Los Angeles gets S&P downgrade on fiscal woes

Bloomberg News

Los Angeles' financial woes brought an S&P Global Ratings downgrade Friday, to AA-minus from AA.

The rating agency also lowered the ratings on the Municipal Improvement Corp. of Los Angeles lease revenue bonds to A-plus from AA-minus.

The rating agency removed the CreditWatch with negative implications assigned on Jan. 15 as the city battled a devastating wildfire in Pacific Palisades.

But S&P replaced the CreditWatch with a negative outlook that signals a one-in-three chance of further downgrades if the city is unable to make the structural budget adjustments necessary to restore operating balance over the two-year outlook horizon.

"The downgrade reflects the city's weakening financial position and an emerging structural imbalance that we expect will decrease the reserve fund below the policy target of 5% in 2025," S&P analysts wrote in Friday's ratings report. "The rapid pace of the reserve deterioration over the last two fiscal years and increasing threats to budget balance highlight the near-term credit risk."

Mayor Karen Bass proposed steep cuts when she introduced her budget on Monday including department mergers and layoffs to close a $1 billion budget deficit.

S&P noted the challenges the city faces, including heightened litigation risk, limited flexibility to unilaterally reduce personnel costs under current labor contracts, and slowing economic growth. The potential for lasting economic and revenue impacts from January's wildfires adds another layer of uncertainty, analysts said.

"We view physical risk factors as elevated given the recent wildfires in Los Angeles County and the increasing frequency and severity of such events, with recent spread into more urban areas introducing heightened potential credit risk for the city tied to negative tax base impacts or litigation from the ongoing wildfires," S&P analysts said.

"While the Pacific Palisades community represents a relatively small portion of the city's vast geographic area, we believe that the large proportion of high-value properties likely affected could represent a more notable portion of the city's overall property tax base," S&P analysts said.

The city, like other issuers in the state, are "also exposed to additional physical environmental risks in the form of extreme rain events, earthquakes, and drought," S&P analysts wrote.

S&P said they believe the city faces an uphill battle to maintain structural balance "given evidence of softening revenue trends and significant underlying budget growth, largely tied to personnel costs following negotiated labor union agreements in recent years."

The city is likely to face resistance to significant reductions in key priorities and services to balance the budget, S&P analysts said.

It could restore the outlook to stable if the city restores balance to general fund operations and restores reserves to the 5% policy level.

The ratings could fall further, S&P said, if it thinks city leaders lack the political will to make the necessary cuts to prevent consecutive operating deficits in coming years.

"We could also lower the rating if additional debt issuance or heightened litigation or contagion risk associated with its utilities (i.e., Los Angeles Department of Water and Power [LADWP]) materially weakens our view of the city's debt and liability profile," S&P said.

S&P in January downgraded its long-term rating on DWP power revenue bonds to A from AA-minus, and its water system revenue bonds to AA-minus from AA-plus.