2011 Outlook: U.S. Public Finance Sector Profiles

Public Finance
U.S.A.
Outlook Report
2011 Outlook: U.S. Public Finance
Sector Profiles
Analysts Rating Outlook
Eric Friedland The U.S. public finance outlooks for 2011 range from negative to stable, depending on
+1 212 908-1632 the individual sector. Local and state governments across the country will face varying
eric.friedland@fitchratings.com
degrees of fiscal and economic pressure as the prospects for recovery differ widely. In
Laura Porter light of this pressure, Fitch Ratings anticipates downgrades to continue to outpace
+1 212 908-0575 upgrades, although ratings stability will continue to dominate the sectors. Outlooks for
laura.porter@fitchratings.com
the eight U.S. public finance sectors are summarized below.
Amy Laskey
+1 212 908-0568 U.S. States  Negative
amy.laskey@fitchratings.com
 The key issues facing states in 2011 are the expiration of federal stimulus funds
James LeBuhn that have supported operating budgets, the slow pace of tax revenue recovery in
+1 312 368-2059
james.lebuhn@fitchratings.com most places, and the continued elevated demand for state services.
Chris Jumper  States face more difficult options in confronting these budget challenges, as most
+1 212 908-0594 drew down reserves in the downturn and have already exhausted the more
chris.jumper@fitchratings.com
palatable available budget management actions.
Doug Scott
+1 512 215-3725  An anti-tax environment nationwide limits revenue-raising opportunities, and many
douglas.scott@fitchratings.com states will need to increase contributions to pension systems.
Douglas J. Kilcommons  Actions taken this year will be a key indicator of the strength of fiscal management.
+1 212 908-0740 States have a long record of seeking and achieving budget balance, as a matter of
douglas.kilcommons@fitchratings.com law and practice, and Fitch is confident that they will continue to do so.
See pages 434 for Sector U.S. Local Government Tax Supported
Profiles. Given its broad scope, Fitch does not assign a rating outlook for the sector as a whole.
Related Research
 Never have the quality of management and the willingness to take difficult
Applicable Criteria measures to adapt been more important to distinguishing variations in tax-
 Revenue-Supported Rating Criteria, supported credit quality.
Oct. 8, 2010
 U.S. State Government Tax-Supported  Assessed valuations will continue to drop, constraining revenues for governments
Rating Criteria, Oct. 8, 2010 reliant on property taxes.
 U.S. Local Government Tax-
Supported Rating Criteria, Oct. 8,  Declining state funding and/or the shifting of responsibilities from states to local
2010 governments will present an additional burden to municipal budgets.
 Tax-Supported Rating Criteria,
Aug. 16, 2010  Reserve levels will continue to decline, as local governments rely on them to offset
 Nonprofit Hospitals and Health their lack of revenue-raising flexibility.
Systems Rating Criteria, Dec. 29, 2009
 College and University Rating  Labor contracts with wage freezes or reductions and re-opening clauses have
Criteria, Dec. 29, 2009 become increasingly common, and this trend will likely intensify in 2011.
 Public Power Rating Guidelines,
June 11, 2009  Pension-related costs will continue to take on a prominent role in municipal budgets
 State Housing Finance Agencies this year, as annual required contributions (ARCs) will increase in many instances to
General Obligation Rating Criteria,
April 6, 2009 absorb the impact of prior investment losses and historical underfunding.
 Rating Guidelines for Nonprofit
Continuing Care Retirement Nonprofit Hospitals and Healthcare Systems  Stable
Communities, Dec. 15, 2008  While several reform elements are slated to take effect this year, Fitch expects the
 Water and Sewer Revenue Bond credit impact of such changes to be relatively modest.
Rating Guidelines, Aug. 6, 2008
www.fitchratings.com March 30, 2011

Public Finance
Related Research  Fitch expects moderate credit benefits to be realized by many providers through
(continued) closer integration with medical staffs, enhanced information technology, and
improvements in quality and safety.
Other Research
 2011 Water and Wastewater  Although the economic downturn elevated uncompensated care levels and reduced
Medians, Jan.18, 2011
patient volumes, Fitch-rated borrowers generally maintained their operating
 U.S. State and Local Government
Pensions: One Size Does Not Fit All, margins and operating cash flow.
Jan. 7, 2011
 High Demand/Diminished Supply:
 Fitch believes merger activity will increase.
Changing Dynamics of Bank
Facilities Market Heighten the Risk Senior Living  Negative
Profile for Some Municipal  A further decline in home prices, which would negatively affect the level of
Borrowers, Dec. 8, 2010 independent living unit sales and entrance fee receipts, remains the primary credit
 U.S. State and Local Government
Bond Credit Quality: More Sparks
risk to the sector.
than Fire, Nov. 16, 2010  Management and marketing departments within the sector have demonstrated
 2010 Median Ratios for Nonprofit
Continuing Care Retirement
surprising creativity in the development of marketing campaigns and incentives to
Communities, Sept. 28, 2010 drive independent living unit (ILU) sales.
 State Housing Finance Agencies
Statistical Information, July 29, U.S. Public Power and Electric Cooperatives  Stable
2010  The risk exists that fiscally strapped local governments could impart greater
 2010 Median Ratios for Nonprofit
Hospitals and Healthcare Systems,
political pressure to limit utility rate increases and/or increase utility system
July 28, 2010 transfers to city general funds.
Other Outlooks  New environmental regulation appears to specifically target smaller, older coal-
 www.fitchratings.com/outlooks fired generation.
 Federal and/or state mandated renewable energy standards are expected to result
in an increase in the overall cost of power supply for many issuers.
 Weather-adjusted public power electric sales are expected to show slow growth
levels, limited further by the effectiveness of energy efficiency and demand-side
management initiatives.
 Coal and other commodity prices have rebounded; however, natural gas prices are
expected to remain low in 2011 due to abundant supply.
 Since natural gas generation sets the market prices in many regions, the spot-
market price of electricity is expected to remain soft through 2011.
Water and Wastewater  Stable
 While water and wastewater utilities have been able to generate solid financial
results overall throughout this economic cycle, some weakening has occurred,
albeit by a modest amount.
 Given the revenue and cost pressures facing utilities, timely rate recovery will be
important to maintaining financial profiles and positioning systems to meet their
long-term capital and service demands.
 Heightened regulations will add to operating and capital challenges for utilities,
although the regulatory environment is relatively stable, and new requirements are
not expected to have material credit implications during the year.
Higher Education  Stable
 Fitch expects most colleges and universities, particularly those rated investment
grade, to maintain or modestly increase student headcount, thereby bolstering
student-generated revenue streams.
 Most institutions have taken action to minimize the volatility of investment returns,
2 2011 Outlook: U.S. Public Finance Sector Profiles March 30, 2011
Public Finance
where possible, and increase the overall liquidity of their total investment holdings.
 As management teams across the higher education industry formalize and codify
policies and practices designed to minimize credit risks across a host of functional
areas, Fitch believes many colleges and universities are now better equipped to
identify and respond to challenges as they arise.
State Housing Finance Agencies (SHFA)  Negative
 The main driver is the slow economic recovery.
 The low interest rate/mortgage rate environment has curtailed SHFA mortgage
production/origination.
 For most SHFAs, there continues to be financial cushion at the issuer level to
survive additional hits to profitability.
 The many SHFAs that participated in the Treasury Department’s Temporary Credit
and Liquidity Program (TCLP) will need alternative liquidity as TCLP expiration
nears.
While delinquencies as a whole grew, many housing issuers’ bond-funded mortgages
have continued to outperform conventional prime fixed-rate loans.
2011 Outlook: U.S. Public Finance Sector Profiles March 30, 2011 3
Public Finance
Rating Outlook U.S. States
NEGATIVE Fitch’s Negative Rating Outlook on the U.S. state government sector reflects the
expectation of negative rating activity above the historical norm in 2011. Although
Analysts Fitch Ratings believes that the credit quality of states will remain very strong and that
most states will continue to be rated ‘AA’ to ‘AAA’, there is the likelihood of an above-
Laura Porter
+1 212 908-0575
average number of incremental downgrades or Negative Rating Outlook revisions in the
laura.porter@fitchratings.com coming year.
Karen Krop Fitch expects 2011 to be a decisive year for state credit. Although economic and tax
+1 212 908-0661 revenue performance is improving slowly, budgets for fiscal 2012, which begins on July
karen.krop@fitchratings.com
1 for most states, will be for many arguably the most difficult since the downturn
Douglas Offerman began due to the dropoff in federal support of operations at a time of reduced
+1 212 908-0889 flexibility.
douglas.offerman@fitchratings.com
Ken Weinstein
States Face Fiscal Challenges in an Environment of Reduced Financial Flexibility:
+1 212 908-0571 The key issues facing states in 2011 are the expiration of federal stimulus funds that
ken.weinstein@fitchratings.com have supported operating budgets, the slow pace of tax revenue recovery in most
places, and the continued elevated demand for state services. States face more
Richard Raphael
Group Managing Director difficult options in confronting these budget challenges, as most drew down reserves in
+1 212 908-0506 the downturn and have already exhausted the more palatable available budget
richard.raphael@fitchratings.com management actions. In addition, an anti-tax environment nationwide limits revenue-
raising opportunities, and many states will need to increase contributions to pension
systems.
Actions taken this year will be a key indicator of the strength of fiscal management.
Beyond those states that currently carry a Negative Outlook, rating actions in 2011 are
more likely to be downgrades from a Stable Outlook than outlook revisions to Negative.
This is because the fiscal soundness of the final measures, currently unknowable, that
states decide on to resolve budget gaps in the upcoming fiscal year (i.e. sustainable
versus stop-gap) will be determinant in their ratings.
Credit Quality of U.S. States Remains Very Strong: The top-tier ratings in the sector will
continue to reflect the inherent strengths of states, and Fitch expects downgrade activity
in 2011 to be incremental, generally only one notch. In the current strained environment
it is unclear that all states currently rated ‘AAA’ will be able to adhere to the very high
standards indicated by that rating; however, their credit quality is likely to remain a very
strong ‘AA+’. Some states rated ‘AA’ already have made fiscal choices that exacerbated
ongoing challenges, making them vulnerable to credit deterioration, but again it is
unlikely that the ratings would fall by more than one notch over the next year. States
have a long record of seeking and achieving budget balance, as a matter of law and
practice, and Fitch is confident that they will continue to do so.
U.S. State Rating Outlooks What Could Change the Outlook?

(%) Management actions will be critical to the maintenance of states’ credit ratings in 2011.
100
86% The year is likely to involve a reconsideration of the level of services that state
80 governments will provide in many places, and consistent action by states to enact
structural solutions to fiscal challenges could stabilize ratings in the sector. The outlook
60
could also improve if economic and revenue recovery is significantly more robust than
40 expected, making fiscal challenges more manageable.
20 12%
0
2%
Key Issues
Positive Stable Negative Expiration of Federal Stimulus Funds: All states benefited from federal stimulus funds
that have directly supported operating budgets in the downturn. Most states have fiscal
years that begin on July 1, and last year’s extension of stimulus funds related to
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Medicaid (FMAP) through June 2011 meant that this program was available for all of
fiscal 2011 in most cases. The expiration of the program, which increased the federal
government’s share of Medicaid expenditures and thereby allowed state funds that
would otherwise have been spent on Medicaid to be used for other purposes, is
particularly significant for states with above-average Medicaid spending. However,
replacement of these funds as well as stimulus funds for education that have supported
local levels of government will be something that all states need to address to some
degree. Given the federal government’s current budgetary and political position, it is
not expected that additional federal funds for budget relief will be forthcoming.
Slow Revenue Recovery: Most state budgets rely on some mix of income and sales tax
revenues. In the downturn at the start of the last decade, steep revenue declines in
certain states, tied primarily to capital gains, were followed by sharp increases,
particularly in the income tax. In the recent downturn, almost all states saw even
larger declines, in both income and sales tax revenues, but recovery is expected to be
much slower and more limited in most cases. Although states generally have had
success in meeting revenue estimates in the past year and key tax sources have started
to grow again, overall revenues are still well below pre-recession levels and there is no
expectation of revenue results that will obviate the need for difficult choices on the
spending side of the equation in the coming year.
Elevated Demand for State Services: In economic downturns the demand for social
services that are funded by the states, particularly Medicaid, rises. Given the continued
economic softness forecast for 2011, and with unemployment levels projected to
remain high, it is expected that the elevated demand for services will continue.
Although certain maintenance of effort limitations associated with the federal stimulus
program expire with the stimulus funding, federal healthcare reform establishes its own
limitations. In the area of K-12 education, the other large state budgetary responsibility,
significant spending cuts could trigger lawsuits regarding the adequacy of funding,
although such lawsuits often take years to be resolved. Overall, Fitch expects budget
discussions in the coming months to involve a fundamental review of the level and
nature of services that state governments should provide in many places.
Anti-Tax Environment: Most states did not raise broad-based taxes in the downturn,
and several of those that did passed the increases on a temporary basis. Given the clear
national sentiment against tax increases, and the fact that many new governors took
campaign positions in specific opposition to tax increases, Fitch does not expect broad-
based tax hikes to play a widespread role in budget balancing this year. The states
where tax increases historically have been more achievable are generally the ones that
have already utilized this option in recent years, making further increases more
difficult.
Pension Funding Demands: State pension fund assets experienced large market losses
in the downturn. In addition, in some cases decisions made to reduce or delay pension
funding have made pension challenges more acute. In general, state pension systems
were adequately funded before the financial market crash, and assets have benefited
from significant investment gains since the crash. However, based on the multiyear
asset value smoothing approach used in most states and the usual lag time between
actual results, actuarial valuations, and the recalculation of the annual required
contribution, many states will be dealing with increased pension funding requirements
as they work to balance their budgets this year. Fitch expects that states will respond
with a combination of increased contributions (employer and employee) and benefit
changes to ensure the long-term adequacy of pension funding.
Management through the Challenges Will Be Key: Fiscal management, always a key
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factor in state credit analysis, will be critical to the maintenance of credit ratings in
2011. Although rating downgrades are often preceded by negative rating outlooks that
reflect a trend of credit deterioration, Fitch expects that, except for the five states
that currently carry a negative outlook, downgrades this year are more likely to occur
from stable outlooks. This is because the downgrades generally will be based on
management actions that result in a financial posture that is no longer consistent with
the state’s rating level, rather than a declining trend. In fact, economic and tax
revenue performance is likely to continue to improve, albeit at a slower pace than past
recovery trends, and if budgeting approaches this year are sustainable the hurdles for
the following year will in most cases be much lower.
The context and control of budget development for fiscal 2012 is in many cases
changed from recent years, making it more difficult to predict how the year will
progress. Gubernatorial elections were held in 37 states in November 2010, and there
are new governors in more than half of the states. There are also significant changes in
the political composition of state legislatures that are responsible for enacting budgets.
Credit Quality of U.S. States Remains Very Strong: While it is true that the current
financial position of states is meaningfully weaker than it was prior to the downturn,
Fitch continues to believe that the states are fundamentally very strong credits. State
ratings generally fall within the two highest rating categories, with most rated ‘AAA’ or
‘AA+’. The top-tier ratings reflect the inherent strengths of states, which generally have
broad economic and tax base resources and substantial, although varying, control over
revenue raising and spending. In varying degrees, states are required to balance their
budgets, debt service is a relatively small percentage of those budgets, most do not rely
on market access to fund operations or debt service, and, notably, states generally fund
rather than provide services and have some ability to cut funding to the service providers,
whether they be local levels of government or private providers of services. Although the
Rating Outlook for the sector is Negative, individual state ratings are very unlikely to be
downgraded by more than one notch in 2011. To the extent there is the possibility of
more significant credit deterioration it likely would be over multiple years.
2010 Review
Fitch downgraded the ratings of three states in 2010 (Connecticut, Illinois, and
Kentucky). In each case, the state’s substantial long-term liabilities (including pensions)
were a factor in the downgrade. Overall, although there were certainly budgetary
challenges for states in 2010, the extension of federal stimulus funds related to
Medicaid (FMAP) through June 2011, the end of fiscal 2011 for most states, reduced the
need for the more difficult spending cuts and/or revenue-raising actions that will be
required this year. Fiscal 2011 budgets for almost all states were passed on time and,
following a year of precipitous declines, tax revenues in most places stabilized in 2010
and met or exceeded forecast targets.
Public Finance
Analysts U.S. Local Government  Tax-Supported
Arlene Bohner
+1 212 908-0554
Challenging Conditions for 2011: 2011 will present familiar if intensifying challenges
arlene.bohner@fitchratings.com to credits in the U.S. local tax-supported sector. As in 2010, local governments across
the country will face varying degrees of fiscal and economic pressure as the rate of
Amy Laskey recovery from the deepest recession since the Great Depression differs widely across
+1 212 908-0568
amy.laskey@fitchratings.com the sector. In light of this pressure, Fitch Ratings anticipates a continuation of the
trend of downgrades outpacing upgrades for the coming year, although the vast
Ann Flynn majority of ratings are expected to be affirmations with Stable Rating Outlooks. Fitch
+1 212 908-9152
ann.flynn@fitchratings.com expects that most downgrades will be in the one- to two-notch range and that more
severe downgrades will be the exception rather than the rule.
Kathryn Masterson
+1 415 732-5622 The tax-supported sector comprises many diverse issuers, with varying security types,
kathryn.masterson@fitchratings.com
credit characteristics, revenue structures, legislative environments, and governmental
Kelly McGary responsibilities. Given its broad scope, Fitch does not assign a rating outlook for the
+1 813 223-6600 sector as a whole. Rather, to help guide investors’ expectations for the coming year,
kelly.mcgary@fitchratings.com Fitch has identified six broad themes that it believes will affect general obligation (GO)
Steve Murray
bond credit quality in 2011.
+1 512 215-3729
steve.murray@fitchratings.com Primary Importance of Management: Never have the quality of management and the
willingness to take difficult measures to adapt been more important to distinguishing
variations in tax-supported credit quality than in this environment of diminishing
revenues and increased operating pressures. Corrective management actions can
partially mitigate the credit pressures discussed in this report.
Negative Assessed Valuation Trends: Assessed valuations (AV) will continue to drop,
constraining revenues for governments reliant on property taxes. Furthermore, Fitch
remains concerned that, after a brief uptick in 2010, housing prices and, thus, future
AVs in most regions will continue to experience declines in 2011.
Intergovernmental Downloading: Declining state funding and/or the shifting of
responsibilities from states to local governments will present an additional burden to
municipal budgets, many of which are already strained by the phase-out of federal
stimulus money this year.
Declining Reserves: Reserve levels will continue to decline, as local governments rely
on them to offset their lack of revenue-raising flexibility. It is likely that an increasing
percentage of local governments will report minimal or even negative amounts of
operating fund balance at the end of 2011, which may lead to increased borrowing for
cash flow, although Fitch believes most will continue to retain at least a moderate level
of reserves.
Reliance on Negotiated Labor Savings: Labor
a
contracts with wage freezes or reductions and U.S. Tax Supported Rating Outlooks
re-opening clauses have become increasingly
(%)
common, and this trend will likely intensify in 100 91%
2011. In addition, healthcare plan design
changes and the introduction or extension of 80
employee cost-sharing will be important tools 60

for governments seeking to cut costs.
40
Furlough and layoff activity is also likely to
continue. 20 7%
1%
0
Escalating Pension Responsibilities: Pension-
Positive Stable Negative
related costs will continue to take on a a
Includes Rating Outlooks and Rating Watches.
prominent role in municipal budgets this year.
Public Finance
Annual required contributions (ARCs) will increase in many instances, as retirement
systems continue to absorb the impact of prior investment losses and historical
underfunding.
Key Rating Drivers

Management’s ability to anticipate and willingness to respond to expenditure demands
and declining revenue will be a fundamental determinant of the direction of credit
quality.
The extent, severity, and impact of intergovernmental downloading will vary among
states but may be great in some cases.
Local governments that fail to adequately address pension costs will experience
negative rating pressure.
Coverage on non-property tax-related special tax bonds (such as sales tax and excise
tax supported bonds) is expected to be stable to increasing given improvement in most
economic indicators.
Key Issues
Primary Importance of Management: While management has always been one of the
main pillars of municipal credit analysis, the importance of a competent, conservative,
and sophisticated management team will be even more pivotal as local governments
navigate unprecedented challenges to credit quality.
The ability to realistically forecast declining and sometimes unpredictable revenues
while correctly gauging spending levels will be key to maintaining budgetary integrity.
Similarly, management’s skill in monitoring and adjusting to budgetary variances
throughout the year will strongly influence financial performance in 2011, as it did in
2010.
Governments’ willingness to take difficult measures to maintain financial stability will
be paramount. Adherence to sound financial policies is both more difficult and more
critical in the current environment than during the economic expansion of most of the
past decade, when such adherence was fairly commonplace. In the current environment,
many governments have relaxed or completely suspended policies that contributed to
strong credit quality, such as fund balance requirements and limits on debt service
relative to spending. Such actions will likely lead to weaker credit profiles.
Negative Assessed Valuation Trends: Many issuers project increases in AV for 2011 and
2012, reflecting their expectations of a near-term housing market recovery; however,
Fitch expects that the majority of issuers will continue to experience AV declines as
prior years’ depressed housing prices, reassessments, and assessment appeals continue
to work their way through the assessment system. Fitch believes there will be widely
divergent levels of severity based on regional conditions.
In addition, Fitch believes that housing values will be slow to recover and that many
regions will continue to see declines. As discussed in “U.S. Structured Finance: 2011
Outlook,” dated Dec. 7, 2010, Fitch projects an additional 10% national decline in home
prices in 2011. Even large declines in AV may be manageable if an issuer is able to
compensate by raising tax rates. The ability to offset AV declines by raising millage
rates varies by state; legislated tax rate caps are becoming more common. Fitch
expects tax rate adjustments, even when legally permissible, to continue to be
politically and practically difficult in the current economic environment.
For tax allocation/tax increment bonds and other non-GO bonds secured by specific ad
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valorem taxes, further declines in coverage are possible. Those most vulnerable to
downgrades are those that have already experienced weakened coverage and those in
real estate markets most susceptible to further erosion.
Intergovernmental Downloading: Municipalities will see reductions in
intergovernmental revenue this year for two reasons: first, federal stimulus money that
was directly channeled to local governments, such as school districts, is being phased
out; and second, the elimination of stimulus funding for states will cause them to
reduce the amount of ongoing support they offer local governments. According to “2011
Outlook: U.S. States,” dated Jan. 25, 2011, Fitch projects that this year “will be for
many [states] arguably the most difficult since the downturn began due to the dropoff
in federal support of operations at a time of reduced flexibility.” Cuts and/or delays in
state aid to local governments are now commonplace, complicating municipal
budgeting for those that depend on such aid, including school districts and governments
that have heavy social service burdens. Midyear cuts in funding are particularly difficult
to manage, often leading to budgetary imbalance and impaired cash flow at the local
level.
Most local governments relied on the nonrecurring federal money to support
maintenance of ongoing basic services and will be left with significant budgetary gaps
beginning in the second half of calendar 2011. Although some harbor hope of an
additional stimulus package, few governments are expecting it and at least can begin
planning for reduced state funding well in advance; however, options to fill the funding
gap are limited.
Intergovernmental downloading may also take the form of shifting responsibilities
previously administered at the state level down to the local level, sometimes with an
accompanying revenue source, but many times without. While shifting responsibilities
to the local level can move decisions and choices about what services to fund closer to
the electorate, municipalities typically have fewer revenue-raising options and greater
restrictions than the states, making funding of these responsibilities problematic.
As more responsibilities are pushed down to the local level, municipalities will be
forced to make hard choices regarding spending priorities and suffer the political
consequences. In some cases, the choice to reduce services is severely limited or non-
existent, such as school districts with mandated class size requirements or counties
with required social service responsibilities.
Declining Reserves: Generally speaking, local governments historically have
maintained sufficient reserve levels to provide a budgetary cushion, ensure adequate
liquidity, and guard against unforeseen circumstances. While Fitch assesses adequacy in
the context of the government’s overall financial profile and level of flexibility, typical
reserve levels historically have been at least 10% of annual spending.
During the recent recession, many local governments have been reluctant to raise taxes
at a time when many taxpayers have lost jobs and homes have lost value. As revenues
have dropped, many governments have, either by design or by necessity, drawn upon
reserves to make up the shortfall under the premise that reserves are for “rainy days”
and the revenue declines are temporary. However, the protracted nature of the
downturn has led to more and more local governments exhausting these reserves.
Investors can expect to see an increasing number of municipalities ending 2011 with
little or negative fund balance in main operating funds.
Many governments started the downturn with reserve levels well in excess of both
policy levels and what Fitch would describe as “adequate” given the issuer’s overall
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financial profile. Fitch is not as concerned about drawdowns in these cases, as long as
they are moderate, well controlled, and used in conjunction with other budget-
balancing methods.
The improving economy has so far had a positive effect on non-property tax receipts, such
as sales tax revenues, which should partially offset the reduction in property taxes and
intergovernmental revenue and reduce the need to rely on reserves. Nevertheless, most
local governments will be forced to make hard choices regarding raising taxes and cutting
spending to restore budgetary balance or continuing to rely on reserves to make up the gap.
Reliance on Negotiated Labor Savings: Labor costs represent the lion’s share of
budgetary expenditures for most local governments. Not surprisingly, many
municipalities have attempted to control these costs at the bargaining table. With the
backdrop of high unemployment and overall economic stress, labor unions have been
more willing to cooperate and agree to concessions, including contract re-openers,
wage freezes or even decreases, unpaid furlough days, and healthcare cost sharing to
forestall layoffs. In some cases, changes have been imposed without the cooperation of
labor, leaving the benefits vulnerable to legal challenges.
While healthcare-related negotiated changes reasonably may be expected to be
permanent, once revenues pick up labor unions will likely expect restoration of wage
increases before reserve levels are replenished. Fitch believes this pressure will be
somewhat offset by the increased focus on public sector compensation (including
benefits) and continued elevated unemployment rates, but the balance between the
competing forces of labor pressure and public sentiment will vary by jurisdiction. Fitch
believes this will contribute to a broader debate about the appropriate balance
between taxation and service provision.
Escalating Pension Responsibilities: A focus on post-retirement costs will continue in
2011. Investment losses and in some cases, historical underfunding of pension ARCs
have led to large unfunded liabilities and burgeoning current ARC payments. Several
states have enacted laws requiring funding of the ARC to ensure that payments become
or remain current. As a majority of local governments participate in state plans that
are under pressure, increases in these budget items for local governments are often out
of their control and difficult to accurately forecast.
Increasing scrutiny of pension actuarial assumptions, including those for investment
returns, may lead to more realistic, albeit more onerous, payment schedules. Many
governmental retirement systems use multiyear smoothing designed to minimize swings
due to investment performance, thus recent investment declines mean that ARC
payments will increase even as return rates improve. Revised GASB standards will not
take effect in 2011, but Fitch expects discussions and analysis of how those standards
might change pension funding requirements to proliferate.
Local governments will also continue to grapple with rapidly expanding other post-
employment benefit (OPEB) costs, mainly retiree healthcare. Most issuers continue to fund
OPEB costs on a pay-as-you-go basis, and many of those that began pre-funding at the onset
of the new standards have discontinued those payments. The inclusion of OPEB costs in
governmental audit reports has led to an increased effort on the part of many governments
to limit this future obligation.
Public Finance
2010 Review
Rating actions where both an issuer’s
rating and Rating Outlook were Trends in Tax-Supported Rating Activity
maintained strongly outpaced both (% of Securities Rated)
downgrades and upgrades during 2010, 2010 2009 2008
demonstrating the continued overall Downgraded 8 8 3
stability of credit quality within the Upgraded 3 6 7
Outlooks Revised to Negative 3 7 3
tax-supported sector. An analysis of Negative Rating Outlook or
rating actions reveals that almost 80% Rating Watch at Year End 7 10 4
of all Fitch rating actions last year Positive Rating Outlook or Rating
Watch at Year End 1 2 3
were affirmations of both ratings and
Rating Outlooks.
While the 2010 percentage of downgrades (8%) matched the 2009 level, fewer ratings
were on Negative Rating Outlook or Rating Watch at year end. Notably, the percentage
of ratings with a Positive Rating Outlook or Rating Watch declined from an already low
2% to 1%. Although fewer ratings are on Negative Rating Outlook compared with 2010,
Fitch expects 2011 downgrade activity to match or exceed 2010 levels. Fitch
anticipates more rapid deterioration of credit quality in 2011 as pressures persist and
options for combating such pressures are fewer given the many tough decisions already
made. Any improvement in the upgrade rate will likely be delayed beyond 2011.
Public Finance
Rating Outlook Nonprofit Hospitals and Healthcare Systems
STABLE Stable: Over the next 12 months, Fitch Ratings expects the affirmation to be its
predominant rating action in this sector, reflecting the preponderance of high-
Analysts performing borrowers in Fitch’s rated portfolio compared to the overall industry.
James LeBuhn Throughout the recession, most Fitch-rated borrowers adjusted their operations,
+1 312 368-2059
james.lebuhn@fitchratings.com expense profiles, and capital spending to preserve their creditworthiness. However,
individual rating or outlook changes that do occur in 2011 will more likely be
Emily Wong downgrades than upgrades, as hospitals and health systems grapple with continuing
+1 212 908-0651 economic weakness and negative pressure on reimbursement rates. Negative actions
emily.wong@fitchratings.com
will largely affect lower-rated credits.
Jeff Schaub
+1 212 908-0680 Healthcare Reform: While several reform elements are slated to take effect this year,
jeff.schaub@fitchratings.com Fitch expects the credit impact of such changes to be relatively modest. Preparations
for major reform programs will continue and intensify prior to implementation in 2012
through 2014, and Fitch expects moderate credit benefits to be realized by many
providers through closer integration with medical staffs, enhanced information
technology, and improvements in quality and safety.
Operating Performance: Although the economic downturn elevated uncompensated
care levels and reduced patient volumes, Fitch-rated borrowers generally maintained
their operating margins and operating cash flow through meticulous labor management,
supply expense control, and ongoing operating efficiency initiatives. Fitch expects
these efforts to continue, as management teams address constraints in the growth of
governmental and commercial insurer payment rates.
Accelerating Consolidation: Fitch believes profitability pressure, capital access, and
the evolution of accountable care organizations will increasingly drive merger activity
in the sector, as smaller stand-alone providers come to terms with their resource
limitations and trade their independence for long-term viability, and as larger
organizations seek to grow and strengthen their market footprints, increase contracting
leverage, and protect their patient bases.
What Could Change the Outlook?

The outlook for Fitch’s ratings in this sector could be revised to negative if profitability
metrics erode significantly due to unexpected additional reductions in overall payment
rates, which may occur through federal deficit reduction initiatives, or through
legislation that mandates sweeping changes in insurers’ business models, to the point
that commercial payment rates are adversely restructured, or that large segments of
the commercially insured population migrate to lower reimbursing health plans. In
addition, faster than anticipated economic recovery could pressure labor costs, with a
Nonprofit Hospital Sector more competitive employment market necessitating higher wage increases.
Rating Outlooks
With intense pressure to reduce healthcare spending by consumers, governments, and
(%) business, it is highly unlikely that Fitch’s outlook would be revised to positive over the
100 90% medium term.
80
60
Key Issues
Operational Initiatives versus Profitability Pressure
40
Fitch generally expects its rated hospitals to continue to make up for volume declines
20
5% 5%
and curbs in reimbursement rate growth with operational initiatives that reduce costs
0
and enhance revenues. Since the recession began, hospitals have demonstrated a
surprising ability to maintain key credit metrics despite reductions in patient demand,
deteriorating payer mix, and an increasing responsibility for payment shifting to the
Public Finance
Operating Cash Flow — Debt patient. Through a combination of stringent labor control, effective nonsalary cost
Service Coverage management, a benign inflationary environment, and low capital costs, operating
AA A BBB
margins have recovered from a downturn that began in 2008 to approach their highs of
(x) the past decade. Moreover, operating cash flow margin (earnings from operations
5.0 before interest and depreciation, divided by total revenue), dipped only slightly in 2008
4.0 before returning to its previously consistent levels.
3.0 The stability of credit metrics and the high proportion of rating affirmations over the
2.0 past year underscore Fitch’s observation that management teams reacted quickly and
effectively to the financial crisis and subsequent recession, employing a multitude of
1.0 tools and tactics to trim costs and preserve liquidity. While not all savings will be
0.0 sustainable, in many cases, the economic downturn and the intensity with which
2007 2008 2009 2010 corrective actions were taken have led to great changes in the way high-performing
Note: Figures are median values by rating
providers deliver care, laying foundations for ongoing improvements in efficiency and
category. 2010 figures are based on partial value.
portfolio information and reflect interim data
as well as audits. With the pace of economic recovery expected to be slow, Fitch believes that patient
volumes will remain subdued and that growth will primarily be a product of market
share gain through programmatic investment, merger, or competitor misstep. On the
Operating Cash Flow Margin expense side, Fitch’s forecasts for both inflation and job growth indicate continued
labor stability, at least for nonphysician staff. Larger systems should be able to
AA A BBB continue to negotiate favorably with suppliers, as reduced demand persists through the
(%)
12.0 year.
10.0 As always, prospects for payment rate growth depend on who’s paying. Governmental
8.0 payers will lag inflation due to budgetary pressures, healthcare reform elements, and
6.0 the cessation of certain stimulus funds. Medicaid rates will be especially pressured,
4.0
although most Fitch-rated hospitals have fairly low Medicaid patient loads. On the other
hand, commercial insurer increases continue to outpace inflation, providing a level of
2.0
subsidization for less favorable payers. Recently enacted medical loss ratio regulations
0.0 appear to be less onerous than initially expected, and Fitch expects moderate growth in
2007 2008 2009 2010 commercial insurer reimbursement rates. There will be exceptions, especially in areas
Note: Figures are median values by rating where insurer premium increases have drawn close scrutiny.
category. 2010 figures are based on partial
portfolio information and reflect interim Limited Healthcare Reform Impact for 2011
data as well as audits.
Although coverage expansion is not scheduled to occur until 2014, a few provider-
related elements of the Patient Protection and Affordable Care Act (PPACA) have either
Days Cash on Hand taken effect or will take effect in 2011. First, growth in provider reimbursement rates
has been reduced, with a 0.25 percentage point offset applied to Medicare market
AA A BBB basket update factors. In addition, hospital inpatient rates were also reduced on Oct.
(Days)
300 1, 2010 to compensate for changes in coding practices. Fitch generally expects
250 hospitals to be able to compensate for these reductions by reducing expenses and/or
enhancing revenues. Commercial insurer payment streams will continue to subsidize
200
shortfalls in reimbursement from governmental payers.
150
100 Providers should also experience minor effects of the regulatory changes imposed on
50
insurance plans related to coverage of pre-existing conditions and dependent children.
Benefits to providers from this increased coverage will have little bottom line impact,
0
and could be offset by payment rate changes, higher deductibles and co-pay
2007 2008 2009 2010 requirements, or by payer mix deterioration due to continued high unemployment.
Note: Figures are median values by
rating category. 2010 figures are based Of potentially greater operational impact will be providers’ activity in forming or
on partial portfolio information and
reflect interim data as well as audits.
participating in the development of accountable care organizations. With payment
incentives scheduled to begin in 2012, many systems are creating alignments and
structures designed to lower cost and improve outcomes. While the magnitude of the
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ultimate cost savings sharing is not determined, Fitch believes that establishing
operating platforms that better coordinate care and engage physicians can result in
Operating Margin credit benefit, regardless of specific Medicare payment mechanisms.
AA A BBB
Liquidity Remains a Concern
(%)
5.0 Although investment performance and capital spending reductions have partially
4.0 restored the sector’s levels of unrestricted cash and investments following the financial
crisis, Fitch remains concerned about the availability and market volatility of
3.0
unrestricted funds. While many providers have shifted investment allocations into more
2.0 stable and accessible vehicles, the past year has highlighted the potential for large,
1.0
relatively unplanned calls on cash. Pension liability funding, swap collateral posting,
and uncertainty about expiring liquidity support for variable-rate demand obligations
0.0 can pose credit risk that large cash balances can mitigate. Fitch expects liquidity to
2007 2008 2009 2010 remain relatively stable in 2011, as most hospitals maintain their more conservative
Note: Figures are median values by rating investment profiles, generate adequate cash flow from operations, and moderately
category. 2010 figures are based on partial
portfolio information and reflect interim data
invest in their capital facilities. A relatively small number of lower-rated credits may
as well as audits. be forced to fix out variable-rate demand debt at unfavorable long-term rates due to
lack of available liquidity support, which may produce negative rating pressure.
Sector Consolidation to Continue

Rating Actions: 2009–2010 Fitch expects that consolidation in the sector will accelerate and that the performance
gap between highly rated and lower-rated borrowers will continue to widen. The types
of operating efficiencies and contracting leverage that have bolstered credit ratings
over the past few years have belonged predominantly to systems that benefit from
economies of scale, strong market presence, and integrated delivery platforms that
operate at multiple locations within single large markets or across multiple geographic
Upgrades areas. These high-performing credits typically have access to the most inexpensive
9% Affirm- capital and to operational and strategic resources that allow the wide implementation
ations
80%
of best practices in both clinical and nonclinical aspects of their enterprises.
Down-
grades With mandates for access, quality, and value becoming increasingly important to
11% patients and regulators, and hence to hospitals’ mission fulfillment and long-term
viability, larger hospitals are looking to enhance their market positions, and smaller
hospitals are looking for partnerships that will enable them to continue to serve their
population bases as the sector’s management and capital needs intensify in response
to reform.
To date, most mergers have not diluted the credit quality of the larger systems, even
though these transactions have involved the assumption or refinancing of debt and/or
some level of capital commitment. Smaller hospitals have typically been stable
performers and have filled holes in the acquirer’s market area or service array, or have
extended the market footprint into adjacent areas.
Public Finance
Rating Outlook Senior Living

Fitch’s Outlook in 2011 for the Not-for-Profit Senior Living sector is Negative: Many
NEGATIVE of the environmental pressures and uncertainties that caused Fitch to issue a negative
Analysts outlook on the sector in 2010 remain in place for 2011. While the creativity and cost
Jim LeBuhn controls implemented by many of the rated entities in Fitch’s portfolio have been
+1 312 368-2059 successful in blunting the impacts of a very difficult operating environment, Fitch
james.lebuhn@fitchratings.com
believes that further weakness in the U.S. housing sector combined with ongoing
Gary Sokolow volatility in the capital markets and a risk averse consumer base is likely to weigh on
+1 212 908-9186 the financial performance of the sector in 2011. Although Fitch expects that
gary.sokolow@fitchratings.com affirmations will be the predominant rating action in the sector, rating movements or
Emily Wong outlook changes that do occur are more likely to be downgrades/negative than
+1 212 908-0651 upgrades/positive.
emily.wong@fitchratings.com
Further Pressure on Real Estate Values: Fitch is projecting a 10% decline in home
prices in 2011 as many of the government programs designed to boost demand and
constrain the supply of distressed properties have expired or been exhausted. A further
decline in home prices, which would negatively impact the level of independent living
unit sales and entrance fee receipts, remains the primary credit risk to the sector.
Bank Facility Renewal Risk: A significant number of bank letters of credit (LOCs)
supporting municipal debt are set to expire in 2011. Fitch believes that competition for
LOCs among municipal borrowers combined with the banking industry positioning itself
for the adoption of Basel III could limit the availability and cost of bank support
agreements to senior living borrowers.
Management Resiliency: During 2010, management and marketing departments within
the sector demonstrated surprising creativity in the development of marketing
campaigns and incentives to drive independent living unit (ILU) sales. Furthermore,
management teams demonstrated an ability to tightly manage operating expenses to
maintain or improve core operating profitability in response to lower entrance fee
receipts and investment income.
Risk-Averse Consumer Base: To a large measure the decision to move into a continuing
care retirement community (CCRC) can be delayed or postponed. Thus, Fitch believes
that the sector is more sensitive to “headline risk” i.e. newsworthy financial or political
shocks that cause the sector’s risk-averse consumer base to delay or postpone the
decision to move into a community.

Fitch’s sector outlook could be revised if the U.S. economic recovery were to
Not-for-Profit Senior Living
accelerate with a meaningful improvement in employment which, in turn, would be
Rating Outlooks expected to drive the stability in home prices experienced in 2010. With the
challenging operating environment facing senior living providers combined with the
(%)
volatility in the global economy and affairs, it is very unlikely that Fitch’s outlook
100 90%
would be revised to positive over the medium term.
80
60 Key Issues
40 Further Pressure on Real Estate Values: In 2010, senior living providers reported improved
levels of interest and better entrance fee receipts as seniors became more accepting of
20
3% 7% current home values. However, Fitch is projecting a 10% decline in home prices in 2011,
0 as many of the government programs designed to boost demand and constrain the supply
Positive Stable Negative of distressed properties have expired or been exhausted. As stated in Fitch’s U.S.
Structured Finance 2011 Outlook, “Although interest rates are expected to remain near
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historical lows throughout 2011, the market still needs to digest a significant amount of
distressed inventory in an environment with weak demand. At September 2010, there
were seven million delinquent loans in the U.S., two million of which were in foreclosure,
according to Lender Processing Services, Inc. While foreclosure timelines and liquidations
have slowed due to loan modification schemes and self-imposed moratoriums, Fitch
believes this inventory ultimately needs to be cleared for the market to begin a
sustainable recovery.” With the expiration of the various government support programs
combined with growing inventories of distressed properties, the ability and willingness of
potential residents to sell their homes could be negatively impacted by softening home
prices , which would likely pressure occupancy and entrance fee receipts.
Real estate values and trends are highly variable depending on regional and local factors.
Fitch notes that many of its rated CCRCs are located in more affluent and
demographically stable areas. While clearly these CCRCs have been impacted by the
negative factors that have been pervasive across the real estate sector, their local
markets have avoided the significant spikes in foreclosure numbers and plunges in area
housing prices that have plagued other areas of the real estate market.
Letter of Credit Renewal Risk: Fitch estimates that roughly $53 billion of bank credit
facilities extended to municipal borrowers are set to expire during 2011. Traditionally,
senior living providers have been active consumers of bank credit facilities, and Fitch
views the renewal and refinancing risk within the sector to be a material credit concern.
While Fitch is maintaining its stable outlook on U.S. Banks for 2011, there are several
issues specific to the municipal market which present elevated credit risk. First, the
expanded bank qualified exemption included in the American Recovery and
Reinvestment Act (ARRA) expired on Dec 31, 2010. The sector was a beneficiary of the
expanded bank qualified exemption, which allowed many borrowers to refinance
existing LOC supported variable-rate demand bonds (VRDBs) into bank qualified (BQ)
direct placements. With the expiration of the program on Dec. 31, 2010, the BQ
exemption falls back to $10 million per issuer from $30 million per borrower. Second,
the implementation of the Basel III, which requires not only higher levels of capital but
higher quality capital as well and increases the minimum regulatory capital levels, is
expected to limit the availability and increase the costs of liquidity support. The sheer
number of LOCs expiring over the next 12 months and the recent sell off in the
municipal market increase the risk that senior living providers could be forced to
convert variable-rate debt to a fixed-rate mode at very high rates. Worse yet, in the
event a borrower could not access the fixed rate market, the VRDBs could revert to a
bank bond mode with term-out provisions that accelerate principal amortization. While
lower rated credits are at a higher risk for limits on market access, even the higher
rated providers who are able to secure LOCs may face higher fees and be subject to
more restrictive provisions.
Management Resiliency: During 2010, Fitch was surprised by the creativity and resiliency
that management and marketing teams showed in the development of marketing
campaigns and sales incentives to generate unit sales. Generally speaking, the sector
has become much more adept at maintaining regular contact and communication with
potential residents and depositors to assist in the moving process. The industry has
developed various programs to help new residents get their homes staged for a timely
sale, as well as prudently using select incentive programs to generate unit sales and
facilitate move-ins. Furthermore, management teams demonstrated an ability to tightly
manage operating expenses to maintain or improve core operating profitability in
response to lower entrance fee receipts and investment income.
Risk-Averse Consumer Base: To a large measure the decision to move into a CCRC is one
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that can be delayed or postponed. As such, Fitch believes that the sector is more
sensitive than other sectors to “headline risk” i.e. negative financial or political shocks
that cause the sector’s risk-averse consumer base to delay or postpone the decision to
move into a community. For example, the industry experienced a temporary absence
of demand after the events of Sept. 11, 2001 and again after the banking crisis in 2008
caused by the Lehman Brothers bankruptcy filing. While providers were able to
successfully navigate each crises until demand eventually returned, it does highlight a
risk factor that Fitch believes is elevated in 2011 due to the fragility of the global
economic recovery and the potential for event risk in the domestic and global markets.
2010 Review
The 2010 results in the senior living/CCRC sector were in line with Fitch expectations.
The stabilization in home prices combined with increased marketing efforts and
incentive programs helped to stem further declines in occupancy and entrance fee
receipts. Rating actions in 2010 largely confirmed Fitch’s outlook with 26 affirmations,
three downgrades, and three upgrades (excluding the four upgrades due to the creation
of the Lifespace Obligated Group).
Public Finance
Rating Outlook U.S. Public Power and Electric Cooperative Sector
STABLE Continued Stability in 2011: In spite of the barrage of negative press surrounding
municipal credit quality that has been raining down on the market recently, Fitch’s
Analysts outlook for the public power and electric cooperative sector remains stable through
Chris Jumper
2011. Overall, the Fitch portfolio of public power and cooperative issuers is expected to
+1 212 908-0594 carry on with their strategy of providing reliable, low cost electric service and
chris.jumper@fitchratings.com maintaining stable financial and operational performance.
Lina Santoro Key Sector Characteristics: The year 2011 begins with a number of issues impacting
+1 212 908-0522
lina.santoro@fitchratings.com the power sector that may be the subject of debate for years to come. While these
issues may not be resolved in 2011, Fitch believes that the fundamental structural
Dennis Pidherny characteristics of the sector’s conservative business model will continue to provide
+1 212 908-0738
dennis.pidherny@fitchratings.com stability and strength, even during this period of uncertainty. The following are the key
credit characteristics of public power and electric cooperative issuers, which should,
Kathryn Masterson once again, serve their customers and investors well in 2011:
+1 415 732-5622
kathryn.masterson@fitchratings.com
 Essentiality of electric utility service.
Eric Espino
+1 212 908-0574  Defined service area, with near monopolistic characteristics.
eric.espino@fitchratings.com
 Local control over rate setting.
Ryan Greene
+1 212 908-0593  Predominately residential and commercial customer base.
ryan.greene@fitchratings.com
 Relative cost advantage over investor-owned utilities.
Bhala Mehendale
+1 212 908-0520  Customers/ratepayers are the ultimate “stakeholders.”
bhala.mehendale@fitchratings.com
Proposed Environmental Protection Agency (EPA) regulations governing greenhouse
gases (GHG) and other emissions, as well as cooling water, and coal ash handling, could
be significant enough to change the Outlooks on many public power and electric
cooperative issuers that Fitch rates. While the impact of the proposed regulations will
be broadly felt throughout the U.S., the severity will vary from region to region. For
example, issuers located in the Pacific Northwest are not likely to be as adversely
impacted, and may even benefit from the regulation given their generally “greener”
power supply base. Whereas issuers located in the Midwest, Southeast, and Mid-Atlantic
states will be more adversely impacted given their relatively higher reliance on smaller,
older coal-fired power resources (units at or under 300 MW and over 30 years old).
The current timeline for enacting and implementing the EPA’s various initiatives began in
January 2011. At the time of writing this Outlook, there was discussion that Congress may
act to derail or postpone the mandated EPA timetable, and draft bills were being
U.S. Public Power Rating proposed; however, no formal action had been taken. Overall, Fitch believes that the EPA
Outlooks initiatives, as currently drafted, could result in significant cost increases for those owners
required to retrofit noncompliant generating units or close generating units ahead of
91%
their expected useful life. Fitch will be monitoring the actions Congress takes (if any)
with respect to the EPA regulatory framework and will continue to assess how individual
issuers are responding and positioning themselves to address new requirements.
Key Issues for 2011

Since Fitch’s “Public Power 2010 Midyear Review” published June 1, 2010, many of the
4% 5% challenges cited in that report remain relevant for public power and electric
cooperative issuers in 2011.
 To date, the fiscal challenges facing many local municipalities nationwide have not
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translated into weaker financial metrics for the public power entities rated by
Fitch. However, the risk still exists that fiscally strapped local governments could
impart greater political pressure to limit utility rate increases and/or increase
utility system transfers to city general funds.
 The impact of the new regulation for GHG and other emissions as well as proposed
cooling water, and coal ash handling regulation by the EPA, which appears to
specifically target smaller, older coal-fired generation.
 Uncertainty over federal and/or state mandated renewable energy standards, which are
expected to result in an increase in the overall cost of power supply for many issuers.
 Electric sales growth for public power experienced a recovery from the low 2009
levels; however, much of the growth was weather related (i.e. warmer summers
and cooler winters). Weather-adjusted public power electric sales are expected to
show slow growth levels, limited further by the effectiveness of energy efficiency
and demand-side management initiatives.
 Coal and other commodity prices have rebounded; however, natural gas prices are
expected to remain low in 2011 due to abundant supply. Since natural gas
generation sets the market prices in many regions, the spot-market price of
electricity is expected to remain soft through 2011.
 Public power and electric cooperative issuers should continue to enjoy access to
the capital markets through 2011, although the expiration of the Build America
Bond (BAB) program is expected to result in higher financing costs compared to
2010.
 Adequate liquidity should be available to the sector through the first half of 2011.
However, the sizable amount of bank facilities coming due for renewal in the
second half of 2011 and 2012 could challenge issuers that rely on lines of credit to
maintain liquidity at adequate levels. Refinancing risk may also increase as letters
of credit to support variable rate debt become in short supply.
Impact of Economic Downturn/Sustainable Financial Performance
As the impact of the economic downturn continues to ripple through local municipal
economies, it should be noted that the concern of a drastic slowdown in public power
and cooperative electric sales, translating into lower operating margins and weaker
financial metrics, has not yet materialized. In fact, given the sector’s concentration of
sales to residential and small commercial customers, weather patterns played a more
meaningful role in electric usage than changes in economic growth in 2010. The chart
below highlights the significant drop in national electric consumption experienced
during the 20082009 recession. While 2010 EIA information is not currently available,
initial estimates indicate usage (normalized for weather) is slowly returning to its
historical growth pattern, although still below the pre-recession levels. While regional
differences will exist, Fitch expects growth of 1.0%1.5% per annum throughout the
sector, muted somewhat by energy-efficiency and demand-side management initiatives.
As previously noted, the sector’s financial performance has not shown signs of material
deterioration during the recent economic downturn, in part due to the slower economic
growth allowing issuers the ability to postpone their pre-recession capital expansion
plans. As Fitch continues to review the audited results for fiscal 2010, however, we
have noticed that several utilities have begun to experience a gradual weakening in
their financial metrics. Overall, Fitch expects that the sector will record increased
leverage in 2011, as evidenced by slightly higher ratios of debt to funds available for
debt service (debt to FADS), debt per customer, and debt to net plant. Fiscal 2010 saw
a significant amount of debt issuance, spurred on in part by the lower net interest costs
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GDP Change Versus Electricity Consumption (Annual)
GDP Change Electricity Consumption Change
(%)
6.0
5.0
4.0
3.0
2.0
1.0
0.0
(1.0)
(2.0)
(3.0)
(4.0)
(5.0)
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: U.S Department of Commerce ― Bureau of Economic Analysis, U.S. Department of Energy ― Energy Information
Administration.
available through the BABs program, which expired at year-end 2010. In 2008 and 2009,
many issuers delayed their large capital projects. As the sector resumed funding and
pre-funding its ongoing capital improvement programs to take advantage of the BAB
subsidy, the proportion of debt has increased noticeably. Finally, Fitch notes that there
was also a significant increase in “off-balance-sheet” obligations, as many issuers
entered into long-term obligations during 2010 to purchase renewable resources.
While public power and electric cooperative issuers entered the current economic
downturn armed with strong balance sheets and healthy financial metrics, our focus
during 2011 will be on the sector’s ability to maintain healthy financial performance
through what is likely to be a prolonged recovery.
Local Political Pressure

As the impact of the economic downturn continues to fiscally strain state and, in
particular, local governmental budgets, public power and electric cooperative issuers
will face mounting political pressure to limit rate increases and/or increase transfers
to city general funds. While there were a few exceptions in 2010, most required rate
increases were passed through to customers as scheduled over the course of the year.
In addition, the majority of the utilities that Fitch rates reported an ongoing
commitment by the local municipality and/or member-owners to maintain a
financially healthy and liquid electric system, and to resist the temptation to draw
funds from the utility system balance sheet in order to strengthen declining general
fund balances.
We note, however, that there have been a growing number of instances where rate
increases and healthy cash balances maintained at the utility have become publicly
questioned and politically unpopular. While these pressures have not had an impact on
credit quality to date, Fitch is concerned that ongoing local political pressure could
result in a gradual tightening of financial metrics.
Volatile Fuel Prices/Low Electric Prices

Low fuel prices have allowed many utilities to soften the impact of required base rate increases
by concurrently passing through fuel cost savings. Based on the NYMEX curve, gas prices are
expected to remain low through 2011, further facilitating planned base rate increases.
Many of the issuers in the Fitch-rated portfolio maintain extensive risk management
processes that are aimed at identifying and diversifying risks associated with fuel costs.
In addition to automatic fuel cost adjustments, issuers have made use of hedging
programs for a portion of their fuel supply to limit fuel cost volatility, thereby providing
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a more predictable cost structure while allowing the utility to still take advantage of
lower fuel costs. Monitoring and diversifying counterparty risk has also reduced the risk
of having to post collateral in the event of sudden market movement. Fitch will
continue to monitor pending Commodity Futures Trading Commission (CFTC) regulations
that would bring comprehensive reform to the regulation of swaps and could require
mandatory clearing on exchanges and collateral posting for end-users, including public
power entities.
While issuers that are dependent upon the sale of surplus electricity were impacted in
2009 and 2010 by lower than expected electric spot market prices, Fitch does not
expect a material impact in 2011, as the majority of the issuers in the Fitch portfolio
have taken steps to seek longer term sale arrangements and revise budget projections
to reflect the lower market prices.
Proposed EPA Regulation

The specter of Federal GHG regulation/legislation loomed large throughout 2010 and
will continue to cast a shadow of uncertainty through 2011. With the conservative shift
in the political landscape as of the November 2010 elections, it now appears unlikely
that Congress will provide any legislative guidance on environmental rulemaking in 2011.
That said, EPA-proposed regulations regarding GHG, carbon, and other emissions slated
to go into effect in 2011 could have a much more immediate and dramatic impact on
the sector than any of the proposals considered by Congress in prior years.
A slew of regulations have been proposed by the EPA that could potentially impact the
operations of power plants. Fitch has classified these rules into two categories: those
that are “imminent” and those that are “planned.” Rules that are “imminent” are the
Tailoring Rule and the Maximum Achievable Control Technology Rule (MACT Rule).
The Tailoring Rule had its origin in the EPA’s Motor Vehicle Rule, which requires the
regulation and control of GHG from non-stationary sources (such as vehicles). However,
the EPA has recently reiterated its position that air pollutants like GHG (including
carbon dioxide) regulated by the Clean Air Act (CAA) under any program, must be taken
into account when considering permits, such as the Prevention of Significant
Deterioration (PSD) permits. As a result, the regulation and control of GHG under the
motor vehicle rule that was implemented on Jan. 2, 2011 also applies to stationary
sources such as power plants during the time of permit renewal. As of Jan. 2, 2011,
power plants undergoing permit review are now technically required to regulate and
control GHG emission using Best Available Control Technology (BACT). In November
2010, the EPA issued draft guidance on the implementation of the Tailoring Rule to
state environmental agencies that have been delegated authority to enforce EPA
regulations under state implementation plans. The EPA guidance acknowledges that at
present there are few available control technologies to limit power plant emissions of
carbon and other GHG covered under this rule other than increasing the plant
efficiency. The EPA’s current position is that increasing the efficiency of the unit can
qualify as BACT.
Additionally, the MACT Rule requires the EPA, acting under a consent decree, to
propose rules for mercury and other air toxins by March 2011 and finalize these rules by
November 2011. Initial consultant studies indicate that the “imminent” rules could
accelerate the retirement of up to 52 gigawatts of smaller, older, less efficient
generation capacity nationwide.
Rules classified as “planned” by the EPA include the Clear Air Transport Rule, which
addresses sulfur dioxide and nitrous oxide emissions; the Coal Combustion Residual
Disposal Regulation, which requires coal ash to be disposed of as a hazardous waste;
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and the Once-Through Cooling Rule, which will impact power plants using open loop
water cooling systems (aka once-through cooling).
Specifically, if all of the “imminent” and “planned” rules are implemented as currently
drafted, the new EPA regulations could result in significant cost increases for those
owners required to retrofit noncompliant generating units or close generating units well
ahead of their expected useful life. Moreover, the premature retirement of this
targeted generation could drive regional power markets with surplus generation into a
deficit position, thereby complicating the capacity planning efforts of many issuers.
Federal and State-Mandated Renewable Projects

Fueled by monies from the stimulus package in the form of grants, subsidies, and tax
incentives, the number of renewable power projects developed and brought on line
during 2010 continued at a record pace. As a result, there has been “overbuild” in
several regions, exacerbated by a lack of transmission and resulting in market
distortions and anomalies such as regional “negative pricing.” Negative pricing
generally occurs during off-peak hours when project developers of intermittent
renewable power resources (primarily wind) will actually pay to dispatch electric
generation in order to receive the federal subsidy payment. There are several
proposed regional transmission projects that, if constructed, would alleviate these
regional market anomalies and move power to urban areas where there is sufficient
demand to absorb load. However, these transmission projects face enormous
challenges in securing rights-of-way and pricing mechanics (i.e. socialized costs
versus the beneficial users paying for the transmission project), which could further
increase the ultimate cost of electricity to end-users.
Fitch notes that over half of the states in the U.S. have adopted renewable portfolio
standards (RPS). While the next 12 months show that the near-term renewable
standards required are at manageable levels, the standards become daunting and
potentially costly in the 20202025 time frame, when renewable energy may be
required to account for 20%25% of the overall power resource mix.
Fitch also notes that most public power and electric cooperative issuers are not
currently subject to an RPS standard either, because (i) the applicable jurisdiction lacks
an RPS or (ii) if one exists, public power entities have been exempted from the imposed
requirements. Nevertheless, Fitch has observed a trend of these issuers entering into
renewable energy supply arrangements in order to demonstrate their commitment to
environmental stewardship and to provide a certain hedge against potential future
environmental regulation. Overall, Fitch expects to see continued development of
renewable power projects in 2011 with increasing participation by public sector
participants in anticipation of eventual required RPS compliance.
California appears to be the exception as far as state-mandated legislation with its
Assembly Bill 32 (AB32, the Global Warming Solutions Act). Under AB32, California is
slated to implement the California Air Resources Board (CARB) regulation for significant
reductions in GHG emission beginning in 2012. Despite some vocal opposition, public
support for AB32 was affirmed during the November 2010 election. The CARB regulation
includes a state-wide cap-and-trade program and gives CARB the authority to enforce
such regulation beginning in 2012. In addition to AB32, California’s Executive Order No.,
S-14-08 imposes an aggressive RPS (33% by 2020), which will also apply to all utilities in
the state. California once again finds itself far ahead of the other states in legislating
change to its electric system. With the patchwork of RPS continuing to evolve
throughout the nation, it remains undetermined whether California has voluntarily
disadvantaged itself.
Public Finance
Overall, Fitch believes that the proliferation of RPS could handicap utilities in the
longer term due to the intermittent nature of these resources and the higher costs of
renewable resource generation. Fitch will continue to monitor the continued
development efforts of renewable projects in 2011 and the impact on public power
issuers, particularly given the uncertain availability of federal subsidies year to year.
Public Finance
Rating Outlook Water and Wastewater
STABLE Stable Outlook: The outlook for the U.S. water and wastewater sector is stable despite
current economic, capital, and political pressures. While rating downgrades have
Analysts accelerated in the past couple years and have outpaced upgrades, rating affirmations
Doug Scott have been and are expected to be the norm in 2011.
+1 512 215-3725
douglas.scott@fitchratings.com Essentiality, Monopoly, and Local Rate Setting Remain as Key Credit Factors: The
Kathy Masterson current operating environment presents water and wastewater utilities with an unsteady
+1 415 732-5622 platform from which they must manage their long-term businesses. Nevertheless, most
kathy.masterson@fitchratings.com
systems exhibit more-than-sufficient financial flexibility, as evidenced by Fitch Ratings’
Adrienne Booker
+1 312 368-5471 published medians (see Fitch Research on “2011 Water and Wastewater Medians,”
adrienne.booker@fitchratings.com dated Jan. 18, 2011, available on Fitch’s Web site at www.fitchratings.com).
Christopher Hessenthaler Significant contributors to the sector’s current and historical financial performance
+1 212 908-0773 have been the essential nature of the services the sector provides as well as the natural
christopher.hessenthaler@fitchratings.com
monopolies and generally local rate-setting authority. These points are typically
Gabriela Gutierrez, CPA understated because of the difficulty in assessing the degree to which these aspects
+1 512 215-3731
gabriela.gutierrez@fitchratings.com mitigate risk exposure. However, the sector’s essentiality, monopoly status, and local
Andrew DeStefano rate setting ability certainly have played a key role in insulating it from the current
+1 212 908-0284 economic climate, allowing it to perform well even as other sectors have experienced
andrew.destefano@fitchratings.com deterioration.
Shannon Groff
+1 415 732-5628 Financial Performance Pressures: While water and wastewater utilities have been able
shannon.groff@fitchratings.com to generate solid financial results overall throughout this economic cycle, some
Julie Seebach weakening has occurred, albeit by a modest amount. Revenues remain somewhat soft
+1 512 215-3740
julie.seebach@fitchratings.com
as a result of decreased service demands. At the same time, operating and capital
expenses have continued to climb. These factors have reduced operating margins from
Andrew Ward
+1 415 732-5617 previous levels and contributed to diminished cash flows and slightly lower debt service
andrew.ward@fitchratings.com coverage. If economic conditions improve and demand for services rise, revenues
Teri Wenck, CPA should experience corollary gains and help to offset rising costs. However, a
+1 512 215-3742 continuation of the current revenue environment coupled with growing expenses could
teri.wenck@fitchratings.com
lead to further erosion of financial results, although no material deterioration is
expected in 2011.
Timely Rate Recovery Key: Given the revenue and cost pressures facing utilities,
timely rate recovery will be important to maintaining financial profiles and positioning
systems to meet their long-term capital and service demands. While many utilities have
garnered some rate relief for this current fiscal year, an inability of systems to achieve
full cost recovery could lessen the sector’s near-term financial health. In some cases
Water and Wastewater rate hikes are politically difficult to achieve at all, as governing bodies contemplate
Sector Rating Outlooks higher taxes and fees to support other non-utility funds, many of which are under
budgetary stress.
(%) 96%
100 Regulations Could Add Costs: Heightened regulations will add to operating and capital
challenges for utilities, although the regulatory environment is relatively stable, and
80
new requirements are not expected to have material credit implications during the year.
60 Nevertheless, some utilities could experience erosion to their operating profile as a
result of additional regulatory requirements, particularly for wastewater utilities
40
seeking renewal of permits to discharge into impaired water bodies.
20
0% 4%
0
Positive Stable Negative While Fitch expects the sector to maintain a stable outlook, a negative outlook could
develop over time if rate hikes are insufficient to preserve the sector’s strong financial
metrics and/or capital demands escalate significantly and force utilities to rely
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increasingly on borrowable funding sources.
Key Issues
Financial Performance
Debt Service Coverage Medians
(x) Senior ADS All-In ADS

4.0
3.0
2.0
1.0
0.0
2007 2008 2009 2010 2011
While sector credits have strong underlying fundamentals, sector financial performance
nevertheless has been impacted somewhat from the economic recession and slow
recovery. The sector entered the recession posting solid financial margins and healthy
balance sheets overall and continues to do so. However, a continuance of the current
economic environment could further diminish sector financial metrics from pre-
recession highs.
One of the key impacts of the current economic environment has been decreased usage
by customers, which has translated into a moderate drop in revenues for utilities. For
the most part, this appears to be tied predominantly to weaker commercial and
industrial demand as opposed to reduced residential consumption, where there is a
relatively stable level of base usage. But certainly all facets of the industry’s customer
base have been affected to some degree. Another result of the economic fallout (and
the collapse of the housing market in particular) has been the dwindling of connection
fee revenues. Since the beginning of the recession, virtually all utilities have realized
and continue to project connection fee revenues at a fraction of 2006 collection levels.
Liquidity Medians
(Days) Days Cash Days Working Capital

400
300
200
100
0
2007 2008 2009 2010 2011
At the same time that revenues have weakened, utility costs have increased. Indeed,
over the past several years annual growth in operating expenses has outpaced revenue
gains. Also, as utilities relied increasingly on borrowable resources over the past few
years, fixed costs have risen. The net effect of these revenue and expense pressures
Public Finance
has been a modest decline in debt service coverage as well as a drop in excess cash
flows available for pay-as-you-go capital projects.
If economic conditions improve, the sector will be one of the first to benefit given the
immediate ability to generate revenues from rising commercial and industrial demand.
Also, as construction activity increases, connection fee revenue will see a
corresponding rise. However, until these events occur, utilities will continue to face
challenges in trying to balance incrementally higher operating and fixed costs without
corresponding rate hikes.
Another potential concern of the current economic environment is that utilities that
are a component of a local government could face increased transfers out of surplus
funds or be used as a source of borrowable resources for other units of that local
government. While Fitch has not detected widespread occurrences to date, as local
governments continue to grapple with budgetary pressures the likelihood of these
situations increases. In the limited instances in which this has occurred, it is viewed as
a negative credit development in that it impairs the capacity of the utility to fund its
own operating and capital needs.
Timely Rate Recovery

To mitigate the impact of the soft revenue environment and rising cost structure (both
operating and capital), it will be important that rate-setting bodies implement rate hikes
that ensure full cost recovery and preserve financial margins. This could prove
challenging in some cases as government officials seek to limit utility increases in the
face of rising taxes and fees to support other governmental functions, which in many
cases are under severe budgetary stress. Consequently, Fitch believes that political
willingness to raise rates remains a key issue for the sector’s financial stability over the
near term. In its credit reviews during 2011, Fitch will continue to place an emphasis on
management’s ability to adapt to the current operating environment and the resolve of
rate makers to implement timely rate relief that preserves their utility’s financial profile
and addresses ongoing capital and supply needs.
Regulatory Environment
Federal and state regulations affect all aspects of utility operations. For 2011 and
beyond, Fitch expects the regulatory environment will remain stable, but incremental
new requirements will be instituted. In particular, Fitch expects the U.S. Environmental
Protection Agency (EPA) to promulgate new rules and pursue certain strategies and key
goals associated with its fiscal years 20112015 strategic plan. The new rules and
strategies being pursued by the EPA in conjunction with state and local regulatory
bodies, while not necessarily expected to result in direct credit implications, will cause
or lead to increases in utility operating and capital expenses and ultimately could
weaken the credit profiles of individual utilities.
Strategically, the EPA expects to progress towards national water and wastewater goals
by focusing on its core programs, promoting sustainable water infrastructure, and
restoring and protecting watersheds. In relation to the EPA’s core programs and
restoration/protection of watersheds strategies, Fitch expects that most wastewater
utilities whose discharge permits are renewed in 2011 will see reductions in allowed
discharge levels, particularly with regards to certain nutrients and oxygen-demanding
substances. For many, these changes will only result in incremental increases to
operating and capital budgets and should not affect the credit quality of the entity.
However, in some cases, especially those utilities discharging into impaired water
bodies, the changes to the discharge permit could lead to substantial additional capital
requirements, which in turn could erode credit quality relatively quickly.
Public Finance
The EPA has initiated certain rules that may become final in 2011 pertaining to
revisions in water quality standards and changes to the National Pollution Discharge
Elimination System program for discharge permits. These proposed rules may
standardize certain permit requirements. However, discharge permits expire after five
years, and establishment of total maximum daily loads for water bodies is an ongoing
process that can have significant implications on discharge permits as a result of
diminished allowed loadings. Therefore, it is likely that wastewater systems will remain
susceptible to potentially significant operating changes as permits are renewed.
In addition to the strategic initiatives and wastewater rules that may become final in
2011, the EPA has promulgated certain drinking water rules that are final, in the
implementation phase, and are moving towards the enforcement phase during or
shortly after 2011. Principally, these include the Long-Term 2 Enhanced Surface Water
Treatment Rule and the Stage 2 Disinfectants and Disinfection Byproducts Rule. In
recent years, water utilities have been making operational changes and/or constructing
capital projects to address these two rules. But as these rules near the enforcement
stage, additional borrowing may be needed in 2011 to complete necessary capital
projects, which could increase utilities’ fixed costs over the near term. However, Fitch
does not expect that compliance with these particular rules will lead to meaningful
credit deterioration for the majority of water credits.
2010 Review
The sector performed very well in
2010 Water and Wastewater Sector Rating
2010, with the vast majority of rating
actions resulting in affirmations. Actions a
Having said this, downgrades did
outpace upgrades by nearly a 2:1
margin during the year. The primary Downgrades
factor contributing to credit 6%
downgrades (relating to 64% of all Affirmations
downgrades) was weak financial 91%
performance. In most cases the Upgrades
financial profiles of these credits 3%
deteriorated over a period of several
years, although in a couple cases
there was a fairly rapid deterioration
resulting from the recession, with the
prospect of these credits recovering a
Excludes recalibrated ratings.
to produce metrics commensurate
with the rating level prior the
downgrades deemed weak.
The second and third most common factors contributing to downgrades during 2010
(cited in 36% and 27% of downgrade actions, respectively) had to do with capital needs
and elevated debt levels. In regards to the former, these utilities experienced
dramatically increased capital programs over a short period of time, with the rise
directly attributable to meeting regulatory requirements in almost all cases. In regards
to the latter, the debt profiles of these issuers experienced incremental weakening
without offsetting credit positives in other areas.
Public Finance
Rating Outlook State Housing Finance Agencies
NEGATIVE Negative: The outlook for the tax-exempt housing sector continues to be negative, with
the main driver being the slow economic recovery. This has put enormous pressure on
Analysts homeowners and has caused the development of government initiatives, which have
Maura McGuigan caused conventional mortgage rates to fall to 60-year lows making state housing finance
+1 212 908-0591
maura.mcguigan@fitchratings.com agencies (SHFA) mortgage product non competitive. While most of the outlooks on Fitch-
rated housing bonds are currently stable, the direction for the housing sector is negative.
Charles Giordano Fitch Ratings expects that rating actions that occur in 2011 will more likely be outlook
+1 212 908-0607
charles.giordano@fitchratings.com changes than downgrades as SHFA fiscal 2011 results will demonstrate continued overall
declines in the profitability and the financial health of housing issuers.
Fitch expects that fiscal 2011 will be just as challenging (for loan production and asset
management) as the last two years given the continued economic uncertainty and high
unemployment rates. In addition to the possibility of increases in the number of
foreclosed loans, foreclosures could remain at an elevated level for years. Many
economists believe that a true recovery in housing will not begin until government
involvement in the housing market subsides and private sector employment growth
increases. The housing sector, weighed down by the number of unsold homes, needs job
growth to boost demand and curb the flow of delinquent loans into foreclosure.
Low Interest Rate Environment: The low interest rate/mortgage rate environment has
curtailed SHFA mortgage production/origination, and the Federal Reserve has
committed to a $600 billion Treasury bond buying program that began in November
2010 and is scheduled to run through June 2011. While the goal of this program is to
keep interest rates down and encourage economic growth, the net effect on SHFAs is
that their mortgage loan product is not competitive with that of the conventional
mortgage market. The low interest rate environment has also dramatically impacted
investment earnings for SHFAs and their profitability levels.
Bank Facility Expirations: SHFA issuers with outstanding variable-rate demand
obligations (VRDOs) continue to present credit risk as many of the bank facilities that
back these obligations expire in 2011 and 2012. Fitch is concerned that bank capacity
for renewals will be constrained, and Fitch expects that available liquidity support
capacity will become increasingly expensive. However, since SHFAs are typically higher
rated credits, Fitch believes they should have opportunities to obtain bank liquidity,
albeit at higher costs, which will again strain profitability.
SHFA Financial Cushion: Fitch believes that, for most SHFAs, there continues to be
financial cushion at the issuer level to survive additional hits to profitability. In the
Housing Sector Rating Outlooks short term, most SHFAs can weather the continued profitability issues, but if the
recovery from the housing crisis continues to be slow for several years and equity
(%)
erodes, negative outlooks will be assigned and/or negative rating actions to SHFA GO
90 ratings will occur.
80%
80
Need for Alternative Liquidity as TCLP Expiration Nears: Many SHFAs participated in
70
the Treasury Department’s Temporary Credit and Liquidity Program (TCLP), which is
60
nearing its stated expiration date. SHFAs will need to find alternative liquidity to
50
replace TCLP by December 2012/January 2013. Since many issuers will be seeking
40
liquidity in the market at the same time, a number of SHFAs are reporting to Fitch that
30
15% they will prudently seek replacement before the final TCLP expiration date, which
20
5% would mean starting the process in 2011.
10
0 Delinquencies and Foreclosures: While delinquencies as a whole did grow from
fiscal 2010 to fiscal 2011 for most SHFAs, many housing issuers’ bond funded mortgages
continue to outperform conventional prime fixed rate loans in their respective states in
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terms of delinquencies and foreclosures. The healthier performance was largely due to
Median Net Operating Revenue
prudent SHFA underwriting standards.
as % of Total Revenue without
GASB No. 31 Adjustments What Could Change the Outlook?
Fitch’s sector outlook could be revised to stable if there is an increase in conventional
(%)
mortgage interest rates (which could increase SHFA loan production) and in short term
14.0
12.8 12.7 interest rates (which could lead to increases in SHFA investment earnings), which
12.0 together could restore SFHA profitability. Additionally, housing market stabilization,
9.5
10.0 with a return of long-term bond buyers and reasonably priced liquidity facilities, could
8.0 also increase the chance of revising the outlook to stable. A final trend that would also
6.0 contribute to an outlook revision would be an increase in employment that should lead
4.0
4.0 to a decrease in the delinquency and foreclosure pipeline.
2.0 With all of the factors currently contributing to negative pressure on SHFA profitability,
0.0 it is highly unlikely that Fitch’s outlook would be revised to positive over the near term.
(2.0) 2006 2007 2008 2009 2010ª
(4.0)
(1.3)
Key Issues
ªIncludes 34 state housing finance agencies.
Low Interest Rate Environment and Profitability: While many analysts expected rates to rise
in 2010, rates actually defied expectations and fell to 60-year lows. However, as the year
ended rates started to rise but still remained historically low. The low interest
rate/mortgage rate environment curtailed SHFA mortgage production/origination, and
the Federal Reserve has committed to a $600 billion Treasury bond buying program that
began in November 2010 and is scheduled to run through June 2011. While the goal of this
program is to keep interest rates down and encourage economic growth, the net effect on
SHFAs is to make its mortgage loan product non competitive with the conventional
mortgage market. SHFA investment income is also dramatically impacted in the low rate
environment, which directly influences SHFA profitability levels.
SHFAs continue to manage through this environment. In the aftermath of the housing
crisis, conventional lenders have imposed extremely tight credit standards, which has
made SHFAs’ 30-year fixed rate mortgage product attractive to some, despite the rate
environment. Indeed for some, the SHFA product was the only high loan to value product
available in the marketplace and this somewhat, but not completely, mitigated the non
competitive aspect of the SHFA mortgage rate. SHFAs are also exploring non traditional
revenue sources such as retaining servicing on loans that they originate to replace lost
revenue sources.
Credit Facility Expirations: Bank facility expirations for SHFA issuers with outstanding VRDOs
is a growing credit risk as large levels of bank facilities expire in 2011 and 2012 and the
TCLP program is set to wind down in late 2012/early 2013. Fitch is concerned that bank
capacity for renewals will be constrained, and Fitch expects that available liquidity
support capacity will become increasingly expensive. (See Fitch’s special report “High
Demand/Diminished Supply Changing Dynamics of Bank Facilities Market Heighten the
Risk Profile for Some Municipal Borrowers,” dated Dec. 8, 2010, available on Fitch’s Web
site at www.fitchratings.com.)
If SHFA issuers are unable to secure replacement facilities to support their VRDOs or are
unable to refinance or convert their VRDOs with instruments not requiring such support,
the VRDOs would face a mandatory tender. The draw on the liquidity facility in most
cases (outside of TCLP) would then have an accelerated principal repayment schedule
(generally three to five years) to the bank.
Since SHFAs are typically higher rated credits, Fitch believes they should have
opportunities to obtain bank liquidity and should not face great difficulty in refinancing
their VRDOs with fixed-rate obligations and terminating swaps; however, this will
Public Finance
dramatically impact the spread between the existing rates on the revenue generating
mortgage assets and the bond interest rates paid within bond programs that may not be
affordable for some SHFA programs.
SHFA Financial Cushion: Fitch believes that, for most SHFAs, there continues to be financial
cushion at the issuer level to survive additional hits to profitability. These SHFA excess
funds were largely built up over time prior to the housing crisis from seasoned bond
programs, which reflect the issuer’s GO pledge strength. In the short term, most SHFAs
can weather the continued profitability issues, but if the recovery from the housing crisis
continues to be slow for several years and equity erodes, negative outlooks will be
assigned and/or negative rating actions to SHFA GO ratings will take place. How soon that
happens depends on how dramatic the profitability issues become. Fiscal 2010 saw
median net operating revenue decline to negative (1.3)% for the 34 SHFAs reporting
financial results, which is dramatically down from 4.0% in fiscal 2009.
Alternative Liquidity: Many SHFAs participated in the Treasury Department’s TCLP, which is
approaching its stated expiration date. SHFAs will need to find alternative liquidity to
replace TCLP by December 2012/January 2013. Since many issuers will be seeking
liquidity in the market at the same time, a number of SHFAs are reporting to Fitch that
they will prudently seek replacement before the final TCLP expiration date, which would
mean starting the process in 2011. Additionally, counterparty risk continues to be a
problem for SHFAs as it concerns liquidity providers (in addition to the counterparty risk
related to private mortgage insurers and guaranteed investment contract providers) in
that the providers are suffering from the aftermath of downgrades over the last two years,
which limits options for SHFAs.
Delinquencies and Foreclosures: While mortgage delinquency rates for all loans rose to an
all time high in first-quarter 2010 according to the MBA National Delinquency Survey, the
market finally saw improvement in third-quarter 2010 with a decline in delinquency and
foreclosure rates. While delinquencies as a whole did grow from fiscal 2010 to fiscal 2011 for
most SHFAs, many housing issuers’ bond funded mortgages continue to outperform
conventional prime fixed rate loans in their respective states in terms of delinquencies and
foreclosures. This was largely due to SHFAs offsetting loan performance risk by continuing
their long standing practices of prudent underwriting, full document and verification policies,
home buyer education requirements, and in some cases, offering job loss protection insurance.
2010 Review
SHFA fiscal results for 2010 marked noteworthy balance sheet changes, compared to
those of the previous years. Comparing fiscal 2010 results with those from fiscal 2009
for the 34 SHFAs reporting on a June 30 fiscal year end, total assets increased by 4.1%
and total debt increased by 3.4%. In previous years through 2008, SHFA total assets and
debt grew by near double-digit figures. Overall SHFA performance during fiscal 2010 on
an operating basis was negative, as certain indicators and margins continued further
weakening from fiscal 2009 levels. Similar to fiscal 2009, decreased interest income,
along with flat or higher expenses, led to decreases in operating revenue in fiscal 2010.
This trend is reflected in a decline in median net operating revenue (NOR) as a
percentage of total revenue for the 34 SHFAs (after eliminating the GASB Statement No.
31 adjustment) to negative (1.3)% in fiscal 2010 from 4.0% in fiscal 2009. If this NOR
trend continues, Fitch would expect an increase in negative rating actions for SHFA GO
ratings.
Despite these diminished operating ratios, there were some satisfactory results. The
median adjusted debt-to-equity ratio for the 34 SHFAs increased slightly to 5.7x in
fiscal 2010 from 5.5x in fiscal 2009 returning back to fiscal year 2006/2007 levels for
the same 34 SHFAs, which is still lower than the median of the 10-year averages of 6.1x.
Public Finance
These lower debt-to-equity ratios in the last two years follow several years of increases,
as SHFA new bond issuance nearly halted in fiscal years 2009 and 2010.
Public Finance
Rating Outlook Higher Education
STABLE Fitch Ratings’ Outlook for U.S. public and private colleges and universities is Stable for 2011.
Outlook stability is predicated primarily upon Fitch’s expectation that the preponderance of
Analysts rating activity within its universe of rated credits will take the form of affirmations, with
Douglas J. Kilcommons individual credit outlooks remaining largely stable across the portfolio over the next 12
+1 212 908-0740 months. Fundamentally underpinning the 2011 outlook is Fitch’s view of the sector’s three
douglas.kilcommons@fitchratings.com primary credit drivers: student demand and enrollment; balance sheet resources and
Colin Walsh liquidity; and risk management practices.
+1 212 908-0767
colin.walsh@fitchratings.com Student Demand and Enrollment: Through a combination of measures designed to
James George enhance recruitment and retention strategies and maintain tuition affordability for students,
+1 212 908-0652 the vast majority of public and private higher education institutions continue to retain
JAMES.GEORGE@FITCHRATINGS.COM
considerable demand flexibility. Consequently, over the next 12 months, Fitch expects
Eric Kim
+1 212 908-0241
most colleges and universities, particularly those rated investment grade, to maintain or
eric.kim@fitchratings.com modestly increase student headcount, thereby bolstering a primary revenue stream:
Angela Guerrero student-generated revenues.
+1 212 908-0259
angela.guerrero@fitchratings.com Balance Sheet Resources and Liquidity: In the wake of the financial crisis, most
Jonathan Bodner institutions have taken action to minimize the volatility of investment returns, where
+1 212 908-0803 possible, and increase the overall liquidity of their total investment holdings. In Fitch’s view,
jonathan.bodner@fitchratings.com this helps to reduce the vulnerability of many college and university balance sheets to
unexpected financial market turbulence and enables many institutions to maintain, if not
increase, their financial cushion relative to both financial leverage and operating
expenditures during 2011.
Risk Management Practices: As management teams across the higher education industry
formalize and codify policies and practices designed to minimize credit risks across a host
of functional areas, Fitch believes many colleges and universities are now better equipped
to identify and respond to challenges as they arise. Operating and financial stability over
time is bolstered by this capability.
Should negative rating and/or outlook action occur, Fitch would expect these actions to be
isolated among marginal private university credits, many of which are already rated at the
lowest end of investment grade or below investment grade and possess more limited
financial flexibility. Public universities, particularly non-flagship institutions more heavily
dependent upon their home state for annual financial support and students, could also
potentially face an increase in credit pressure over time as appropriations are reduced in
light of severely constrained state budgets. Still, over the next 12 months, an increase in
negative rating actions for these institutions seems unlikely given the continuing ability and
increasing willingness of nearly every public college and university to ratchet up tuition and
fees, without negatively impacting demand, in response to funding cuts.
U.S. Public and Private Higher
Education Rating Outlooks What Could Change the Outlook?
 Sectorwide stagnation or reduction in student-generated revenues, driven by
(%) 92.7%
100 declines in enrollment, and/or an increasing inability to pass along higher
instructional costs or backfill reduced state funding with tuition and fees hikes.
80
60
 Turbulence in financial markets leading to widespread, material erosion in institutional
resources, particularly among institutions reliant upon investment returns.
40
20
4.5%
Key Issues
2.7%
0
While Fitch expects the higher education sector’s primary credit drivers, as mentioned
Positive Stable Negative above and to be discussed in greater detail below, to remain stable, if not modestly
improve in 2011, Fitch acknowledges that the operating environment for most colleges
Public Finance
and universities remains perennially influx. Fierce competition for students; global
financial market volatility; and increased physical plant demands necessitating ongoing
investment and reinvestment complicate and challenge even the best laid business plan.
Consequently, when considering the projected ratio of positive rating actions to
negative rating actions, excluding affirmations, for 2011, Fitch recognizes that the
negative rating actions could possibly equal or exceed the number of positive rating
actions. However, the proportion is not expected to be statistically significant, nor
indicative of heightening systemic risks for the sector.
Student Demand and Enrollment: Given that student-generated revenue is the primary
source of funding for most private universities, and a significant and growing source of
budgetary support for most public institutions, a college or university’s ability to meet
current year enrollment targets, bolster retention and graduation rates, and maintain a
robust pipeline of prospective students for subsequent in-coming freshmen classes is
extremely important. As evidenced by the U.S. Department of Labor Statistics record high
(70%) college enrollment rate for the 2009 graduating high school class (ages 16―24), most
institutions have successfully strengthened enrollment management in response to the
financial crisis several years ago, notably implementing targeted marketing and recruiting
strategies; increasing budget support for financial aid; and focusing on student success. As a
result, enrollment levels at most private colleges and universities continue to increase.
Public universities have experienced an updraft in both student demand and enrollment for
similar reasons, and have further benefited from the affordability advantage discussed
above. While tuition and fee increases instituted by public universities over the past several
years have outpaced increases by private universities, resulting in a slight narrowing of the
affordability gap, most private institutions have now also resumed regular tuition increases
and remain more expensive than their public university competitors. Given these factors,
Fitch expects most colleges and universities to sustain the demand and enrollment trends
experienced over the past 12 months throughout 2011.
Balance Sheet Resources and Liquidity: With management at most institutions now
squarely focused on balancing the desire to maximize long-term investment returns
with the practical realities of working capital sufficiency and need for liquidity, the
asset side of the balance sheet for most colleges and universities is expected to exhibit
greater stability in 2011 than it has in previous years. Though the performance of global
financial markets is outside of the control of university finance professionals and
investment officers, most institutions have taken decisive action to permanently reduce
return volatility through more balanced asset allocation; have increased liquidity within
their short and long-term investment portfolios; and remain flexible in their application
of endowment spending policies, with the ability to reduce or defer a payout should
future financial flexibility appear to be in jeopardy. While short-term portfolios, which
are designed to support near-term liquidity needs, have long been focused on
preservation of principal through investments in highly liquid, high-quality securities,
such as obligations of the federal government, many colleges and universities have also
moved to increase the exposure of long-term investment pools to more traditional asset
classes, including cash, and freezing further investments in alternatives, notably
private equity. This portfolio reallocation represents a marked departure from just
several years ago when institutions at nearly every rating level were investing a greater
percentage of long-term financial assets into illiquid, nonmarketable securities. Fitch
notes that alternative assets will continue to comprise a significant component of long-
term investments for many, well-endowed private and public colleges and universities,
notably at the upper rating levels. So long as these long-term pools are not relied upon
for liquidity, and the allocation is part of a well-balanced portfolio, exposure to
alternative assets is not in and of itself a credit concern.
Risk Management Practices: While many colleges and universities benefit from strong
Public Finance
leadership, the trend towards institutionalization of policies and practices designed to
minimize risk has accelerated over the past several years, largely in response to the
challenges presented by the financial crisis and national economic recession. For 2011,
Fitch expects the trend towards codification of best practices to continue, empowering
management to respond nimbly and effectively to challenges as they arise. While many
policies covering a range of functional areas now exist, a key example of a policy which
directly contributes to a reduction in credit risk and, thus, sector stability, is a
comprehensive debt policy. Unlike debt policies developed in past years, many of which
were either amorphous or loosely applied, comprehensive debt policies of late have
been updated to include parameters detailing tolerance to variable-rate debt, use of
interest rate hedges, and exposure to liquidity banks.
Over the past several years, many colleges and universities have grappled with the failure
of the auction-rate market; the need for liquidity, either external or internal, to support
variable-rate borrowings; swap terminations; and the failure or potential failure of a
liquidity provider. While these events, as they occurred, tested management and board of
director capabilities and, in isolated cases, pressured balance sheets, the vast majority of
institutions successfully dealt with these challenges and immediately implemented checks
and balances to avoid repeat events in the future. During 2010, as an example, many of
Fitch’s private colleges and universities rated ‘A’ and below restructured their debt
portfolios, materially reducing or altogether eliminating their variable-rate exposure and
terminating interest rate hedges. Some higher rated institutions, which possess the
flexibility to manage the risks attendant to variable-rate debt and swaps, also took
advantage of a favorable long-term interest rate environment and fixed out a portion of
their exposure to floating-rate debt. While a handful of Fitch-rated higher education
institutions will need to manage the process of renewing an expiring liquidity facility during
2011, each of these credits has the financial wherewithal to do so or possesses the ability to
affordably access capital markets to effectuate a fixed rate take-out of the associated
variable-rate obligation.
2010 Review
Stabilization in global financial markets during 2010 enabled many institutions that had
seen material erosion in balance sheet resources during the previous two years to
recover a significant percentage of lost wealth. While changes in either rating or
outlook during 2008 and 2009 as a result of investment losses were limited to cases
where the college or university was disproportionately reliant upon accumulated
market gains to subsidize an otherwise deficit-generating operation, market recovery in
2010 provided a more stable footing for all institutions to begin shoring up financial
cushions and rebuilding liquidity.
Predictions of widespread, massive enrollment losses at more expensive private
universities, driven by the loss of personal wealth in the wake of the financial market
collapse and national recession, ran wild during 2008 and 2009. By 2010, however, it
became apparent that a decline in private university enrollments would not be even,
with demand pressures, as was expected by Fitch, primarily to be felt by those colleges
or universities lacking institutional identity and strong credit fundamentals (e.g.,
manageable debt burden). Consequently, nearly all of the rating changes and/or
outlook revisions over the course of the past 12 months were enrollment related, with
many of the downgraded institutions experiencing a stagnation or decline in net tuition
and fee income resulting in a slippage in operating margin to a level deeply below
break-even. Importantly, Fitch notes that many of these institutions were rated at or
just below ‘BBB―’, with little, if any, flexibility to remedy their demand weakness.
Public Finance
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AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION,
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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
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verification of that information from independent sources, to the extent such sources are available for a given security or in
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www.fitchratings.com March 30, 2011

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