Moody’s Approach to Local Government Credit Analysis

Eric Hoffmann, Senior Vice President / Manager, February, 2019 Public Finance Department Agenda

1. Moody’s Credit Rating Basics 2. Initial Credit Rating Process 3. Maintenance of the Rating 4. General Obligation Methodology 5. Lease, Appropriation, Moral Obligation Methodology 6. Municipal Utility Revenue Debt Methodology

Moody’s Approach to Local Government Credit 2 Analysis Moody’s Credit Rating 1 Basics The Meaning of a Moody’s Credit Rating

» An indication of the relative risk that 1) a municipal debtor may not fully make its debt service payments as scheduled and 2) in the event of non-payment, investors likely financial losses

Types of Credit Ratings: » Long-term and short-term » Underlying, enhanced, fully-supported, insured » Issuer Rating » Indicative rating

Moody’s Approach to Local Government Credit 4 Analysis Moody’s Global Long-Term Rating Scale

Lowest Risk

Highest Risk

Moody’s Approach to Local Government Credit 5 Analysis Moody’s Short-Term Rating Scales

Moody’s Approach to Local Government Credit 6 Analysis Initial Credit Rating 2 Process The 6-Step Rating Process

Step 1: Step 2: Step 3: Step 4: Step 5: Step 6: Assignment Methodology Analysis Discussions Committee Publication

Assignment Methodology Analysis Discussions Committee Publication

The rating The Lead The Lead The Lead The Lead The Lead process starts Analyst identifies Analyst gathers Analyst holds a Analyst Analyst informs with the the appropriate information and credit discussion develops a the marketplace assignment of a methodology begins to with the Issuer recommendation of any rating Lead Analyst analyze the (in-person/ and presents it actions by credit conference call) to a committee publishing a of senior report analysts

Moody’s Approach to Local Government Credit 8 Analysis Methodologies -- Publicly Available on Moodys.com

Moody’s Approach to Local Government Credit 9 Analysis Methodologies: Consistency & Nuance

» Three broad methodology types: cross-sector, sector, and security

» Most commonly used methodologies: – US Local Government General Obligation Debt – Lease, Appropriation, Moral Obligation and Comparable Debt of US State and Local Governments – US Municipal Utility Revenue Debt

» Sector and security specific methodologies general structure: – A “scorecard” that provides guidance on likely rating level for the typical credit – A list of common adjustments that might be made to the scorecard guidance, reflecting state, sector or security specific variations from the typical credit – Allowance for additional considerations that may not be common

» All ratings are ultimately determined by vote in a rating committee

Moody’s Approach to Local Government Credit 10 Analysis Methodologies: Consistency & Nuance

» Typical general obligation: Contractual full faith and credit pledge of unlimited ad valorem taxing power of the local government » California local government GO bonds are not “typical” – Directly voter approved – Benefit from statutory lien – Some have a third-party “lockbox” – May have “special revenue” status in bankruptcy » California local government GO bonds above-average GO security results in a half to full notch automatic adjustment upward in the scorecard rating guidance » California also uses a relatively unusual legal theory for lease-backed obligations (“abatement” rather than “annual appropriation”)

Moody’s Approach to Local Government Credit 11 Analysis Moody’s Issuer Guide

Moody’s Approach to Local Government Credit 12 Analysis Maintenance of the 3 Rating US PFG Monitoring Framework

» We review every rating at least annually » Initial surveillance process involves multiple, quantitative screens » Most ratings are deemed appropriate through the various screening and review steps – Some proceed to a rating committee for possible rating action

Quantitative screens (Threshold Filtering and Analyst Batch Review)

Review by an analyst (Individual Review) Analysts reach out to issuers when necessary, but always if Rating rating committee will be held Committee

Moody’s Approach to Local Government Credit 14 Analysis US PFG Monitoring Framework

» For credits that go to a rating committee, the rating process is the same for initial ratings as it is for reviews of existing ratings » We have one combined group responsible for initial ratings and surveillance » Analysts reach out to issuers for additional information when necessary and will always contact the issuer if a credit could go to a rating committee » Financial advisors, auditors, bond counsel, etc. are welcome to participate in the credit discussion with the issuer

Moody’s Approach to Local Government Credit 15 Analysis General Obligation 4 Methodology Methodology Scorecard: Analytical Starting Point

Moody’s Approach to Local Government Credit 17 Analysis Methodology Scorecard: Analytical Starting Point

Moody’s Approach to Local Government Credit 18 Analysis GO Scorecard Guidance Adjustment/Notching Factors

Description Direction Economy/Tax Base Institutional presence up Regional economic center up Economic concentration down Outsized unemployment or poverty levels down Other analyst adjustment to Economy/Tax Base factor (specify) up/down Finances Outsized contingent liability risk down Unusually volatile revenue structure down Other analyst adjustment to Finances factor (specify) up/down Management State oversight or support up/down Unusually strong or weak budgetary management and planning up/down Other analyst adjustment to Management factor (specify) up/down Debt/Pensions Unusually strong or weak security features up/down Unusual risk posed by debt/pension structure down History of missed debt service payments down Other analyst adjustment to Debt/Pensions factor (specify) up/down Other Credit event/trend not yet reflected in existing data sets up/down

Moody’s Approach to Local Government Credit 19 Analysis Lease, Appropriation, 4 Moral Obligation 5 Methodology Lease Ratings are “Notched” off the GO Rating Standard California abatement leases have a “moderate” legal structure

Moody’s Approach to Local Government Credit 21 Analysis Examples of More and Less Essential Leased Assets

Moody’s Approach to Local Government Credit 22 Analysis Municipal Utility 4 Revenue Debt 6 Methodology Municipal Utilities Scorecard Factors

Broad Scorecard Factors Factor Weighting Rating Sub-Factor Sub-factor Weighting

Asset Condition (Remaining Useful Life) 15.0%

System Characteristics 35% Service Area Wealth (Median Family Income) 12.5%

System Size (O&M) 7.5%

Annual Debt Service Coverage 15.0%

Financial Strength 35% Days Cash on Hand 12.5%

Debt to Operating Revenues 7.5%

Rate Management 10.0% Management 20% Regulatory Compliance and Capital Planning 10.0%

Rate Covenant 5.0% Legal Provisions 10% Debt Service Reserve Requirement 5.0%

Total 100% Total 100%

Moody’s Approach to Local Government Credit 24 Analysis 1. System Characteristics (35%)

System Characteristics (35%) Aaa Aa A Baa Ba B and Below

Asset Net Fixed Assets/Annual Net Fixed Assets/Annual Net Fixed Assets/Annual Net Fixed Assets/Annual Net Fixed Assets/Annual Net Fixed Assets/Annual Condition Depreciation : Depreciation : Depreciation : Depreciation : Depreciation : Depreciation : (15%) > 75 years 75 years ≥ n > 25 years 25 years ≥ n > 12 years 12 years ≥ n > 9 years 9 years ≥ n > 6 years ≤ 6 years

Service Area Wealth > 150% of US median 150% ≥ US median > 90% 90% ≥ US median > 75% 75% ≥ US median > 50% 50% ≥ US median > 40% ≤ 40% of US median (12.5%)

Water Only / Sewer Only / Water Only / Sewer Only / Water Only / Sewer Only / Water Only / Sewer Only / Water Only / Sewer Only / Water Only / Sewer Only / Water & Sewer / Combined Water & Sewer / Combined Water & Sewer / Combined Water & Sewer / Combined Water & Sewer / Combined Water & Sewer / Combined Utility / Solid Waste: Utility / Solid Waste: Utility / Solid Waste: Utility / Solid Waste: Utility / Solid Waste: Utility / Solid Waste: O&M > $70M $70M ≥ O&M > $40M $40M ≥ O&M > $17M $17M ≥ O&M > $10M $10M ≥ O&M > $5M O&M ≤ $5M System Size (7.5%) Stormwater: Stormwater: Stormwater: Stormwater: Stormwater: Stormwater: O&M > $15M $15M ≥ O&M > $7.5M $7.5M ≥ O&M > $4M $4M ≥ O&M > $2M $2M ≥ O&M > $1M O&M ≤ $1M

Gas or Electric: Gas or Electric: Gas or Electric: Gas or Electric: Gas or Electric: Gas or Electric: O&M > $115M $115M ≥ O&M > $65M $65M ≥ O&M > $30M $30M ≥ O&M > $15M $15M ≥ O&M > $8M O&M ≤ $8M

Moody’s Approach to Local Government Credit 25 Analysis 2. Financial Strength (35%)

Financial Strength (35%) Aaa Aa A Baa Ba B and Below

Annual Debt Service Coverage (15%) > 2.00x 2.00x ≥ n > 1.70x 1.70x ≥ n > 1.25x 1.25x ≥ n > 1.00x 1.00x ≥ n > 0.70x ≤ 0.70x

Days Cash on Hand (12.5%) > 250 days 250 days ≥ n > 150 days 150 days ≥ n > 35 days 35 days ≥ n > 15 days 15 days ≥ n > 7 days ≤ 7 days

Debt to Operating Revenues (7.5%) < 2.00x 2.00x ≤ n < 4.00x 4.00x ≤ n < 7.00x 7.00x ≤ n < 8.00x 8.00x ≤ n < 9.00x ≥ 9.00x

Moody’s Approach to Local Government Credit 26 Analysis 3. Management (20%)

Management (20%) Aaa Aa A Baa Ba B and Below

Strong rate-setting record; Average rate-setting record; Adequate rate-setting Excellent rate-setting Below average rate-setting Record of insufficiently Rate Rates and cost adjustments in Rates and cost adjustments record; Rates and cost record; Rates and cost record; Sizeable General adjusting rates; Large Management 21 - 50 days; Small and well- 51 - 80 days; Moderate adjustments 81 - 120 days; adjustments in 20 days or Fund transfer not governed General Fund transfer not (10%) defined General Fund transfers General Fund transfers Large General Fund transfer less by policy governed by policy governed by policy governed by policy not governed by policy

Fully compliant OR Regulatory proactively addressing Actively addressing minor Moderate violations with Significant compliance Compliance compliance issues; compliance issues; Maintains adopted plan to address violations with limited Not fully addressing Not addressing and Capital Maintains sophisticated comprehensive and issues; Maintains solutions adopted; Maintains compliance issues; Limited or compliance issues; No Planning and manageable Capital manageable 10-year Capital manageable 5-year Capital single year Capital weak capital planning capital planning (10%) Improvement Plan that Improvement Plan Improvement Plan Improvement Plan addresses more than a 10- year period

Moody’s Approach to Local Government Credit 27 Analysis 4. Legal Provisions (10%)

Legal Provisions (10%) Aaa Aa A Baa Ba B and Below

Rate Covenant > 1.30x 1.30x ≥ n > 1.20x 1.20x ≥ n > 1.10x 1.10x ≥ n ≥ 1.00x ≤ 1.00x (5.0%)

Debt Service Reserve DSRF funded at less than 3- DSRF funded at lesser of NO explicit DSRF; OR funded with speculative grade Requirement DSRF funded > MADS DSRF funded at MADS prong test OR springing standard 3-prong test surety (5.0%) DSRF

Moody’s Approach to Local Government Credit 28 Analysis Municipal Utility Debt Scorecard Guidance Adjustment/Notching Factors

Adjustments/Notching Factors

Factor 1: System Characteristics Additional service area economic strength or diversity Significant customer concentration Revenue-per-Customer greatly over/under regional average Exposure to weather volatility or extreme conditions Resource vulnerability (1/3 or greater) Sizable or insufficient capacity margin Weak depreciation/reinvestment practices relative to industry norms Other analyst adjustment to System Characteristics (Specify) Factor 2: Financial Strength Debt Service Coverage (Annual or MADS) below key thresholds: Additional Bonds Test and 1.00x coverage Constrained liquidity position due to oversized transfers Outsized capital needs Oversized ANPL relative to debt or significant ARC under-payment Significant exposure to puttable debt and/or swaps or other unusual debt structure Other analyst adjustment to Financial Strength factor (Specify) Factor 3: Legal Provisions Structural Enhancements/Complexities Other analyst adjustment to Legal Provisions factor (Specify) Factor 4: Management Unusually strong or weak operational or capital planning Other analyst adjustment to Management factor (Specify) Other Credit Event/Trend not yet reflected in existing data set

Moody’s Approach to Local Government Credit 29 Analysis Relationship with General Obligation Rating

» A utility rating will typically be within two notches, up or down, of the local government’s GO rating

» A utility rating more than two notches higher than the GO rating can be supported by:

– Unusually weak GO rating that is driven by factors less relevant to utility strength – Non-coterminous service area – Closed loop flow of funds – Separation of management and governance

» A utility rating more than two notches lower than the GO rating can be supported by: – Unusually weak utility rating that is driven by factors less relevant to general government’s credit strength – Service area that is narrower and less diverse than municipality as whole – Low likelihood that the general government would transfer funds to assist the utility – Rating triggers tied to GO credit quality in utility financing

Moody’s Approach to Local Government Credit 30 Analysis 4 Appendix Moody’s Default Research

Moody’s Approach to Local Government Credit 32 Analysis Moody’s Municipal Default Research

Moody’s Approach to Local Government Credit 33 Analysis Moody’s Municipal Default Research

Moody’s Approach to Local Government Credit 34 Analysis Moody’s Municipal Default Research

Moody’s Approach to Local Government Credit 35 Analysis Eric Hoffmann Senior Vice President / Manager One Front Street, Suite 1900 San Francisco, CA 94111 415.274.1702 [email protected]

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Moody’s Approach to Local Government Credit 37 Analysis