Public Finance

U.S.A.

2012 Outlook: U.S. States

Challenging Times Continue, But Fundamental Strength Remains
Outlook Report
Rating Outlook

Rating Outlook
Stabilization of Rating Outlook: Fitchs stable outlook for U.S. state ratings in 2012 compares to the negative outlook assigned in 2011. At the time the 2011 outlook was published, there was tremendous uncertainty as federal stimulus funding was expiring, new governors had been elected in more than half the states, and the political composition of many state Legislatures had changed. The stable outlook for state ratings in 2012 reflects the recurring budget measures that most states took this year and the expectation of their continued commitment to budget balance in an environment of continued slow economic and revenue recovery. This sector outlook is consistent with Fitchs ratings on individual states, with 38 of Fitchs 43 state ratings currently carrying a Stable Rating Outlook. Budget Gaps Smaller than Prior Year: States confronted large projected budget shortfalls for fiscal 2012 as the significant federal stimulus funding that supported finances in the downturn expired. Since gaps were closed without undue reliance on one-time solutions in most cases, the shortfalls to be addressed for the coming year are meaningfully lower. Balancing will still require difficult choices; however, the economic recovery, albeit slow, provides some relief. Medicaid a Key Issue: Fitch expects that Medicaid will present the biggest budget challenge for states in the coming years, in addition to other spending pressures such as pensions. Although Medicaid has been a focus of cost control for the states, options are limited by federal mandates, and the status of the 2010 healthcare reform bill is an additional point of uncertainty.

STABLE

U.S. States Rating Outlooks

(%) 88

100 80 60 40 20 0

7 5 Positive Stable Negative

Related Research
U.S. Government and State and Local Credit (How Federal Deficit Reduction Could Affect State and Local Government Finances), Sept. 21, 2011

Federal Action a Wildcard: Given fiscal challenges at the federal level, Fitch believes that states remain significantly exposed to potential federal funding cuts. Fitch expects that states will have time to react to federal plans, and the risk to near-term budgets is fairly limited. Austerity in Service Funding to Continue: A credit strength of states is that they primarily fund transfers to service providers, rather than providing services directly. In recent years, states have demonstrated their flexibility to devolve budget challenges to these providers. Fitch expects cuts made to date will be sustained, and funding will continue to be constrained.

Analysts
Laura Porter +1 212 908-0575 laura.porter@fitchratings.com Marcy Block +1 212 908-0239 marcy.block@fitchratings.com Karen Krop +1 212 908-0661 karen.krop@fitchratings.com Douglas Offerman +1 212 908-0889 douglas.offerman@fitchratings.com Ken Weinstein +1 212 908-0571 ken.weinstein@fitchratings.com Richard Raphael +1 212 908-0506 richard.raphael@fitchratings.com

What Could Change the Outlook

Hitting Limit of Spending Control: The stable outlook assumes continued spending control. Evidence that states have reached a legal or practical limit to their flexibility in this area, in an environment of relatively modest revenue growth, could lower the outlook for the sector. Unexpected Economic Deterioration: State revenue systems quickly reflect economic conditions. Most states have seen meaningful revenue recovery in the past year, but there is downside risk to economic and revenue forecasts that would require further budget balancing. A sharp economic decline could weaken states financial positions to the point that credit quality is threatened. Steep Federal Funding Reductions: Significant federal spending cuts or tax changes without time to adjust to their impact and/or flexibility to reduce, reconfigure, or do away with affected programs could reduce states overall credit strength.

www.fitchratings.com

December 14, 2011

Public Finance
Key Issues
Fiscal 2013 Budget Gaps Lower than Those of Fiscal 2012
All states benefited from federal stimulus funds that directly supported operating budgets during the recession. According to the Spring 2011 Fiscal Survey of the States jointly produced by the National Governors Association (NGA) and National Association of State Budget Officers (NASBO), over three years, from 20092011, the states benefited from $135 billion in flexible emergency funding through the federal stimulus program. Spending from these funds totaled $61.1 billion in fiscal 2010, dropping to $50.3 billion in fiscal 2011 and to a minimal $3 billion in fiscal 2012 with the phase-out of the program. The vast majority of the federal stimulus funding expired in June 2011. As a result, most states had to deal with the loss of a significant amount of such funding in their budgets for fiscal 2012, which for most began on July 1, 2011. Since revenue growth was not sufficiently robust to cover the loss of stimulus funding, budgeting for fiscal 2012 required difficult choices on the spending side. In most cases, states addressed projected shortfalls with ongoing rather than stop-gap measures. Given the apparent sustainability of budget adjustments made this year, the expected budget gaps to be closed for the coming fiscal year are significantly smaller. This is true even though the demand for state services is still elevated due to continued high unemployment levels, and increased required contributions to pension systems will be an additional pressure for many states. Budgets will still be challenging given the extent of action that has already been taken. At this point in the economic cycle, the states have lower reserves and fewer cost-cutting options, and given the federal budget situation it seems unlikely that there would be any operating support available in the event of an unexpected economic shock. However, assuming continued slow economic and revenue recovery, Fitch believes that the challenges this year are comparatively manageable. States are required to seek, if not achieve, budget balance. Fitch is confident that they will continue to do so, most likely through spending control rather than revenue increases in most places. State debt burdens, with a median at about 3% of personal income, have remained largely stable in the downturn, and Fitch expects to see very little deficit financing in the coming year. Fitch expects states to continue to replenish reserve funds slowly in the recovery, as many have started to do this year.

Revenues Quickly Reflect Economy

The bulk of state own-source revenues are from income and sales taxes that closely track the economy. State revenues have shown clear signs of recovery in 2011, although the pace of growth has slowed in many places. Fitch notes that expectations for the national economy declined significantly over the summer, after state revenue forecasts for the current fiscal year were developed. Revenue results in comparison to forecasts for the fiscal year-to-date vary, with most still performing in line with estimates. In general, Fitch expects fairly constrained revenue growth for the coming year and believes there is more downside than upside risk to forecasts.

Related Criteria
Tax-Supported Aug. 15, 2011 Rating Criteria,

U.S. State Government TaxSupported Rating Criteria, Aug. 15, 2011

2012 Outlook: U.S. States December 14, 2011

Public Finance
State Tax Revenue Trends
(Rolling Four-Quarter Totals)
1,000,000 900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0
2Q 91
($ Mil.) State Total Individual Income General Sales and Gross Receipts

2Q 10

2Q 08

2Q 03

2Q 04

2Q 05

2Q 06

2Q 01

2Q 99

2Q 94

2Q 96

2Q 97

2Q 92

Source: U.S. Census Bureau; includes impact of tax law changes.

2Q 93

Continued Austerity in Service Provider Funding

The states primary role is funding rather than providing services, primarily education and social services. In the current anti-tax environment, budget balancing has been weighted towards spending control rather than revenue increases; Fitch expects this to continue to be the case in 2012. This means that service providers, such as school districts and healthcare providers, are unlikely to see meaningful growth in funding levels even after some significant funding cuts this year. Fitch notes that there are legal and practical limits to the ability of state governments to constrain funding and closely monitors each states situation to assess how close they are to those limits. In the area of Medicaid, although certain limitations associated with the federal stimulus program expired with the stimulus funding, federal healthcare reform establishes some of its own limitations. With K-12 education, the other large state budgetary responsibility, spending cuts or limitations can trigger lawsuits regarding the adequacy of funding, although such lawsuits often take years to be resolved. Of course, voters can ultimately have the strongest voice in budgeting decisions. This can be in the form of a specific initiative or referendum in some states; however, it is more commonly seen in elected representatives responding to actual or perceived voter sentiment regarding financial matters. In a worst-case scenario, this can result in political stalemate as voters resist both service reductions and tax increases, leading to nonrecurring and unsustainable measures to maintain budget balance. Fitch notes that although anti-tax sentiment remains, in the past year elected officials at the state level in most cases have been willing to make significant spending adjustments and indicate the willingness and ability to continue to control costs. Fitch believes that states continue to have significant spending control flexibility. There is no indication that most states will have difficulties staying within budgeted fiscal 2012 spending levels, and the slow economic and revenue recovery should allow for limited additional spending in the coming year.

Medicaid Costs and Uncertainty a Challenge

Spending on health and welfare services, particularly Medicaid, is the second largest expenditure item for state governments in aggregate, after education. The rate of growth of these programs has been well above that of the states revenue streams. Fitch is currently monitoring the success of the states healthcare cost control efforts, some of which require the states to secure Medicaid wavers from the federal government.
2012 Outlook: U.S. States December 14, 2011 3

2Q 98

2Q 95

2Q 00

2Q 02

2Q 07

2Q 09

2Q 11

Public Finance
States options to reduce Medicaid costs at present are limited. These include lowering rates of payment to healthcare providers, reducing benefits, tightening eligibility rules, and cost sharing with enrollees. Each of these options presents its own challenges given federal mandates, including those related to healthcare reform. Fitch expects continued cost control efforts in this area in budgets for the coming fiscal year. In addition, the progress of federal healthcare reform will be an important issue in light of legal and political challenges that are likely to come closer to resolution in 2012.

Federal Deficit Reduction an Ongoing Risk

Fitch does not expect federal deficit reduction to have any widespread near-term rating impact on states, although the efforts present much uncertainty and risk. The biggest concern for states is the potential for reductions to mandated Medicaid payments, as Medicaid is by far the largest area of intergovernmental federal funding to the states. This funding is protected from the automatic cuts that are scheduled to start in January 2013 following last months failure of the congressional super committee. The automatic triggered cuts will result in cuts in other funding to the states and could have noticeable effects on certain state economies and budgets. Given the degree of federal fiscal strain, Fitch expects that federal deficit reduction will be something the states have to deal with in the coming years regardless of whether the automatic triggered cuts are allowed to proceed. Although this is likely to prolong and exacerbate a challenging environment, actions on the federal level are likely to be incremental over the next decade, giving states time to adjust. Depending on the nature of federal deficit reduction, some states will be more heavily affected than others. The impact will depend on the form the deficit reduction takes and the specifics of the credit being analyzed. What is most important for state credit is the magnitude of spending cuts, how they are allocated, and whether the federal government provides flexibility to reduce, reconfigure, or do away with affected programs. Different measures would affect state economies differently, and actions such as federal tax changes also would have disparate effects on the states depending on their nature. For more information on Fitchs analysis of federal deficit reduction and the states, see Fitch Research on U.S. Government and State and Local Credit: How Federal Deficit Reduction Could Affect State and Local Government Finances, dated Sept. 21, 2011, available on Fitchs Web site at www.fitchratings.com.

Retiree Benefit Reforms to Continue

Largely due to the smoothing in of market losses from the downturn, as well as a return to normal pension contributions for some that reduced funding as part of budget balancing efforts, most states will accommodate increased pension funding demands into their fiscal 2013 budgets. Numerous states undertook pension reform in the past year, some of which had a significant effect on liability and required contribution calculations. Fitch expects that in the coming year this trend will continue as states use a combination of increased contributions (employer and employee) and benefit changes to ensure the long-term adequacy of pension funding.

2012 Outlook: U.S. States December 14, 2011

Public Finance
2011 Review
Rating activity in 2011 was heavily influenced by management actions to resolve budget gaps as well as the overall economic and revenue environment. Fitch downgraded the ratings of three states (Hawaii, Minnesota, and New Jersey); each downgrade was by one notch. In the other direction, the Rating Outlooks on Michigan and New York were revised to Positive from Stable, the Rating Outlook on Rhode Island was revised to Stable from Negative, and West Virginia was upgraded one notch from a Positive Rating Outlook. In January 2011 Fitch stated that the rating outlook for the U.S. state government sector in 2011 was negative, reflecting the expectation of negative rating activity above the historical norm. At that time, Fitch noted that the budget season was likely to involve a reconsideration of the level of services that state governments would provide going forward in many places, and that consistent action by states to enact structural solutions to fiscal challenges could stabilize ratings in the sector. Although the budgets were for many arguably the most challenging since the downturn began due to the expiration of temporary direct federal budget support at a time of reduced flexibility and continued elevated demand for state services, in almost all cases the budgets relied primarily on sustainable rather than stop-gap measures. Most budgets employed spending control and cuts to achieve balance. This included reductions in funding to lower levels of government. Such cuts were generally focused on education, which is by far the local government service most heavily funded by the states. Similarly, given the large role that Medicaid plays in state budgets, virtually all budget plans included some action in this area. There were also numerous changes affecting public employee wages, benefits, and headcount at the state and local levels.

2012 Outlook: U.S. States December 14, 2011

Public Finance
Fitch State Ratings and Rating Outlooks
State Alabama Alaska California Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nevada New Hampshire New Jersey New York North Carolina Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Rating AA+ AA+ A AA AAA AAA AAA AA AA (Lease) A AA+ (Lease) AAA (Implied GO) AA (Lease) AA (Lease) AA AA+ AAA AA+ AA AA+ AA+ AAA AA+ AA+ AA+ AA AA AAA AA+ AA+ AA+ AA+ AA AAA AA (Lease) AAA AAA AAA AAA AAA AA+ AA+ AA Rating Outlook Stable Stable Stable Stable Stable Negative Stable Stable Stable Stable Stable Stable Stable Negative Stable Stable Stable Stable Positive Stable Stable Stable Stable Stable Stable Stable Positive Stable Stable Stable Stable Negative Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable

2012 Outlook: U.S. States December 14, 2011

Public Finance

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE. Copyright 2011 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. In issuing and maintaining its ratings, Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. The manner of Fitchs factual investigation and the scope of the third-party verification it obtains will vary depending on the nature of the rated security and its issuer, the requirements and practices in the jurisdiction in which the rated security is offered and sold and/or the issuer is located, the availability and nature of relevant public information, access to the management of the issuer and its advisers, the availability of pre-existing third-party verifications such as audit reports, agreed-upon procedures letters, appraisals, actuarial reports, engineering reports, legal opinions and other reports provided by third parties, the availability of independent and competent third-party verification sources with respect to the particular security or in the particular jurisdiction of the issuer, and a variety of other factors. Users of Fitchs ratings should understand that neither an enhanced factual investigation nor any third-party verification can ensure that all of the information Fitch relies on in connection with a rating will be accurate and complete. Ultimately, the issuer and its advisers are responsible for the accuracy of the information they provide to Fitch and to the market in offering documents and other reports. In issuing its ratings Fitch must rely on the work of experts, including independent auditors with respect to financial statements and attorneys with respect to legal and tax matters. Further, ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts. As a result, despite any verification of current facts, ratings can be affected by future events or conditions that were not anticipated at the time a rating was issued or affirmed. The information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. This opinion is based on established criteria and methodologies that Fitch is continuously evaluating and updating. Therefore, ratings are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for a rating. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. All Fitch reports have shared authorship. Individuals identified in a Fitch report were involved in, but are not solely responsible for, the opinions stated therein. The individuals are named for contact purposes only. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers. 2012 Outlook: U.S. States December 14, 2011 7