California update

S&P downgraded California’s general obligation (GO) bonds and related ratingsin Jan. but, in our view, the rating action does not reflect significant changes in the state’s credit position.

The Governor’s Jan. budget proposal seeks to address estimated gaps of USD 6.6bn in fiscal  year (FY) 2010 and USD 12.3bn in FY2011. Cash will be tight in March, a usual low point in the
annual cash cycle, and may trigger cash conservation measures, as we saw in 2009. However, the year-end cashcushion is expected to be sufficient to repay revenue anticipated notes maturing
in Mayand June, even if the FY10 shortfall is not addressed by then.

S&P lowered the state’s GO bond rating to A- from A on 13 Jan. 2010, with state lease debt simultaneously taken to BBB+ from A-. Approximately USD 65bn of GO and USD 7.3bn of lease debt is outstanding. S&P’s rationale for the downgrade is that
many of the easier one-time solutions have already been utilized. The Jan. budget proposal
incorporates a greater share of uncertain budget assumptions than prior fiscal
years.

One source of uncertainty is the proposed budget’s reliance on either federal funding or
relief from certain federally-mandated spending requirements to close about 40%
of the gap. S&P also cites the chronic constraints imposed by the state’s budget
process, including the two-thirds majority vote of the legislature required to approve
budgets and tax increases, and a rigid expense structure. The state has limited discretion
for approximately 65% of general fund expenditures.

S&P’s downgrade rationale also comprises the state’s narrowed overall liquidity position,
large structural gaps and uncertain revenue trends. These concerns have contributed
to difficulties over the last two budget cycles and prompted Fitch and Moody’s to take the state’s GO rating to the  “BBB” level last year. In several reports issued over the past year, the state’s Legislative Analyst’s Office has predicted budget gaps of the size anticipated in the Governor’s budget. This S&P downgrade brings its ratings on the state’s credits more in line with Moody’s and Fitch and positions the GO rating to fall
into the BBB category should budget negotiations become increasingly fractious this spring. In contrast, Moody’s and Fitch’s assert that their ratings on the state’s GO bonds already reflect the current level of fiscal stress, at least as measured by the size of estimated budget gaps. We caution, however, that downgrade pressure persists even on these ratings, as the state’s overall fiscal outlook remains fragile. Current spreads, while remaining  at historically wide levels, were not adversely impacted by the S&P downgrade.


[UBS Financial Services Inc.]