Creative Commons/Marshall Astor

San Francisco City Hall

Moody's Investors Service downgraded San Francisco's credit rating late yesterday from Aa1 to Aa2. The credit-rating agency's report highlighted concerns with the city's "extraordinarily thin" cash reserves, its persistent structural budget problems, and the lack of political will in the city to address these issues. San Francisco's rating is still relatively strong compared to other cities, however.

"The city still has a very strong debt rating," said Eric Hoffmann, the San Francisco-based Moody's executive who co-authored the report. "That's the same rating as New York, Aa2. It is stronger than Los Angeles," which has the same Aa2 rating, but a negative outlook. The outlook for San Francisco is now stable. 

San Francisco is expected to go to market with $80 million in general obligation bonds on Dec. 1. The effect of the downgrade means that the city will have to pay more interest on the debt, but Hoffmann could not say how much more the city would pay. The amount of interest the city pays on its $2.6 billion in outstanding general obligation debt will not be affected by the downgrade.

"The downgrade primarily reflects the city's very narrow financial position and the minimal prospect of material improvement in the near term," Moody's said in the report. "The city ended fiscal 2009 with a balance sheet that was weaker than at any time in the prior ten years and extremely weak by comparison with other similarly rated local governments."

The city was, unsurprisingly, not pleased with the downgrade. "I was disappointed the action was taken now," said Nadia Sesay, director of the controller's office of public finance. The city's first-quarter revenues were better than expected, she noted. "On the face of it, it looked like our financial position improved," Sesay said. "We understand there is a shortfall that needs to be addressed, and we are clearly aware that the state's [ever-deteriorating] situation will impact us."

San Francisco's rating "is still very strong," she noted, and though the city will have to pay more for newly issued bonds, "we have to remind ourselves that it is still a strong rating for a city and county [governmental entity] with all of the social issues [and costs] connected with that."

The city's efforts in the past two years to close big budget shortfalls didn't impress the Moody's analysts. City leaders "relied heavily on one-time solutions, including draws on reserves, to close sizable projected budget gaps, suggesting that final audited results will show little balance sheet improvement." Moody's notes that there is a projected $394 million shortfall for the fiscal year that begins in July 2011.  "There are no indications that there is the political will or practical ability to bridge this still very large gap in a structurally sound manner."

The report also cited the defeat of Proposition B, a ballot initiative that would have required city employees to contribute more toward their pension and benefits costs, as a factor in the downgrade. "The defeat in the election earlier this month of a local pension and health care cost control measure suggests that little near-term fiscal improvement is likely to result from external political pressure," the report said.

Moody's also cited the defeat of other measures, including a hotel-tax initiative, that would have raised revenue. The only tax increase to be approved, Moody's noted, was a transfer tax on real estate selling for more than $5 million, "a fairly volatile and unpredictable revenue stream."

Still, the outlook for the city's finances could be worse. Moody's cited the city's "extremely large" unfunded retiree health care liability, which is estimated at around $4 billion, but noted that the city still has time to work out a solution for that problem. Full funding of the retiree health care liability would claim as much as an additional 10 percent of the city's general fund revenues. In a previous election, "city voters approved a charter amendment that reduces the post-retirement eligibility and benefits available to new hires starting in January 2009," the report said. "But virtually no progress has been made in addressing the already outstanding liability." Moody's current rating for San Francisco "assumes that the city will prepare a long-term solution to this funding challenge which it will implement when economic conditions improve."

Moody's noted that "the city's long-term economic prospects remain sound," but that the state of California's ever-deepening financial woes will likely mean more cuts in the near term." Given the city's narrow fund balances, substantial state cuts could have a severe impact on the city's financial strength."