Fitch Rates Ohio Treasurer of State $50MM Bonds 'AA'; Outlook Stable

Fitch Ratings has assigned an 'AA' rating to the $50 million state of Ohio (Treasurer of State) capital facilities lease-appropriation bonds, series 2014A (mental health facilities improvement fund projects).

The bonds are expected to be sold via negotiation on Jan. 22, 2014.

In addition, Fitch affirms the 'AA' rating on approximately $1.9 billion outstanding appropriations backed bonds of the state, including those issued by the Treasurer of State and previously by the Ohio Building Authority and the Ohio Public Facilities Commission.

The Rating Outlook is Stable.

SECURITY

The bonds are a special obligation of the state, payable from payments under a lease agreement between the Ohio Public Facilities Commission (OPFC) and the department of mental health and addiction services and the department of developmental disabilities (together: the mental health departments.) The lease agreement is subject to appropriation from the state's general revenue fund (GRF).

KEY RATING DRIVERS

APPROPRIATION MECHANISM: The rating on the bonds backed by Ohio's lease appropriation, one notch below the state's GO rating, reflects the state's general credit standing, sound lease structure, and constitutional authorization for these types of bonds.

BROAD ECONOMY WITH LARGE MANUFACTURING SECTOR: The state's economy is broad and diverse, although the manufacturing sector continues to represent a disproportionally large segment of the economy. The state's economy is modestly expanding but at a slower pace than immediately following the recession and the unemployment rate has recently shifted to above the national average.

MODERATE LIABILITY BURDEN: The state's debt burden is moderate and rapidly amortized. Debt is typically conservatively managed and primarily consists of GOs. On a combined basis, outstanding debt and pension obligations are a manageable and below-average burden on the state.

DEMONSTRATED ABILITY TO MANAGE BUDGET CHALLENGES: The state generally has a careful approach to financial operations and has consistently managed to achieve budgetary balance, inclusive of surplus operating results in fiscal 2013, which provided for full funding of the state's budget stabilization fund (BSF). The budget enacted for the 2014 - 2015 biennium applies additional fiscal 2013 surplus revenues to pay for a large personal income tax rate cut while incorporating sizable growth in appropriations.

RATING SENSITIVITY

The rating is sensitive to changes in the state's 'AA+' GO rating to which it is linked.

CREDIT PROFILE

The series 2014A bonds currently offered are secured by rental payments that are appropriated biennially under a lease between the OPFC and the mental health departments pursuant to a trust agreement. The debt is authorized by the state's constitution and secured by the state's pledge of legislative appropriation, with the lease renewable biennially until the bonds are repaid.

The OPFC is required to submit an estimate of the debt service requirements to the mental health departments and to the director of budget and management prior to the start of each fiscal year. Debt service must be included in the budget of the departments. The trustee does not have the ability to take possession of or operate the leased projects. The current offering will be applied to construction of capital facilities operated by the mental health departments.

The state's 'AA+' GO rating is based on its generally careful financial management, ongoing record of maintaining fiscal balance, and a moderate, rapidly amortizing debt burden. Debt is supported by an economy that is slowly adding jobs lost in the recession. The recession had a widespread impact on the Ohio economy, accelerating a longstanding slump in manufacturing and weighing on the slowly growing service sector. The state has recorded consecutive months of year-over-year (y-o-y) job gains since July 2010, largely incorporating gains in the manufacturing sector as well as in the services sectors, although growth has moderated over the past eighteen months.

In the biennium that ended on June 30, broad budget balancing actions, notable growth in tax revenues, and the lease of the state's liquor distribution system to JobsOhio, a newly created not-for-profit economic development entity, enabled the state to record sizable operating surpluses and deposits to its rainy day fund. At the close of fiscal 2013, the state reports that its BSF was fully funded at 5% of general revenue fund (GRF) revenues.

STEADY ECONOMIC GROWTH

The state steadily added jobs in 2011, evidenced by y-o-y growth in every month from July 2010, and 2012 evidenced a continuation of this positive trend with 1.5% annual growth recorded. Beginning in July 2012, monthly y-o-y growth slowed as compared to national averages, and the 0.4% growth reported in November 2013, when compared to 1.7% growth for the nation, continued this trend. The slow growth reflects a cooled pace in manufacturing employment growth aided by more substantial growth in education and health services and professional and business services, tempered by continuing losses in the government and construction sectors; down 1.3% and 2.9%, respectively, y-o-y in November 2013. Natural resources and mining employment jumped in November 2013 by 3.2% y-o-y due to progress in drilling in the Utica shale formation.

Y-o-y through November 2013 state employment has increased by 20,000 jobs, yet employment remains well below its pre-recession peak that was set in 2006. Employment figures for 2012 show Ohio's annual employment growth in 2012 just below the national average: 1.5% as compared to 1.7% for the nation. The annual unemployment rate for 2012 was 7.2%; better than the 8.1% rate for the U.S. The deceleration in the state's labor growth in 2013 is reflected in unemployment rates that in September 2013 began to move above the national average and have been sustained; November 2013 state unemployment rate of 7.4% compared to a national rate of 7%.

An increase in state personal income per capita to $39,289 in 2012 (92% of the U.S.) from $37,836 in 2011 reflects the economic improvements in the state. Recent quarterly personal income data points to an economic recovery approximating national and regional averages, with third quarter personal income growth y-o-y of 3.8% compared to 3.6% for the nation and surrounding region.

DEMONSTRATED ABILITY TO MANAGE BUDGET CHALLENGES

Fiscal management practices in Ohio are sound and the state has consistently maintained budgetary balance, including during the recession. The state's fiscal position is substantially improved from the downturn, when the state employed one-time measures for fiscal relief.

GRF revenues in fiscal 2012 grew 3.1% from fiscal 2011, in contrast to a forecast 2.2% decline that was partly driven by a steep drop-off in federal stimulus funds. These results produced a $129 million net increase in the GRF's cash balance, to $973.4 million, after a $235.1 million transfer to the BSF, increasing the BSF to $482 million (about 1.8% of fiscal 2012 GRF revenue).

GRF actual revenues in fiscal 2013 were boosted by $500 million in unbudgeted proceeds from the lease of the state's liquor distribution system to JobsOhio as well as robust personal income tax (PIT) revenue that incorporated the acceleration of income into tax year 2012 due to anticipated federal tax law changes. The state reports revenue growth of 8.7% from actual receipts in fiscal 2012, including a 10.6% increase in tax receipts. Included in the growth are a 12.7% increase in PIT revenue and a 4.5% increase in non-auto sales tax revenue.

These results brought the state's fiscal 2013 ending cash balance to $2.6 billion; $995.9 million of which was transferred to the BSF, bringing its balance to $1.478 billion, its statutory maximum of 5% of GRF revenues. The unencumbered GRF fund balance increased to $1.11 billion, well above the statutorily required minimum fund balance of $147.8 million. The difference between the actual ending unencumbered fund balance and the minimum required amount, $963.1 million, has been reserved and is expected to be applied as an offset to the state's enactment of a three-year PIT rate reduction as part of the 2014 - 2015 biennial budget, adopted in the 2013 legislative session.

The legislatively enacted budget for the 2014 - 2015 biennium authorized GRF expenditures of $30.26 billion in fiscal 2014 and $31.7 billion in fiscal 2015. The fiscal 2014 budget, enacted in June 2013, was a 10.3% increase from estimated disbursements in fiscal 2013, incorporating 16.8% expected growth in the Medicaid program related to increased participation of currently eligible residents. The state had not moved to expand Medicaid under the Affordable Care Act at that time. While federal matching funds were expected to increase in line with the increased participation, the state's baseline costs for the program were estimated to increase by $186.3 million in fiscal 2014 (contributing to 12.2% state-share program growth) and $334.8 million in fiscal 2015 (contributing to 6.5% state-share program growth).

In October 2013, the seven-member state controlling board, consisting of the state budget director (or his designee) and six representatives of the state legislature, through its authority to approve the expenditure of additional federal money, voted to authorize the expenditure of approximately $562 million in fiscal 2014 and approximately $2 billion in fiscal 2015 of additional federal funds linked to an expansion of the Medicaid program in the state. The controlling board's approval of these expenditures was challenged but was recently upheld by the state Supreme Court.

As noted earlier, the budget also included a change to the PIT that will lower rates by 10% over three tax years beginning in 2013, increased the sales tax rate by 0.25% as an offset, reduced income taxes on small business owners, modified the K-12 education funding formula to provide additional state funding to lower-wealth districts, implemented new Medicaid cost-containment initiatives, redesigned the higher education funding formula to incorporate performance-based outcomes, and authorized a leveraging of the Ohio Turnpike system's revenues to fund key northern Ohio road projects.

The PIT rate reductions and tax modifications for small business owners are expected to result in a sizable amount of foregone revenue over the biennium and are only partly offset by the sales tax rate increase (revenue increased by $319.1 million in fiscal 2014 and $452.8 million in fiscal 2015, above the baseline forecast), some PIT index and exemption freezes, and other tax reform measures. Increasing sales tax revenue is also expected from the anticipated growth of medical health insurance corporations as health care coverage expands in the state. The PIT rate reductions are expected to reduce revenue compared to baseline by $1.56 billion in fiscal 2014 and $1.35 billion in fiscal 2015. The larger reduction in fiscal 2014 includes the retroactivity of the 8.5% rate change on withholding payments to Jan. 1, 2013. Included in these amounts is the income tax modification for small business owners that will result in $515.8 million in foregone revenue in fiscal 2014 and $537.8 million in fiscal 2015.

Based on the state's forecast of key economic variables, combined tax law changes are expected to result in GRF tax revenues declining by 4.9% in fiscal 2014 rather than a modest increase of 0.3% expected from baseline revenue growth from fiscal 2013. For fiscal 2015 the state projects GRF tax revenue growth of 8% which includes 11% expected growth in the PIT and a total of 7.8% growth in sales tax receipts. Fitch believes there is downside risk to the state's expectation of PIT growth given that employment growth in the state has slowed over the past 12 months. In the event of economic and revenue under-performance, the application of fiscal 2013 surplus funds to the fiscal 2014 - 2015 operating budget could lead to structural imbalances beyond the 2014 - 2015 biennium.

CONSERVATIVE DEBT MANAGEMENT

The state's debt management is generally conservative. Debt amortization is rapid, with all debt fully retired in 20 years and 78% of GRF-backed debt amortized in 10 years. Total tax-supported debt of $11.2 billion is equivalent to a manageable 2.4% of 2012 personal income.

A $1.78 billion capital improvement plan (CIP) for fiscal years 2013 and 2014 was enacted in the 2012 legislative session and will be largely funded by $1.4 billion of GRF-backed debt. The CIP will be supplemented by $432 million of additional authorization approved in the 2013 legislative session. The largest beneficiaries of the plan are higher education, primary and secondary education, and local infrastructure projects. Debt ratios are expected to approximate current averages as GRF principal continues to roll off. Personal income is also expected to continue to grow.

Funding for Ohio's pension systems had declined significantly, with the largest system, PERS, declining from a strong 96% funded ratio as of Dec. 31, 2007 to 77.4% funded as of Dec. 31, 2011. In September 2012, the governor signed several pieces of pension reform legislation targeted to improve the financial condition of all five Ohio pension systems. Reform measures affected employee contributions, number of years of service credit, minimum retirement age, cost of living calculations, and final average salary calculation. The most recent PERS valuation, from Dec. 31, 2012, showed the benefit of the reform measures as the reported funded ratio increased to 80.9%. Using Fitch's more conservative 7% discount rate assumption, PERS would have a 72.9% funded ratio.

On a combined basis, the burden of the state's net tax-supported debt and adjusted unfunded pension (UAAL) obligations equals 3.9% of 2012 personal income, well below the median of 7% for U.S. states rated by Fitch. The calculations include 45% of the liability of PERS that Fitch estimates to be attributable to the state division of PERS and a small share of the teachers' retirement system (TRS) UAAL for which the state is responsible.

Additional information is available at www.fitchratings.com.

Applicable Criteria and Related Research:
--'Tax-Supported Rating Criteria' (Aug. 14, 2012);
--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:
Tax-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015
U.S. State Government Tax-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=813280
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