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Credit Risk - US Public Finance, 2005 Year-End Results and Outlook for 2006 (January 20, 2006)

Location: New York
Author: Alex Bumazhny, Mike McDermott and David Litvack
Date: Friday, January 20, 2006

Results for the fourth quarter and for the year 2005 were significantly influenced by the effects of Hurricane Katrina. Fitch remains mostly positive on credit trends for 2006, despite lower metrics for 2005. For the first time in more than a year, quarterly downgrades exceeded upgrades as the upgrade-to-downgrade ratio was reduced to 0.6:1 from the third-quarter's ratio of 3.0:1. With the hurricane-influenced downgrades excluded, the ratio still demonstrates a negative credit trend, but only at 0.9:1.

Ten credits across the tax-backed, state, water & sewer, and transportation sectors were downgraded directly as a result of Hurricane Katrina. Fitch now considers the short- and longer term prospects for recovery more problematic, given the large number of displaced residents that have not returned to the city, the coordination difficulties facing federal, state, and local officials in rebuilding efforts, and the subsequent impact on the business community and the local government sector. Three of the affected credits are now below investment grade and all of the affected credits remain on Rating Watch Negative.

The economic trend remains positive, as overall November-over-November total employment grew at 1.19% in 2005, albeit at a slower rate than the November 2004-over-November 2003 rate of 1.54%. Gross domestic product continues to grow at an annualized rate of 3.6% as of third-quarter 2005, and other economic indicators such as consumption and personal income continue to look positive.

According to U.S. Census data, the housing markets are showing resiliency as 469,000 privately owned housing units were started in third-quarter 2005 compared to a three-year running quarterly average of 387,000. Houses sold in November 2005 totaled 1.3 million, reflecting a 6.0% annual change from November 2004, for a comparable median sales price of $225,200, a figure that is slightly higher than the November 2004 median sales price of $224,500. Fitch views the performance of the housing market as an important indicator for tax-backed credits as changes in the market can affect assessed valuations and/or portend property tax rate changes.

Health Care Sector

In the health care sector, the continued implementation of management best practices and a relatively stable revenue environment will offset pressures related to rising expenses, competition with physicians, and constrained Medicaid reimbursement. Fitch's near-term outlook on the nonprofit hospital and health care system sector is stable. However, due to potential declines in Medicare reimbursement, a downward shift in growth rates on payor contracts, and growing capital needs in the sector, Fitch remains concerned about the sustainability of the current trends beyond 2006. Fitch anticipates continued improvement in the long-term care sector and believes long-term care upgrades may continue to outpace downgrades in 2006. Capital needs and the expansion of communities may place short-term pressure on financial performance.

Public Power

Despite record fuel price volatility and rising interest rates, the public power sector continued to provide investors with a high level of rating stability in 2005. The general outlook for 2006 is for a continuation of this trend. Supporting this outlook is the role of the public power industry, which is to provide its customers with reliable electric service at the lowest reasonable price, without taking undue risk.

Public power's ability to raise rates without state commission oversight, and to therefore pass increases in fuel prices through to its customers in a timely manner, is also a key positive credit factor. These inherent credit strengths, combined with reasonable financial and liquidity ratios, have enabled the public power sector to maintain solid credit ratings. Despite the stable outlook for the public power sector, Fitch does believe that the industry and select credits in particular will face challenges and be subject to certain credit risks and concerns. As the public power industry becomes more complex, management's ability to plan for its own internal needs, given possible unexpected industry or global events, will likely play an even greater role in the evaluation of public power credits.

Tax-Exempt Housing

Fitch continues to view the tax-exempt housing sector as stable. Over the past two fiscal years, based on financial information of 50 State Housing Finance Agencies (SHFAs), the sector experienced declines in aggregate-total assets as well as total debt. Despite the decrease in aggregate-total assets and total debt, SHFAs have continued to strengthen their capital base positions, with debt-to-equity ratios at their lowest since Fitch started reporting the combined statistical results of the SHFAs in 1993.

Going forward, as long-term conventional interest rates continue to rise, the mortgage rates offered by SHFAs will become more competitive and the agencies should begin to see a gradual increase in demand for their products. The increase in demand may be somewhat mitigated by the fact that the sector will still face rate competition from the sub-prime mortgage market in both new mortgages and refinancing.

Rating Actions

The fourth quarter of 2005 saw 28 downgrades and 16 upgrades, with 14 of the downgrades attributed to either the deteriorating finances of the city of Detroit or the effects of the Hurricane Katrina on credits in the Gulf Coast. As of Dec. 31, 2005, 49 credits were on Rating Watch Negative (21 of which were due to Hurricane Katrina) while only two were on Rating Watch Positive. For a longer term perspective, 102 credits had a Negative Rating Outlook and 70 credits had a Positive Rating Outlook. The positive-to-negative Rating Outlook ratio of 0.69:1 is an improvement over the 0.62:1 ratio at the end of the third quarter.

As of Dec. 31, 2005, the only two credits on Rating Watch Positive were from the public power sector (Central Valley Financing Authority and Sacramento Cogeneration Authority), while the credits on Rating Watch Negative span mostly across tax-backed, healthcare, water & sewer, public power, and transportation. Fitch maintained 22 tax-backed credits on Rating Watch Negative as of end of 2005, 12 of which were linked to the effects of Hurricane Katrina.

Among other credits that ended the year on Rating Watch Negative due to the effects of the hurricane, two are from the water & sewer sector (New Orleans Sewerage & Water Board), two are from the transportation sector (Louisiana Transportation Authority), two are from the health care sector (Ochsner Clinic Foundation in Louisiana and Memorial Hospital at Gulfport in Mississippi), and three are from other revenue sectors. The health care sector finished the year with nine credits on Rating Watch Negative, only two of which were related to the events of Hurricane Katrina.

Of the 172 credits with Positive or Negative Rating Outlooks as of Dec. 31, 2005, 75 were in the tax-backed sector, with 33 of these with a Positive Rating Outlook and 42 with a Negative Rating Outlook. In the health care sector, 21 ended with a Positive Rating Outlook versus 22 with a Negative Rating Outlook. Transportation sector credits ended with a negatively skewed Positive-to-Negative Rating Outlooks ratio of 0.10:1, 21 credits with a Negative Rating Outlook compared to only two with a Positive Rating Outlook.

The dramatic change in the ratio is mostly attributed to the bankruptcy filings of Delta and Northwest, which negatively affected eight credits. Public power credits ended the quarter with 10 credits with a Positive Rating Outlook and only four with a Negative Rating Outlook, reflecting a high level of stability within the sector. In the higher education sector, three credits had a Negative Rating Outlook; in the water & sewer sector three credits had a Negative Rating Outlook while two had a Positive Rating Outlook.

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