2017 with the annual spending plan. Pennsylvania must now adopt a revenue plan to support its indebtedness approved in a budget of the General Assembly that became law after Governor Wolf refused to approve it timely.
Why should Pennsylvania borrow money to pay its bills as they become due? “Deficit borrowing does not exemplify strong management practices, but, in our view, borrowing that restores the Commonwealth’s liquidity to a position in which it can make timely payments would be preferable from a credit perspective then an accumulation of unpaid bills,” explained Carol Spain. For purposes of continued good relations with creditors and instilling confidence in other third parties critical to the Commonwealth’s fiscal health and its citizens’ welfare, timely payment is the most prudent course of action.
There is no revenue plan to support the budgeted expenditures because the four caucuses and the Governor do not agree on how to patch the $2.2 billion deficit. The Senate and Governor Wolf have agreed on a recurring revenue plan: (a) severance tax on Marcellus Shale for $100 million annually, (b) gross receipts tax on natural gas, electronic and telecommunications bills for $405 million annually, (c) 6% sales tax on vendors who sell on the Internet, (d) $200 million in annual revenue from gambling expansion, and (e) borrow $1.3 billon against future revenues from the Commonwealth’s 1998 tobacco settlement (“Senate Plan”). The House of Representatives more recently proposed to fund that deficit with little recurring revenue: (a) $630 million in special fund transfers, (b) selling rights to a portion of Pennsylvania’s tobacco settlement fund, (c) applying more than $400 million in funds authorized but not spent in prior budgets, (d) $225 million in casino gaming expansion, (e) $20 million from legislative reserve accounts and (f) $50 million from the Pennsylvania Liquor Control Board (the “House Response”). The House of Representatives first voted against the Senate Plan and the Senate later voted against the more recent House Response.
The Pennsylvania Treasury has previously provided short‑term loans to the Commonwealth to help pay bills as they accrue during times when there is no revenue plan to support the budget. Most recently, on August 3, 2017 the Pennsylvania Treasury lent to the Commonwealth $750 million for two weeks to pay bills as they became due. On September 25, 2017, however, State Treasurer Joe Torsella declined authorizing a second loan in light of the failure to adopt revenue legislation for the 2017‑2018 budget. “We want to see a plan for the budget being in balance,” he said.
Without a revenue plan to support the $32 billion budget (and plug the $2.2 billion revenue shortfall) and no short‑term funding from the Treasury, the Commonwealth delayed paying $1.167 billion to Medicaid managed care organizations and $581 million to PSERS (public school pension). “We understand the Commonwealth plans to make payment to both the Medicaid insurers and school districts within a week of the scheduled payment dates; however, in the absence of additional liquidity, and with the likely need from external borrowing, these late payments could recur,” Carol Spain said.
On June 12, 2017, Governor Wolf approved Senate Bill No. 1, the law that has introduced a defined contribution plan component for pensions of all state and school district employees other than state police officers and correctional officers. The cost savings for the Commonwealth from that law are distant and do not address the present unfunded pension liability. By June 30, 2017, the Pennsylvania state government failed to adopt a timely budget and revenue plan. On July 6, 2017, S&P Global Ratings placed the state’s general obligations on credit watch with negative implication. We should not be surprised by S&P Global Ratings’ recent downgrade of our GO Bonds.
How does Pennsylvania resolve the structural imbalance and the present Fiscal Year budget deficit, and enjoy efficient execution of its GO Bonds? State spending should not rise above inflationary adjustments and adequate state revenues should recur without annual one-time solutions to address the existing imbalance and deficit. Those achievements and adoption of spending and revenue plans by June 30 of each year will address the issues underlying the downgrade by S&P Global Ratings. Fortunately, the credit ratings of our GO Bonds by Fitch Ratings and Moody’s Investors Services, the other two large rating agencies, remain at AA‑minus and Aa3, respectively, each a notch above the A+ from S&P Global Ratings. Perhaps the interest rate paid by the Commonwealth on future GO Bonds will not adversely increase and the state leadership will make the difficult decisions to resolve our fiscal issues.
© 2017 Robert J. Hobaugh, Jr.