Overview

California counties and municipalities (local governments or LGs) have maintained stable or improved credit quality overall during the past two fiscal years, reflecting a strong economic recovery since the onset of the global pandemic. However, negative economic pressures such as elevated price levels fueled by high inflation, albeit moderating, has resulted in slowing growth in revenues and are presenting budgetary challenges with many cities forecasting general fund deficits in fiscal 2025 and beyond. We believe many cities and counties will be challenged with the task of balancing their financial operations to avoid a structural imbalance and will be tested in their ability to make the necessary budget adjustments. We also believe cities will likely seek ways to increase revenues, such as turning to voters for sales tax increases during the upcoming November 2024 election session. However, should those efforts to increase revenues fail, we may see cities begin to draw on their existing rainy day reserves that were built up in previous years while management seeks ways to cut or control spending. Should reserve levels fall materially during the next several years without a reasonable plan to restore balance to operations, we could see credit quality deterioration in the near term.

S&P Global Ratings maintains ratings on 262 LGs within the state. Overall, LG credit quality remained stable from September 2023 to October 2024. During that period, there were 23 rating actions, or 9%. Of the 23 rating actions, 18 were positive--with 15 raised ratings, two outlook revisions to positive, and one outlook revision to stable on general obligation or general-fund-secured bonds. There were only five negative rating actions--two rating downgrades (cities of Santa Monica and Willows City), and three outlook revisions to negative. Almost 98% of the ratings have a stable outlook. Only three municipalities (Saint Helena, San Francisco, and Willows City) have ratings with a negative outlook and three municipalities (El Cerrito, Mammoth Lakes, and Palmdale) have ratings with a positive outlook. In line with 2023, most of the ratings in this portfolio are stable and we expect this trend will continue for the remainder of 2024. Following the release of our "Methodology for Rating U.S. Governments," published Sept. 9, 2024, on RatingsDirect, we placed the ratings on four California cities and counties under criteria observation (UCO), signaling that those ratings could change as a result of the application of new criteria. For more information on the UCO designation and our plan for reviewing ratings under the new criteria, please see "Credit FAQ: A Closer Look At The New Methodology For Rating U.S. Governments," and "Ratings On 436 Issuers Placed Under Criteria Observation Following Publication Of New U.S. Government Methodology," published Sept. 9, 2024.

What We're Watching In 2024 And Beyond

Slowing revenue growth forecasted to be outpaced by growing operating costs for many cities

After several years of strong growth property tax revenues from a robust housing market and property development with double-digit growth in sales tax revenues following a boom recovery after the COVID-19 pandemic in fiscals 2022 and 2023, many cities are now seeing assessed value growth normalize and are forecasting revenue to grow at a much more modest pace in fiscal 2025 and beyond. Although strong home prices continue to prop up assessed value (AV) levels for most issuers, the high mortgage rate environment, exacerbated in some places by net out migration, has resulted in a noticeable decline in real estate activity, which has contributed to slowing AV growth and property tax revenues. In some downtown areas, such as the one in San Francisco, declining office occupancy and associated property valuations have begun to weigh on property tax growth.

Sales tax revenue growth has also slowed to a much more modest pace for many cities, partly driven by the higher cost of goods and services from high inflation as well as slowing economic activity to more normal levels after several years of above average growth that many cities saw during the pandemic recovery.

Operating costs have also been growing at a steady pace, driven by rising labor costs, increased salaries and benefits, and the high cost of goods due to inflation. Many cities are now forecasting their operating expenditures to outpace revenue growth and long-term forecasts show operating deficits down the line, which can result in a growing structural imbalance and a deterioration of credit quality if left unmitigated.

Cities look to avoid structural imbalances by seeking voter approval for higher sales taxes

With many cities now forecasting general fund operating deficits in future years, some are now looking to increase revenue through higher sales tax rates. Cities in California can seek voter approval for general use sales tax rate increases, which only require a 50% simple majority under Proposition 218 (1996 election) and many cities have historically been successful in passing these sorts of sales tax measures. Certain cities are now planning to seek additional sales tax increases and place these measures before voters during the upcoming November 2024 general election. For example, San Diego plans to propose a 1% sales tax rate increase under Measure E on Nov. 5, 2024, up to a total of 8.75%. Similarly, Santa Barbara plans to ask votes for a 0.5% sales tax increase under Measure I, which would bring the total sales tax rate up to 9.25%. The average sales tax rate for California cities is approximately 8.85% which is notably higher than the 7.5% national average sales tax rate for cities. As of January 2024, California currently ranks eighth in the nation for the highest combined state and average local sales tax rates. Within the state, the highest combined sales tax rates for cities reached 10.75%, primarily within Alameda and Los Angeles counties.

While California cities have generally been successful in passing sales tax measures in the past (63% success rate in the 2022 general election and a 71% success rate in the 2020 general election), we note that voters may be more resistant to raising sales taxes if current rates are already seen as high, especially when compared with the rest of the nation. Should cities fail to pass sales tax increases in the upcoming November 2024, we believe many cities will be faced with the difficult task of adjusting their budgets by reducing staff, cutting services, and deferring capital expenditures, otherwise they risk risk drawing down their available general fund reserves.

Issuers may face political resistance in making critical spending cuts

With the growing structural imbalance that they are now forecasting, some cities may face difficult fiscal and political tradeoffs, especially if their revenue-raising efforts fail. Spending reductions generally fall under staffing layoffs and service cuts, which can be difficult to approve and implement due to political resistance from key constituencies. Infrastructure spending and capital maintenance can often fall by the wayside, potentially increasing the city's exposure to physical and climate risks or infrastructure failure. Other cities may find that staffing reductions are not a viable or realistic option since any further layoffs will materially pressure a city's ability to function. Cities also see increased risk of labor strikes if negotiations between the city management and bargaining units fall apart, signaling elevated governance risks related to governance structures or risk management and oversight. If cities demonstrate an inability or unwillingness to adjust their budgets in a timely manner to avoid projected fiscal imbalances, it could materially pressure credit quality.

Reserves remain strong on average and are a critical factor in our credit analysis

Overall, the median reserve level for California municipalities and counties remains strong compared to historical levels, bolstered by strong operating performance in previous years as well as the inflow of one-time federal stimulus or state aid funding. We believe reserves will continue to be a critical credit factor when analyzing the credit strength of issuers, especially during times of fiscal distress when structural imbalances may grow, as many cities are now forecasting. Having high general fund reserve levels provides issuers with invaluable time to adjust their budgets or implement strategies to generate more revenue. However, if cities and counties are unable to sufficiently adjust their budgets in a timely manner, resulting in significant draws on reserves without a reasonable plan to restore them, then credit quality could weaken.

California Child Victims Act (CA AB-218)

The California Child Victims Act was signed into law in 2019. The law significantly reformed the statute of limitations for child sexual abuse cases, extending the amount of time for victims to come forward and seek justice. We believe this law may affect cities or counties who maintain child youth programs, such as after-school programs, youth centers, or community-center programs. Cities and counties may face substantial financial liabilities for child sexual abuse cases if current or former employees are found liable for these sorts of crimes. A recent example includes Santa Monica, which paid a $230 million settlement to resolve legal claims brought against the city. While the scope of this liability risk is unknown, we believe the passage of CA AB-218 increases uncertainty with respect to the size of potential liabilities and their financial effect on California cities and counties. Should cities or counties be found liable for a substantial sum that results in a material drawdown in reserves or the issuance of a material amount of judgment obligation bonds, we could lower ratings by one or more notches.

California counties maintain strong credit quality bolstered by positive operating performance

California counties have benefited from continued growth in property tax revenues that have grown in tandem with increasing operating costs. Property taxes are generally the largest revenue stream for counties and most counties are not dependent on sales tax revenues to fund operations. Operational costs for counties are typically not as large of a burden as compared to cities, and we believe county management teams tend to be robust with formalized policies and practices that position them well to manage their financial operations. We do not expect credit quality for counties overall to deteriorate in the near-term.

Spotlight On Environmental, Social, Governance Factors

The state remains broadly exposed to a wide range of risks stemming from the physical effects of climate hazards. Some of these acute physical risks include wildfires and droughts, as well as chronic issues resulting from extreme heat, flooding, hydrological volatility, and sea level rise. Furthermore, water scarcity and hydrological volatility have heightened natural capital risk for some entities without adaptation measures. While the state continues to be affected wildfires and drought, the heavy rainfall in 2023 and 2024 that was close to twice the average rainfall the state normally receives provides a brief respite. However, with the atmospheric river storm and the snowfall increasing in the local mountain areas, the risk of flooding became elevated in areas affected by the substantial rainfall and melting snow.

Housing affordability issues and the high cost of living continue to loom over the state as a social capital risk. In addition, California local governments are subject to the affordable housing laws enacted by the state requiring municipalities to construct sufficient levels of affordable housing in their jurisdiction, which could help stem the net outmigration trend, if they have the intended effect. (See "No Quick Fix For The U.S. Affordable Housing Shortage," published Aug. 21, 2024.)

Governance risks remain neutral, although we may see an increase in elevated governance risks in the form of labor strikes, late budget adoptions, or an inability to adjust the budget because of forecasted deficits, for example due to disagreements between city management, city councils, or constituents.

We have also encountered an increase in cyber attacks toward municipalities in 2024, thereby substantiating the local governments to be more vigilant and alert toward existing cyber risks. For more insights on cyber risk, see "Cyber Risk Insights: Recession Pressures Could Expose More U.S. Public Finance Issuers To Cyber Attacks," published June 6, 2023.

California Counties And Municipalities Data

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