New Jerseys GO Rating Lowered To A+ On Continuing Structural Imbalance; Outlook Stable

Primary Credit Analyst: John A Sugden, New York (1) 212-438-1678; john.sugden@standardandpoors.com Secondary Contact: David G Hitchcock, New York (1) 212-438-2022; david.hitchcock@standardandpoors.com

NEW YORK (Standard & Poor's) April 9, 2014-- Standard & Poor's Ratings Services lowered its rating on New Jersey's general obligation (GO) debt to 'A+' from 'AA-'; its rating on the state's appropriation-backed debt to 'A' from 'A+'; and its rating on the state's moral obligation debt to 'BBB+' from 'A-'. The outlook on all the ratings is stable. "The downgrade reflects our view that despite a generally improving economic environment, the state continues to operate with a sizeable structural imbalance and that measures used by the state to balance the budget will contribute to future budgetary pressures," said credit analyst John Sugden The 'A+' GO rating on New Jersey reflects our view of the state's credit weaknesses: A trend of structurally unbalanced budgets that include only partial funding of pension obligations and the reliance on one-time measures that are contributing to additional pressure on future budgets; A large and growing unfunded pension liability; Significant postemployment benefit obligations; and An above-average debt burden. In our opinion, credit strengths include New Jersey's: Diverse economic base, which is showing signs of improvement, but has a long way to go to full recovery; High wealth and incomes, which are still among the highest of the 50 states. Standard & Poor's also assigned its 'A' rating to the New Jersey Educational Facilities Authority's (NJEFA) series 2014A and 2014B higher education capital improvement fund issue revenue bonds, and series 2014C and 2014D higher education capital improvement fund issue revenue refunding bonds. The bonds are secured by funds received by the authority pursuant to a contract with the

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New Jerseys GO Rating Lowered To A+ On Continuing Structural Imbalance; Outlook Stable

state. Contract payments are subject to appropriation by the New Jersey legislature. The state is issuing the series 2014A and 2014B bonds to fund capital improvement grants to certain public and private higher education institutions. The series 2014C and 2014D bonds are being issued to advance refund the series 2004A bonds, for estimated net present value savings of $3.04 million. Savings will be taken evenly over the life of the bonds and there is no extension of maturities. All four series of bonds are being sold at a premium, with total premium estimated at $22.5 million. Almost five years after the official start of the economic recovery, New Jersey continues to struggle with structural imbalance and stands in stark difference to many of its peers who registered sizeable budgetary surpluses in fiscal 2013. As we have stated in past years, bullish revenue assumption and overreliance on untested or uncertain revenues in fiscal 2013 and 2014 (see " New Jerseys 2014 Proposed Budget: Structural Balance Remains Elusive," published March 13, 2013, and "New Jersey Governor's Proposed Budget is Structurally Unbalanced; Revenue Assumptions Could Be Optimistic," published Feb. 24, 2012, both on RatingsDirect) have led to additional budgetary gaps opening throughout the year. For the most part, the potential issues we raised about fiscal 2014 have come to pass and the state now has to close a $786 million budget gap that developed through the first eight months of fiscal 2014. The gap is the result of revenue projections that were overstated by $342 million, a weaker starting position due to revenue shortfalls ($152 million) from fiscal 2013, and $292 million in increased funding needs. For fiscal 2014, the state is relying on $694 million in spending reductions and other one-time measures, including savings from lower pension payments, and use of fund balances to close the gap. Additionally, the state is relying on $92 million in additional one-time revenues that it received in fiscal 2014 from the monetization of tobacco settlement revenues by providing credit enhancement to certain tobacco settlement bonds, which is expected to reduce general fund revenues by approximately $50 million to $60 million a year starting in fiscal 2017. When this amount is added, the use of one-time measures to close the fiscal 2014 midyear gap grows to $786 million, or 2.4% of the revised budget. Additionally, in its most recent disclosure the state indicated that it expects to have additional snow removal costs of $25 million and that there is the potential that $60 million in legal settlements may not materialize. The Office of Legislative Services (OLS), which is independent of the executive branch and provides its own revenue estimates to the legislature, estimates that revenues for fiscal 2014 could fall 0.7%, or $217 million, below the state's estimates. Based on these estimates, we calculate the use of one-time measures to range from $811 million to $1.03 billion, or 2.5% to 3.2% of the budget. When non-recurring measures of $1.17 billion used to balance the enacted budget are included, total use of non-recurring measures range from $1.8 billion to $2.07 billion, or between 5.5% and 6.3% of the budget, depending on whether these additional shortfalls materialize. This compares the use of one-time measures of approximately $1.7 billion, or 5.4% of budget, in the fiscal 2013 budget. These figures would be about double if the state were fully funding its pension annual required contribution. Year-to-date revenues as of February are running 4.7% ahead of last year's collections, but below the 5.5% revised revenue growth target. Income tax

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New Jerseys GO Rating Lowered To A+ On Continuing Structural Imbalance; Outlook Stable

revenues are 3.4% above collections for fiscal 2013, which remains well below their 6.8% target growth rate for fiscal 2014. Although April collections play an important role every year, they play an even greater role in fiscal 2014 due to certain factors, such as the one-time impact of accelerated tax payments in fiscal 2013, refund timing differences, and very strong market performance in tax year 2013, which make year-end collections in fiscal 2014 harder to predict. Sales tax revenue, the second-largest revenue source, is coming in 5.7% ahead of last year's and slightly higher than the 5.4% projected growth. Corporation income taxes, the state's third-largest revenue source, are 7.2% ahead of last year and approximately three times higher than the 2.3% projected growth rate, however, this remains a smaller portion of overall revenues. Should the state's revenue collections accelerate with income tax revenues coming in higher than budgeted, it would lower the target growth rate for fiscal 2015 from its current 8.1% and contribute to increased reserves. Currently, the state's reserves are estimated at $301 million, or less than 1% of revenues, which provides limited cushion should April revenues fall below their targets. Governor Christie's proposed fiscal 2015 budget totals $34.4 billion, up 5.6% from the revised fiscal 2014 budget (calculated by us at $32.6 billion after lapses). In what he dubbed the "Attitude of Choice" budget, the governor highlighted the tough choices the state had to make choosing between funding pension, retiree health care, and debt, or investing in other state priorities, such as education, health care, and transportation. Approximately 26% of the budget and 94% of increased spending is going to pay for pensions, employee and retiree health care, and debt, which are ultimately crowding out other services. School aid funding increases by less than 0.5%. The state has indicated that the methodology used to determine school aid funding levels in fiscal 2014 and 2015 is different from the statutory funding formula, which we believe could become a source of pressure if funding is found to be insufficient. In our view, the budget continues to be structurally unbalanced and continues to feature recurring expenditures well exceeding recurring revenues even before accounting for the underfunding of the pension annual required contribution (ARC) payments. The fiscal 2015 budget assumes 5.8% growth in total revenues. Income tax revenues, which account for about 40% of revenues, are budgeted to grow 8.2%, a rate that is much higher than that of neighboring New York and Connecticut. The state is forecasting sales tax revenues to grow by 6.1% relative to fiscal 2014, but includes several tax initiatives. For fiscal 2015, the governor has proposed closing several tax loopholes to enhance revenues, including reducing the business-to-business tax exemption for Urban Enterprise Zone businesses, revising the nexus status for certain out of state internet vendors to determine if they should remit taxes for online sales, and penalizing "bad" electronic payments. A portion of these enhanced revenues would come from extending sales tax on tobacco to include e-cigarettes. These measures would require additional legislation and, like casino gaming revenues, are untested. OLS revenue estimates are $309.4 million, or 0.9%, below the Treasury's estimates and reflect 5.5% growth from a lower base. The state continues to rely on one-time measures such as legal settlements, debt restructurings, and use of surplus to close budget gaps. For fiscal 2015, the use of one-time measures amounts to $949 million, or approximately 2.8%, of the budget. As we

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New Jerseys GO Rating Lowered To A+ On Continuing Structural Imbalance; Outlook Stable

have seen over the past few years, the state's reliance on one-time measures tends to increase midway through the year. In our view, future pressures for the state include growing debt, pension, and other post-employment benefit (OPEB) costs as well as the need to continue to fund growth in education. Although the state has experienced revenue growth over the past few years, the growth has not been sufficient to keep pace with growth in expenditures. While our outlook on the national economy remains positive, we recognize that the current expansion will have reached its fifth year at the time of budget enactment and that a bull market in equities has already surpassed the five-year point. By using bullish assumptions about revenue growth and one-time measures to close budget gaps, the state defers making long-term structural changes to better align revenues and expenditures, defers budgetary pressures to future years' budgets and increases its exposure to an eventual economic downturn. This is evidenced by the state's continuous use of debt restructuring which, while artificially lowering current-year debt payments to make them affordable also gradually increases future year's payments, demanding even greater revenue growth or continued restructurings to manage its debt burden. Not only has the state's reliance on one-time measures continued during a period of economic expansion, but the sources are becoming less conventional, such as changes to retroactive pension contributions and monetization of future year's revenues. New Jersey's economy is showing continued signs of improvement, despite some slowing of the state's economy in the second half of 2013 due to weaker shore tourism. According to IHS Global Insight Inc., the state registered 1% employment growth in 2012 and 1.4% growth in 2013. The state's unemployment rate averaged 8.2% (seasonally adjusted) in 2013, down from 9.5% for 2012. As of January 2014, unemployment had declined to 7.1%, just slightly above the nation's 6.7% rate. Preliminary figures for February point to no change in the unemployment rate. According to the U.S. Bureau of Labor Statistics-, the decline in unemployment reflects both a decline in employment as well as a decline in labor force participation. Although one would expect employment in New Jersey to be growing significantly due to Hurricane Sandy reconstruction efforts, the chill of the "polar vortex" this winter could have caused lower construction employment. In fact, construction, which had experienced 3.4% growth year over year as of August 2013, was showing a 2.0% decline as of February 2014, according to IHS Global Insight. Downsizing in the pharmaceutical sector could have also contributed to the overall declines in employment. IHS Global Insight is forecasting 1.3% average job growth over the next six years, ranking New Jersey 35th among the states in a muted recovery. The outlook reflects our expectation that New Jersey's budget will continue to be structurally imbalanced and that reliance on one-time measures will remain at or close to current levels. In our view, although a generally improving economy could partially lower this reliance, it will not eliminate it altogether. While revenues for the remainder of fiscal year could show some acceleration in growth, we don't think they will materially alter the state's overall structural budget alignment given growing fixed-cost pressures and the below-average pace of economic expansion. Should revenue growth forecasted for fiscal 2014 and 2015 fail to materialize, further increasing the state's reliance on one-time measures and deferring pressures into future budgets, there could be additional downward pressure on the rating. Absent long-term

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revenue and expenditure alignment measures that lead to structural balance, improved reserves and that allow for more conservative budget assumptions, we don't anticipate revising the rating upward. RELATED CRITERIA Related Criteria USPF Criteria: USPF Criteria: USPF Criteria: AND RESEARCH State Ratings Methodology, Jan. 3, 2011 Appropriation-Backed Obligations, June 13, 2007 Moral Obligation Bonds, June 27, 2006

Related Research U.S. State And Local Government Credit Conditions Forecast, April

7, 2014

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