Understanding the Downgrade

S&P Global Ratings (S&P) recently downgraded Commonwealth and certain other Massachusetts agency bond ratings one notch from AA+ to AA. The AA rating is still considered a high mark in terms of the investment grade of the bonds, meaning S&P believes the state will meet its debt obligations.  While it is fair to say that the downgrade is not a calamity, it is certainly a warning signal as to what could happen should the state continue practices that do not lead to long-term fiscal health.  It’s a reality check to which we should pay close attention.

As shown in Figure 1, the state’s S&P rating on Massachusetts bonds is still well above 2001 levels and is now at the same level it was from 2005 to 2011.

Figure 1. Massachusetts bond ratings by Standard and Poor’s 2001 to present.

The recent downgrade was on the Commonwealth’s currently $22 billion in outstanding general obligation bonds as well as on debt from Commonwealth agencies and authorities that rely on state revenue, including the MBTA and MassDOT. There are three major rating agencies that assessed the Commonwealth’s bond this June:  Moody’s, Fitch and S&P.  Of these, S&P was is the only one that downgraded; the other agencies left the state’s bond rating unchanged.

The question, though, is why, when a booming economy expands outward from the state’s capital, would any rating firm downgrade Massachusetts bonds?

S&P’s Rationale

The S&P report provides very explicit answers to this question.  Growing fixed costs and increasing MassHealth expenditures coupled with federal funding uncertainty heightens the need for fiscal restraint.  In FY17, debt service, pension and funding for non-pension retiree benefits such as health insurance (known as OPEB) accounted for 12.2 percent of the state budget.  That is high compared to other states and it’s expected to increase next year.  With both the state’s pension contribution and MassHealth expenses growing faster than expected revenues, there will be less flexibility to regroup after budget variances, highlighting the need for a robust budget stabilization fund (BSF).

Contributions to the BSF are expected to fall about $225 million short of what the Governor’s original FY17 plan.  The policy for funding the BSF is for capital gains tax receipts in excess of an amount just over $1 billion to go into the fund, with a portion of that used to fund pension and OPEB obligations.  Because overall state revenues were less than expected, the state used some of what would have gone to the fund to cover operating expenses, as it had in the prior fiscal year.

S&P calculates its ratings based on set criteria in five categories.  Each category is rated between 1 and 4, with a 1 being the highest ranting.  While S&P reaffirmed its AA+ rating as recently as this March, despite an improved score in Economy, the downgrade resulted from a drop in its rating of the Commonwealth’s Budgetary Performance.

This is a comparison of the state S&P scores by category:

	RATINGS CATEGORY	SCORES
		Mar-17		Jun-17
	Government Framework	1.5		1.5
	Financial Management	1.0		1.0
	Economy	1.7		1.4
	Budgetary Performance	1.7		2.0
	Debt and Liabilities	3.5		3.5

According to S&P’s report, the reasons for the AA rating were threefold:

• The state not rebuilding reserves consistent with its policy
• The state’s tendency to experience revenue volatility
• Elevated debt levels and large unfunded pension obligations

The report states:

The state’s reserves peaked at fiscal 2012 levels and, after declining through 2014, balances have stagnated in years since.  However, we recognize the state benefits from world-class institutions of higher education, the commonwealth’s workforce attracts growth-oriented research and development industries that enable its economy to consistently grow at a rate faster than the nation’s, but from a credit standpoint it has not insulated itself from an economic slowdown or other uncertainties that a higher rated issuer would during a period of economic expansion.

In other words, during times of economic growth, the expectation is to sock away funds for future economic downturns, a common sense fiscal policy that the state was unable to execute because of growing fixed costs and healthcare costs.

The factors that kept the rating in the high investment grade category include:

• The state’s deep, diverse economy
• High income and wealth levels
• Timely monitoring of revenue and expense levels and a facility in making adjustments when needed
• Strong financial management practices, with debt affordability statement annually and capital planning processes
• A modest stabilization fund

S&P was clear that the rating could be upgraded if the state were to better fund the BSF, provided the benefit wasn’t offset by rising debt and unfunded retirement obligations.  Given the practice of extending funding schedules for long-term liabilities, that proviso could prove challenging.

Bonds could also be further downgraded if the state proves unable to come close to a structurally balanced budget during periods of growth, or if fixed costs continue to grow faster than revenues, leading to structural deficits.  It must be clear to all that one of the most significant drivers of risk for the state is related to burgeoning Medicaid costs.

Moody’s and Fitch’s Ratings

The other two national bond rating agencies, Moody’s and Fitch, have thus far not agreed with S&P. They had just finished giving Massachusetts’ $717 million June 2, 2017 bond issuance the same rating they had applied continuously since 2011.  In fact, in assessing Massachusetts’s credit for that bond issuance, Moody’s praised the current administration and legislature in its credit rating report by stating: “The Aa1 ratings are based on the commonwealth’s full faith and credit pledge, reflecting its strong financial management practices and demonstrated willingness to balance its budget through spending cuts, revenue increases and use of reserves.”

On the same day, Fitch’s credit report said:

“The Commonwealth has exceptional fiscal resilience, with strong gap-closing capacity stemming from a practice of building solid reserve balances and making revenue and spending changes as needed in response to changing circumstances. Conservative budgeting, ongoing economic and revenue monitoring, and mechanisms to protect the general fund from economically sensitive PIT and judgment and settlement receipts, support the Commonwealth’s fiscal flexibility.”

As shown in Figure 2, five states have been downgraded by all three major rating agencies (Standard and Poor’s, Moody’s, and Fitch) between January 2015 and June 2017.  They are Alaska, Connecticut, Illinois, Louisiana, and West Virginia. New Jersey and New Mexico have been downgraded by Standard and Poor’s and Moody’s, but not Fitch.  Five states have been downgraded by Standard and Poor’s, but not by Moody’s and Fitch: Kansas, Kentucky, North Dakota, Oklahoma, Mississippi, and Massachusetts.

Figure 2. States downgraded by rating agencies between January 2015 and June 2017.

State	S&P Jan 2015	S&P June 2017	Moodys Jan 2015	Moodys June 2017	Fitch Jan 2015	Fitch June 2017	Summary
Alaska	AAA	AA+	Aaa	Aa2	AAA	AA+	Downgrade by 3 agencies
Connecticut	AA	A+	Aa3	A1	AA	AA-	Downgrade by 3 agencies
Illinois	A-	BBB-	A3	Baa3	A-	BBB	Downgrade by 3 agencies
Louisiana	AA	AA-	Aa2	Aa3	AA	AA-	Downgrade by 3 agencies
West Virginia	AA	AA-	Aa1	Aa2	AA+	AA	Downgrade by 3 agencies
New Jersey	A	A-	A1	A3	A	A	Downgrade by 2 agencies
New Mexico	AA+	AA	Aaa	Aa1	NR	NR	Downgrade by 2 agencies
Kansas	AA	AA-	Aa2	Aa2	NR	NR	Downgrade by 1 agency
Kentucky	AA-	A+	Aa2	Aa2	A+	AA-	Downgrade by 1 agency
Massachusetts	AA+	AA	Aa1	Aa1	AA+	AA+	Downgrade by 1 agency
North Dakota	AAA	AA+	Aa1	Aa1	NR	NR	Downgrade by 1 agency
Oklahoma	AA+	AA	Aa2	Aa2	AA+	AA+	Downgrade by 1 agency
Mississippi	AAA	AAA	Aaa	Aaa	AA+	AA	Downgrade by 1 agency