July 20 - Fitch Ratings has affirmed and removed from Rating Watch Negative the following tax allocation bonds (TABs) for Pittsburg Redevelopment Agency, CA (the RDA): --$129 million senior non-housing TABs, at 'A'; The Rating Outlook is Stable. Fitch also removes the Rating Watch Negative and affirms the following TABs with a Negative Outlook: --$144.2 million subordinate non-housing TABs at 'BB+'; The following TABs remain on Rating Watch Negative by Fitch: --$26.6 million housing TABs at 'BBB'. SECURITY The senior non-housing TABs are secured by all tax revenues allocable to the successor agency (SA) collected within the sole project area. This is minus the 20% housing set-aside, and a county administrative fee. The subordinate non-housing TABs are secured by all taxes allocated to the SA, a general bond reserve (additive to standard debt service reserve fund), and payments from swap contracts, minus senior debt service payments, the 20% housing set-aside, and the county administrative fee. The housing TABs are secured by a first lien on the 20% housing set-aside revenues. KEY RATING DRIVERS CASH FLOW TIMING ISSUES: The Rating Outlook Negative reflects Fitch's concern about a cash flow timing gap that is somewhat exacerbated by the dissolution of RDAs. This concern is not fully mitigated due to the SA's insufficient internal liquidity, aside from debt service reserve funds. Fitch also remains concerned over uncertainty about the city's (implied general obligation bonds rated 'AA-') continued willingness to provide cash flow loans if debt service coverage continues to fall. PROGRESS ON AB 1X26 IMPLEMENTATION: The City of Pittsburg (the city) has been recognized as the SA to the RDA. The recognized obligation payment schedules (ROPS), which include calendar 2012 debt service, have been approved by the oversight board and state. The SA has received sufficient payments, along with available cash reserves, to cover the debt service included in the ROPS. IMPLICATIONS OF AB 1484: The governor signed this trailer bill to the state's fiscal 2013 budget on June 27, 2012. The bill includes what Fitch believes are improvements to the ROPs approval process and other procedures going forward. However, it required repayment by many SAs of property tax distributions from December 2011 and January 2012 that the state believes should have been directed to other taxing entities. The SA is disputing the size of the required $3.5 million repayment. If the SA were to ultimately lose its appeal, the subordinate bonds would not be materially impacted due to $44 million of LOC-required subordinate TAB cash reserves (in excess of the SA's standard debt service reserve funds). The Rating Watch Negative on the housing TABs reflects the lack of any such excess reserves. Thus, if a portion of the claw back were to be allocated to the housing bonds, it could result in a one-time draw on the housing debt service reserve fund that would nonetheless likely be replenished in future years with surplus housing tax increment. CASH FLOW RESOLUTION PROPOSED. Management has identified a method of permanently closing its cash flow timing gap. However, it assumes sufficient proceeds from liquidation of assets and would require approval from the California Department of Finance (DOF) and the RDA's oversight board. HOUSING REVENUE AVAILABILITY: The lack of distinction between former housing set-aside revenue and total tax increment under AB 1X26 did not affect Fitch's assessment of credit quality. The SA has stated its intent to track pledged revenue in the manner required under bond indentures. Therefore, Fitch believes that in the event of a shortfall in total tax increment revenue, housing bond debt service payments would continue to be made from the portion of revenue formerly allocated to housing purposes. LOC EXTENDED. In March, 2011, the SA successfully extended its letter of credit (LOC) supporting the non-housing 2004A bonds for an additional three years. As a condition of the renewal, the SA increased the size of its 2004A debt service reserve fund by $10 million and created a $2 million administrative expense reserve. UNUSUALLY LARGE RESERVES. The subordinate TABs' debt service reserves are sized to atypically high levels. This provides an adequate cushion for bondholders against falling assessed valuation (AV); Fitch estimates that these reserves would need to be drawn upon if AV falls moderately from current levels. PARTIAL HOUSING MARKET STABILIZATION. AV is benefiting from a degree of stabilization in the housing market, as evidenced by substantially lower foreclosure levels and more modest home price contractions compared to recent years. Recent AV changes have been in line with Fitch's expectations. Further, pending appeals are small as a percentage of total AV and so do not pose a material risk to AV. SWAP ISSUES. The SA's variable-rate bonds (non-housing subordinate series 2004A not rated by Fitch) are hedged with an interest rate swap with a negative $20 million termination value. If the counterparty were to terminate the swap, the payment would be subordinate to subordinate TAB payments, so TAB debt service ought not be affected. WHAT COULD TRIGGER A RATING ACTION ON THE SUBORDINATE NON-HOUSING BONDS -- INABILITY TO DEAL WITH CASH FLOW GAP. A downgrade may take place if the SA were not able or willing to close its ongoing cash flow gap with asset sales or through other permanent means. The cash flow gap would not impact senior bonds. -- FURTHER MATERIAL AV DECLINES. Substantial AV declines exceeding Fitch's range of expectations could lower debt service coverage to a level inconsistent with the 'BB+' rating category. -- SWAP, LOC COMPLICATIONS. Complications arising from the SA's swap and LOC potentially could expose the SA to higher debt service costs. This in turn has the capacity to materially lower debt service coverage. WHAT COULD TRIGGER A RATING ACTION ON THE HOUSING BONDS -- CLAW BACK ISSUES. If the SA were to lose its appeal over the size of its claw back payment and it then allocated a material portion of such payment to its housing debt, resulting in a potential drawdown of the housing TAB's debt service reserve fund, Fitch would downgrade the rating. CREDIT PROFILE CASH FLOW TIMING MAY AFFECT SUBORDINATE NON-HOUSING BONDS The Negative Rating Outlook on the subordinate non-housing bonds largely reflects Fitch's concern regarding ongoing cash flow loans needed to avoid draws on reserve funds (included in and outside the indenture). The SA historically has paid for debt service using cash advances from the city's investment pool, later reimbursing the pool with tax increment. Although this process has operated as planned in the past, it could be problematic moving forward. Issues could arise if the SA were expected to be unable to pay back such loans due to inadequate debt service coverage. In this case the city likely would no longer make such loans. Further, dissolution legislation requires the county to disburse April tax increment in June, thus extending the SA cash flow timing gap by two months. Management believes that the potential liquidation of the SA's land assets would be sufficient to permanently close the $20 million cash flow gap. However, the use of such proceeds for cash flow purposes would require approval from DOF and the SA's oversight board. To date, DOF has permitted all TABs and most requested items on the SA's ROPS, including a $12 million placeholder to allow for a cash flow reserve. Although DOF has been inconsistent regarding the approval of non-TAB ROPS items with other agencies, due to the passage of AB 1484 Fitch expects DOF would continue to approve the SA to place cash flow reserves on ROPS moving forward. PITTSBURG BENEFITS FROM LOCATION ON THE DELTA IN GREATER BAY AREA Pittsburg is located in the northeastern portion of Contra Costa County and situated along the Sacramento-San Joaquin River Delta. Moderate population growth has been driven by the area's affordability, availability of developable land, and proximity to major Bay Area employment centers with good transportation options. Nonetheless, the city has been severely affected by the economic recession. February 2012 unemployment fell 200 basis points year-over-year. However, it still very high at 15.2% and well exceeded the state and county averages of 11.4% and 9.6%, respectively. Homes have lost two-thirds of their peak values and have continued to fall recently, albeit at much more modest levels in line with Fitch's expectations. Foreclosure levels are down substantially from recent years' levels and outstanding appeals seem manageable. The SA's merged project area is large at 5,750 acres, encompassing more than half of the city of Pittsburg and about two-thirds of its AV. About three-quarters of the project area's AV consists of residential properties, with the remainder split between commercial and industrial properties (including a major power plant). AV concentration is low to moderate, with the top 10 taxpayers making up 20% of AV. Concentration concerns are further mitigated by the essentiality of the top payer, Delta Energy Center (11% of AV) which is a power plant. Due to rapidly falling home prices, project area AV fell 3.1% and 14.3% in fiscal years 2009 and 2010, respectively. AV declines have since moderated, falling 1.5% and 0.9% in fiscal years 2011 and 2012, respectively. January 2012 home values were down 5% from prior year levels. Because fiscal 2013 AV is set based upon these values, Fitch conservatively has modeled base case debt service coverage assuming a 5% AV loss in fiscal 2013. DEBT SERVICE COVERAGE DECLINES IN LINE WITH EXPECTATIONS Fitch estimates that fiscal 2012 non-housing tax increment revenues cover all-in annual debt service of $30.3 million an adequate 1.11 times (x) (incremental revenues after senior debt service will cover subordinate debt service an adequate 1.17x). However, due to rising debt service fiscal 2012 revenues would cover fiscal 2013 debt service by just 0.98x (0.97x), leaving a shortfall of about $700,000. Due to interest earnings on large debt service reserves, however, this gap may be closed. This would potentially eliminate the need to draw on the bonds' debt service reserve funds. Management estimates these earnings at approximately $1.7 million in fiscal 2012. Under Fitch's base case scenario, which assumes a 5% AV contraction in fiscal 2013 and a 15% success rate for outstanding appeals, subordinate lien coverage would fall to just 0.93x (0.88x) in fiscal 2013, opening a more substantial $2.5 million shortfall (before interest earnings and other revenues) and would be more likely to necessitate a draw on the subordinate TABs' reserves. SIZEABLE RESERVES PROVIDE SUPPORT FOR SUBORDINATE NON-HOUSING BONDS The subordinate TABs enjoy very large cash-funded reserve levels. In addition to the TABs' $21.5 million indenture debt service reserves, as a condition of the series 2004A variable-rate bond's LOC, the SA also established a $26.8 million debt service reserve fund exclusively for the non-housing 2004A TABs. An additional $17.3 million general debt service reserve fund for all other non-housing subordinate TABs was established. However, to the extent the 2004A TABs' debt service reserve fund would be drawn upon, the general debt service reserve fund would replenish it. Due to the large size of the TABs' debt service reserve funds, they stand up well under most but not all Fitch-designed scenarios. Under the base case scenario, total subordinate reserves would fall a cumulative 10% through fiscal 2019 before beginning to recover thereafter. Under a perpetual no growth scenario (where fiscal 2012 AV is held steady in perpetuity), there would be no draw upon reserves. Under a double dip recession scenario (where AV falls by 14.3% and 3.1% in fiscal years 2013 and 2014, representing a duplication of the project area's worst AV performance, followed by 2% AV growth perpetually beginning in fiscal 2018) it is possible non-2004A subordinate TABs would default. This represents, however, a severe scenario that Fitch does not anticipate would occur. VARIABLE-RATE STRUCTURE AND SWAP POSE RISKS The SA's debt structure poses a significant credit vulnerability. A quarter of subordinate debt ($117 million) is variable-rate, supported by the LOC and hedged by an interest rate swap. An inability to extend or replace the SA's LOC, which expires in 2014, likely would result in conversion of the variable rate bonds to bank bonds. This could raise interest costs on the variable rate debt to as high as 12%. At the maximum rate, Fitch estimates annual debt service costs would rise a net $8.1 million. Nonetheless, the absence of accelerated payout provisions in the LOC agreement means the debt service reserve fund could tolerate drawdowns for some time, assuming no additional and substantial AV declines. The SA's interest rate swap (Piper Jaffray is the counterparty) has a negative value of $20 million, and may be terminated by the counterparty if Standard & Poors downgrades the SA's debt to below BBB-. Upon termination, the SA would owe the counterparty $20 million on a subordinated basis to all TAB debt service. There are no cross-default provisions if the SA is unable to pay the termination fee. SENIOR NON-HOUSING AND HOUSING TABS DEBT SERVICE COVERAGE REMAINS ADEQUATE Fitch estimates fiscal 2012 net revenues cover housing TABs' debt service an adequate 1.34x. AV could decline by approximately 24% before coverage would fall below 1.0x. Senior non-housing TAB debt service coverage in fiscal 2012 is estimated by Fitch at a robust 3x in fiscal 2012. Senior debt service rises in fiscal 2013, but Fitch-estimated coverage remains above a strong 2.50x. AV would have to decline by a severe 57.3% for Fitch-estimated senior debt service coverage to fall to 1.0x.