Fitch Ratings has upgraded the following Fresno, California ratings:
–Issuer Default Rating (IDR) to ‘A’ from ‘BBB+’;
–$95 million Fresno Joint Powers Financing Authority (Fresno JPFA) lease revenue bond (LRB) series 2008A, 2008C, 2008E, 2008F, 2004A, and 2004C to ‘A-‘ from ‘BBB-‘;
–$41.9 million Fresno JPFA LRB series 2009A and 2006A to ‘A-‘ from ‘BBB’.
The Rating Outlook is Stable.
The bonds are payable from lease rental payments from the city (the obligor) to Fresno JPFA (the issuer) for use and occupancy of various governmental assets. The city has covenanted to budget and appropriate lease rental payments from any legally available resource. The lease is subject to abatement risk.
KEY RATING DRIVERS
The IDR remains below average for the sector because of the city’s weak financial performance during the last recession. The upgrade to an ‘A’ IDR reflects improvements in the city’s financial resilience, inherent budget flexibility and the reserve safety margin. Fitch believes the gains are likely to prove durable because they are driven by significant changes in financial policies and procedures as management and the electorate sought to institutionalize lessons learned during the Great Recession.
Economic Resource Base
Fresno is California’s fifth-largest city with about 516,000 residents. The city is the economic and cultural hub of the San Joaquin Valley, the nation’s most productive farming region, with significant farm, food processing and agribusiness employment. The economy has expanded and diversified over several decades of rapid population growth, but agriculture remains dominant. Economic indicators are weak with U.S. median household income at just 79.2% of the U.S. and chronically elevated unemployment.
Revenue Framework: ‘bbb’ factor assessment
The city’s property and sales tax-dominated revenue framework provides solid long-term growth above the level of inflation and economic growth, but it has very limited independent revenue flexibility due to the strict property tax limits of the California state constitution. Most revenue increases require a vote of the people.
Expenditure Framework: ‘aa’ factor assessment
Policymakers have solid spending flexibility with the solid control over staffing and wage levels and moderate fixed costs. Fitch expects expenditure growth to roughly match revenue growth across the business cycle despite short-term imbalances during recessions.
Long-Term Liability Burden: ‘aaa’ factor assessment
The total long-term liability burden is low relative to the city’s economic base. City pensions are over-funded due to pension obligation bond issuance and a pre-Proposition 13 pension property tax override that creates a dedicated funding source for pensions.
Operating Performance: ‘a’ factor assessment
Operating performance is normalizing after a prolonged period of financial stress during and after the last recession. The city’s reserves have increased rapidly following expiration of inflexible long-term labor contracts, expenditure cuts, renewed growth in revenues and improvements in financial management. The city appears adequately positioned to withstand typical cyclical stress and is expected to increase financial flexibility to more robust levels in the near term.
Operating Performance to Drive Rating: The rating could come under downward pressure if the city fails to continue to actively align expenditures with revenues, slipping into a sustained structural budget imbalance during periods of economic expansion. The rating could move higher if the city builds and maintains a more robust reserve safety margin on a sustained basis.
Fresno’s economy suffered very steep and long-lasting declines during the national housing downturn, but the economy has grown at a solid pace in recent years with job and tax base growth accelerating. The region’s agricultural sector has proven resilient through the current California drought and continues to provide a solid base of economic activity for the region. Like many agricultural centers, Fresno suffers from chronic high unemployment and low incomes that are likely to remain a feature of the resource base regardless of near-term cyclical changes.
The city benefits from a diverse general fund revenue mix that is dominated by property (36% of total general fund revenues in 2015) and sales (25%) taxes. It has very minimal legal ability to raise revenues due to Proposition 13 tax limitations.
Fitch believes future general fund revenue growth is likely to be solid, outpacing inflation in the absence of policy actions. Fresno’s revenues and tax base have expanded with its population, which has grown faster than the national average over the past two decades and expanded by about a third. The compound annual growth rate (CAGR) of revenues outpaced both inflation and economic growth at 4% over the past decade. The number is somewhat inflated by the city’s decision to absorb non-general fund departments into its main operating fund in the aftermath of the last recession, but the revenue framework generally allows the city benefit from the underlying growth in the economy. Sales taxes revenues track local economic activity well. The city’s property taxes have generally grown faster than inflation, but Proposition 13 only allows the city to capture growth in existing property values up to 2% annually. The city beats inflation by capturing more growth when properties turn over (creating a new base for Proposition 13 values of existing properties) and when new development occurs.
The city has very limited independent revenue raising flexibility due to California Proposition 13 tax limitations. It may not raise its operating property tax rate under any circumstance, and it may only raise other taxes with a vote of the people. The council’s only independent policy lever for revenue control is the level of fees, and this tool is insufficient to offset cyclical revenue declines in typical recessions.
Fresno is a full service city with responsibility for police, fire, parks and recreation and public works. The city’s expense structure is typical and dominated by labor with public safety workers accounting for the plurality of the workforce and the majority of spending.
The natural pace of spending growth is expected to be in line with revenue growth on average. The city’s main expense drivers are wages, which Fitch expects to track revenue growth well.
Expenditure flexibility is solid. Fresno largely controls spending through labor negotiations and headcount control. The collective bargaining framework is structured but reasonably flexible. While the city must meet and confer with its unionized workforce, the city council has the authority to impose contract terms when it cannot reach agreement with public employees. None of the city’s labor groups is subject to binding arbitration. The city’s track record in labor negotiations is mixed but improving. Fresno agreed to long-term public safety contracts that severely limited its spending flexibility in the Great Recession, leading to a period of sustained deficits and reserve depletion as revenues declined. The city has since overhauled its financial policies and practices to better prepare for the next downturn. Management now aims to limit contracts to a more reasonable two years, while avoiding clauses that prohibit layoffs or furloughs.Fresno also staggers contracts to maintain flexibility in case of a downturn. Current contracts appear affordable with inflation-like raises and rising worker retirement and healthcare contributions.
The carrying costs of pension, other post-employment benefits (OPEB) and debt service are 20.4% of governmental funds expenditures, but carrying costs are likely to decline gradually over the next few years with decreasing debt service payments and stable pension payments.
Long-Term Liability Burden
The total long-term liability burden (direct and overlapping debt) is low at 7.4% of personal income. The city’s outstanding direct governmental debt portfolio is dominated by fully amortizing fixed-rate lease revenue bonds and pension obligation bonds. Amortization is solid with 29.5% of governmental activities debt repaid in five years and 58.9% in 10 years. The city has no current plans to issue new tax-supported debt.
The city offers defined benefit pensions through two single-employer plans: the City of Fresno Employees Retirement System and City of Fresno Police and Fire Retirement System. The plans are overfunded by an estimated $205 million as of the most recent valuation date in 2014, assuming Fitch’s standard 7% rate of return assumption. The city reports a higher net pension asset of $326.7 million, based on its higher rate of return assumption. The city has $145.7 million of pension obligation bonds outstanding, and debt service is paid from a pre-Proposition 13 property tax override.
Fresno is once again adequately positioned to withstand cyclical revenue stresses after rapidly rebuilding reserves over the past three fiscal years. The city rebuilt reserves in fiscal 2014 and 2015 as revenues recovered from recession and policymakers kept tight control on spending restorations. Fitch also expects the city to add significantly to reserves when its fiscal 2016 audit is published and to continue reserve building in fiscal 2017. Fitch’s analytical sensitivity tool (FAST) generates a 4.9% decrease in general fund revenues in Fitch’s standard 1% decline in U.S. GDP stress scenario, suggesting above average revenue volatility based on analysis of the city’s historical revenue performance. Fitch expects the city to manage future revenue declines through a combination of reserve spending and continued strong control over labor costs through headcount control. The city has restored a good deal of its inherent budget flexibility by moving away from long-term labor contracts. The unrestricted general fund balance was a little more than twice the level of the FAST revenue loss scenario at 11.9% at the end of fiscal 2015. Fitch expects reserves to reach three times the FAST revenue loss scenario by the end of the current fiscal year.
Fresno’s budget management in times of recovery is solid. The city conducts comprehensive and conservative long-range budget forecasting that keeps policymakers focused on maintaining and restoring structural budget balance. The city moves quickly to rebuild financial flexibility after periods of financial stress. In the current expansion, reserves grew slowly in the years right after the recession as the city paid off deep fund balance deficits accrued during the unusually deep downturn, but a pattern of improvement (first reductions in deficits followed by robust reserve building) has been clear since shortly after the recession. The city pays the full actuarially required pension contributions.
Fresno’s recent operating performance is much improved from prior periods. Fitch believes the improvement is likely to be durable because it is supported by significant changes in financial policies. The city instituted a series of changes in financial practices that aimed to institutionalize lessons learned during the Great Recession, including strengthening of formal reserve policies, creation of a policy to address negative cash balances outside the general fund, and a shift to shorter-term labor contracts.
The current rating action begins the process of normalizing the city’s ratings, moving it to the lower end of the expected range for U.S. local government IDRs (‘A-‘ to ‘AAA’). Fitch expects the rating to move higher within the expected range if improvements in financial management prove durable, but further upgrades will be very gradual. Upgrades are unlikely until the city shows that it can maintain the improved level of performance and sustain compliance with improved financial policies across mayoral administrations and across a full business cycle. The rating is likely to remain a notch or more below the sector average of ‘AA’ even after the city fully recovers, reflecting its relatively weak revenue framework and high degree of revenue volatility.
The upgrade to the lease revenue bonds reflects both the upgrade to the IDR (based on recent credit improvements) as well as criteria changes that no longer require notching distinctions between typical leases based on essentiality assessments.
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.
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
Dodd-Frank Rating Information Disclosure Form