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NEW YORK, Feb 4, 2010 -- Moody's Investors Service has assigned a Aa2 rating to the State of Hawaii's $312 million General Obligation Bonds of 2010, Taxable Series DX (Build America Bonds - Direct Pay) and $225 million General Obligation Refunding Bonds of 2010, Series DY.

Concurrently, Moody's has revised the outlook on the state's rating to negative from stable and affirmed the outstanding Aa2 rating on approximately $4.7 billion outstanding general obligation bonds. The Aa2 rating incorporates the state's historical fiscal conservatism; actions to address significantly lower revenue growth; a tourism-based economy that experiences volatility tied to national and international economies; and a high debt burden.

As a heavily tourism dependent state, Hawaii's economy has been hurt by reduced travel due to the national and international recession. Consecutive downward revenue revisions in fiscal 2009 and continuing in fiscal 2010, beyond those already anticipated by the state, have resulted in further draws on already reduced reserves to achieve budget balance.

Late last spring, the state closed a sizeable combined budget gap of $2.7 billion covering fiscal years 2009 through 2011. In addition, a correction to conveyance and general excise tax collections over the past two years resulted in very modest combined available reserves of less than 1% for fiscal year 2009.

Based on the current revenue forecast, Hawaii now faces another large budget gap of $1.2 billion for the biennium, representing 12% of revenues. With reduced time to achieve ongoing savings in the current fiscal year (2010), the state will likely increase its use of one-time budget solutions to balance the budget and maintain liquidity.

As in most other states, federal stimulus funds are providing significant funding flexibility and Hawaii has also taken steps to reduce ongoing spending and increase recurring revenues.

The negative outlook reflects Hawaii's vulnerability to further downward revenue revisions given the uncertainty surrounding the timing and strength of the economic recovery and its impact on the state's vital tourism sector; tighter liquidity reflected in a fiscal 2009 retirement payment deferral and a proposed delay in fiscal 2010 income tax refunds; additional debt restructurings for budget relief; modest ending balances projected over the near term forecast horizon; and out-year structural gaps due to one-time solutions already incorporated in the enacted budget. Future credit reviews will focus on the state's revenue performance and success in achieving targeted spending reductions to balance the budget.

Hawaii plans to sell the current offerings the week of February 8. Proceeds of the refunding series will be used to refund outstanding bonds for significant upfront savings ($16 million in fiscal 2010 and $72 million in fiscal 2011), with negative savings in the out-years through 2020. The state has used similar refundings for one-time budget relief recently, contributing to structural budget imbalance beyond the current biennium. Proceeds of the new money series, which are being issued as taxable Build America Bonds - Direct Pay, will be used for various statewide projects.

Credit strengths are:

• Well-established multi-year and quarterly consensus forecasting by state's council on revenues

• Strong executive power to reduce spending, including labor related expenses

• Historical fiscal conservatism; prompt action to address revenue shortfalls

• Continued military housing construction helps offset slow residential and commercial markets

• Liquidity is sufficient for the state to avoid short-term borrowing for cash flow purposes

• No exposure to variable rate debt or derivative products

Credit challenges are:

• Vulnerability to sudden shifts and/or extended downturn in tourism-based economy, resulting in revenue falloff and budget shortfalls

• Significantly lower reserves reduce state's ability to address further revenue erosion

• Large state and local government employment sector contributes to spending pressure for salary and benefit settlements

• Debt ratios likely to remain very high given state-level capital funding, especially for education

• Low pension funding levels and high other post-employment benefit (OPEB) liability

CONSECUTIVE DOWNWARD REVENUE REVISIONS ADD BUDGET CHALLENGES

In December 2009, Hawaii's council on revenues lowered its forecast for the state's tax revenue year-over-year change to negative 2.5% for fiscal 2010, down from negative 1.5% in the August 2009. Revenues are forecast to increase by 7.6% in fiscal 2011, coming off a low base, and 6% in fiscal 2012. Still, tax revenues are not expected to recover to the 2008 pre-recession peak until fiscal 2012, reflecting the magnitude of the recent downward revenue revisions over the past two years. If the national and/or international recessions are deeper or more prolonged than anticipated, Hawaii's budget would be challenged to address further revenue shortfalls.

Hawaii closed a sizeable combined budget gap of approximately $2.7 billion for the three fiscal years covering 2009 through 2011. For the remainder of the biennium, the state now faces another budget shortfall of approximately $1.2 billion, representing about 12% of general fund revenues. The governor has presented a proposal to address the budget gap and solutions include both recurring and non-recurring actions. As it has in recent years, the state expects to take up-front budget savings from debt restructurings that are effectively deficit financings. This would save $20 million in fiscal 2010 and approximately $75 million in fiscal 2011.

In addition, the proposal includes a revision of processing procedures for income tax refunds that would save the state $275 million in fiscal 2010, but push the liability forward into fiscal 2011.

The governor's proposal also includes ongoing cost reductions of approximately $284 million in fiscal 2010 and approximately $600 million in fiscal 2011. If adopted, the state would accomplish these savings through additional furlough days, department savings, the elimination of certain vacant positions, and layoffs. On the revenue side, the governor has proposed suspending the distribution of revenues from the transient accommodations tax to the counties ($99 million) and actions to tighten tax enforcement ($79 million).

Available reserves, consisting of unreserved, undesignated general fund plus emergency and budget reserve fund (EBR) balances were reduced at the end of fiscal 2009 to very modest levels that represented only about 0.5% of general fund revenues. The decline in reserves was worse than anticipated due to a downward adjustment in tax revenues to reflect accurate collections. To balance the fiscal 2009 budget on a cash flow basis, the state shifted to fiscal 2010 a $130 million payment for state employee health and retirement funds, and certain Medicaid reimbursements. On a GAAP basis, these actions will accrue to fiscal 2009. If the governor's proposal to delay income tax refunds until fiscal 2011, these will accrue to fiscal 2010, further weakening the state's ending GAAP balance position.

ADOPTED 2010-2011 BUDGET INCORPORATED ONGOING AND ONE-TIME SOLUTIONS

As in many states across the nation, Hawaii balanced its fiscal 2010-2011 budget using a combination of recurring and one-time solutions. The state expects significant ongoing savings from a 14% reduction in discretionary costs across all agencies. Labor costs have been reduced through furlough days and, in the case of the teachers' union, negotiated furlough days.

The government sector is a major employer in Hawaii, and labor costs account for approximately 60% of total state operating costs. Unlike many states, Hawaii's governor has strong executive powers to cut spending to balance the budget and recent actions to reduce expenses underscore ongoing willingness to take those steps.

On the revenue side, the state increased its cigarette and tobacco taxes, and raised the conveyance tax on certain high value properties. It also enacted certain temporary tax measures, including an increase in the transient accommodation tax, a new high income tax bracket; redirection of interest earnings from certain special funds to the general fund; and the distribution of tobacco settlement funds to the general fund.

One-time solutions in the adopted budget accounted for approximately 41% ($1.1 billion) of Hawaii's gap-closing solutions. The use of federal stimulus funds made up 18% of the shortfall. Fund balance transfers total $92 million and $24 million was drawn from the EBR at the end of fiscal 2009. Debt restructuring is estimated to save approximately $105 million in fiscal 2009 and $205 million in the current biennium. Additionally, a shift from pay-go to debt financing is budgeted to save $63 million.

PREVIOUSLY STRONG RESERVE LEVELS DECLINE; LIKELY TO REMAIN MODEST OVER NEAR TERM

Combined available reserves, consisting of the UUFB plus the emergency and budget reserve, remained relatively strong at about 8% of general fund revenues at the end of fiscal year 2008, although balances have declined from peak levels at the end of fiscal 2006. As revenues forecasts were repeatedly reduced over the course of fiscal 2009, the state was forced to draw on available balances as it adjusted to higher baseline spending and the impact of the economic downturn on revenues. Combined reserves are currently projected to rise to 2.4% and 4.5% at the end of fiscal years 2010 and 2011, respectively, assuming an economic recovery taking hold in the second half of fiscal 2010. However, reserves are expected to remain modest (under 2%) in the out-years of the forecast horizon, reflecting the significant use of one-time actions including the use of federal stimulus funds to balance the budget.

Strong reserve levels are important for Hawaii given the state's heightened vulnerability to national and international shifts in its essential tourism-based economy. The currently low reserve levels leave Hawaii with reduced flexibility to address additional shortfalls that may emerge.

As part of the $206 billion tobacco settlement master agreement between the major tobacco companies and 46 states and five US territories, the state of Hawaii expects to receive annual payments ranging from $42 million to $63 million through fiscal year 2027. A portion of the settlement funds was used to build up the state's EBR to $74 million at fiscal year-end 2008, a relatively modest 1.5% of general fund revenues. Legislation in 2009 reduced the amount of settlement moneys dedicated to the EBR from 24.5% to 15%, while increasing the allocation to the general fund. This reduced allocation, in combination with draws on the EBR to address budget shortfalls, is expected to result in $57.6 million in the EBR at the end of fiscal 2010. Appropriations from the fund require a two-thirds majority vote of each house of the legislature and can only be made during times of emergency, economic downturn or unforeseen reductions in revenues. With a more modest allocation of the tobacco settlement funds, the EBR is expected to grow to $65.1 million by the end of fiscal 2011.

CONSERVATIVE BUDGET CONTROLS POSITION STATE WELL TO MANAGE ECONOMIC DOWNTURNS; STATE CONSTITUTION REQUIRES REVENUE FORECASTS

Pursuant to the state constitution, the state legislature is required to establish a general fund expenditure ceiling that limits the annual rate of expenditure growth to the rate of growth of Hawaii's economy. State appropriation levels from the general fund may not exceed the expenditure ceiling without a two-thirds vote of both houses of the legislature. The expenditure ceiling is determined by adjusting the prior year expenditure ceiling by the estimated growth in the state economy. This growth factor is determined by averaging the annual percentage change in total state personal income for the prior three years.

Appropriations did not exceed the expenditure ceiling for eight fiscal years through the 2004-2005 biennium. Following strong revenue growth, the legislature voted to approve expenditures that exceeded the ceiling in the 2006-2007 biennium, and at the same time the state increased its available reserves. Appropriations for fiscal years 2008 and 2009 did not exceed the ceiling, and the same is expected for the current biennium. This expenditure limitation, combined with conservative forecasting and periodic updating by the state's council on revenues, helps mitigate fiscal stress that may emerge unexpectedly.

The state constitution requires the council on revenues to prepare revenue estimates which serve as the basis for the governor's budget preparation and the legislature's appropriation of funds and enactment of revenue measures. The council reports its estimates and revisions each June 1, September 10, January 10, and March 15. The council also revises its estimates when it determines that such revisions are necessary or upon request of the governor or the legislature. In the fall of 2008 and spring of 2009, as the legislature was considering the 2010-2011 biennial budget, special revenue forecasts were made, underscoring Hawaii's proactive governance practices that help the state address budget shortfalls in a timely manner.

ECONOMY REMAINS WEAK IN LINE WITH NATION; RECOVERY NOT EXPECTED UNTIL 2011

Hawaii is heavily dependent on its tourism sector which accounts for about 17% of total non-farm jobs in the state, nearly twice the national average of 9.8% for the leisure and hospitality services sector. Total visitor arrivals to Hawaii, reflecting mostly air, but also cruise ship arrivals, declined by 10.6% in calendar year 2008 after flat growth in 2007. A further decline of 4.5% in 2009 is reflected in the most recent forecast from the state's Department of Business, Economic Development, and Tourism, and 2% growth is projected for 2010. The forecast has improved somewhat from the prior projection of a 5.9% decline in 2009 followed by 1.2% growth in 2010.

In addition to continuing job losses in its tourism sector, Hawaii is experiencing a housing market slowdown that is affecting construction and building permit activity. While not as severe as in some states that experienced the housing boom, Hawaii's construction sector job losses mounted over the course of last year.

Continued demands for federal military housing and defense-related building have helped support the state's construction sector to some extent, and the state reports that several commercial projects are underway, including hotel renovations. Jobs in Hawaii's leisure and hospitality sector were down 5.4% year-over-year in 2009, more than twice the national pace of loss (negative 2.1%) in the sector.

Hawaii's unemployment rate rose sharply over the past year, from 4% in 2008 to 6.9% as of December 2009. However, during this recession, the state's unemployment rate has remained well below the national level which was 10% in December, in part reflecting the state's low in-migration rates.

The national economic performance continues to be tempered by job losses in manufacturing, a sector that represents less than 3% of total employment in Hawaii. It should be noted that while government jobs represent the state's largest employment sector (20.2% versus 16.4% nationally), the state's primary source of jobs gains in recent years have been in several industry sectors, particularly services and construction. In recent years, service sector growth has added some diversification to the state's employment base beyond the tourism industry, with positive gains posted in educational and health services, and professional and business services, although the latter sector is now shedding jobs in Hawaii.

LARGE MILITARY PRESENCE PROVIDES STABLE EMPLOYMENT BASE

Federal defense spending in Hawaii, dictated by the island's strategic geographic importance, plays a large part in the state's economy. Federal activity in Hawaii amounts to about 13% of the state's gross state product, with much of it defense related. The large federal defense presence provides a continuing and stable source of employment and income which helps to support the state's volatile tourist-based economy.

This is augmented by federal transfer payments for Social Security and federal retirement benefits which also support the state's economy. The state economy should benefit over the near term from military expansion plans and the privatization of military housing.

DEBT BURDEN REMAINS AMONG THE HIGHEST IN NATION; LOW PENSION FUNDED RATIO

Hawaii has historically been one of the nation's most heavily-indebted states, both in terms of net tax-supported debt as a percentage of revenue, and debt per capita. The high debt ratios reflect, in part, the state's assumption of capital funding for many functions performed at the local level in other states such as capital financing for schools.

Based on Moody's 2009 State Debt Medians Report, Hawaii ranked third highest in terms of debt per capita, which is $3,675 while the 50-state median is $865. For debt as a percentage of personal income, Hawaii's 9.4% ratio is over three times the 50-state median of 2.5%.

While still very high, Hawaii's debt to personal income ratio declined from 12.1% in the 2007 medians due to the state's recent gains in personal income at paces that exceeded those of both the U.S. and the far west region. Still, Hawaii's high debt burden places significant strain on the state's operating budget, as total general obligation bond debt service is about 10% of the general fund budget. Hawaii has no exposure to variable rate debt or derivative products, and payout of the state's general obligation debt is relatively rapid with 90% repaid in 16 years.

While the state does not engage in short-term borrowing for cash flow purposes, some liquidity strain is indicated by payment deferrals at the end of fiscal 2009 and the proposed delay in fiscal 2010 personal income tax refunds until fiscal 2011. This action will likely weaken the state's GAAP basis balance sheet since the cost will be paid in fiscal 2011 but booked as a fiscal 2010 expense, thereby increasing liabilities at the end of the fiscal year.

In addition to high debt ratios, pension contributions are an area of expenditure concern given Hawaii's below average retirement system funded ratio of 65% at the end of fiscal year 2009, down slightly from 68% in fiscal 2008. While the state has been making its annually required contributions, health and retirement fund payments booked for FY2009 were shifted to FY2010 on a cash flow basis. The fiscal 2010-2011 biennial budget includes the full annual required contribution (ARC) for the pension systems.

Hawaii's other post-employment (OPEB) obligations were evaluated to meet GASB 45 disclosure requirements. The OPEB obligation is quite sizeable at $7.2 billion for state employees and $1.6 billion for teachers, reflecting full health benefits paid by the state.

These amounts are larger than the size of Hawaii's annual general fund revenues which totaled about $5 billion in fiscal year 2009. The fiscal 2008 annual required contribution was $518 million for state employees and $200 million for teachers while actual payments were $200 million and $14 million, respectively. For the present time, the state plans to continue funding these obligations on a pay-go basis. The reports are updated every two years. The July 2009 report in expected in spring 2010.

LAST RATING ACTION AND METHODOLOGY

The last rating action was on October 13, 2009, when Moody's affirmed the Aa2 rating and stable outlook on the State of Hawaii's General Obligation Refunding Bonds of 2009, Series DT, DU, DV, DW and Taxable General Obligation Bonds of 2009 (Qualified School Construction Bonds), Series DS (Tax Credit Bonds).

The principal methodology used in rating the State of Hawaii's General Obligation Bonds of 2010, Taxable Series DX (Build America Bonds - Direct Pay) and General Obligation Refunding Bonds of 2010, Series DY) was Moody's State Rating Methodology, published in October 2004 and available on www.moodys.com in the Rating Methodologies sub-directory under the Research & Ratings tab. Other methodologies and factors that may have been considered in the process of rating this issuer can also be found in the Rating Methodologies sub-directory on Moody's website.

Outlook

The negative outlook for Hawaii's credit rating reflects the state's vulnerability to further downward revenue revisions given the state's significant reliance on the tourism industry which has slowed dramatically and could face continued near term headwinds given the uncertainty of economic recovery at both the national and international level. The negative outlook also reflects Hawaii's narrowed financial operations as underscored by significantly lower reserve levels and payment deferrals that indicate liquidity challenges; and out-year structural gaps due to one-time solutions already incorporated in the enacted budget and proposed for the recently identified budget shortfall. Hawaii continues to exhibit strong management practices demonstrated in its willingness to reduce spending cuts, and its well-established quarterly economic and revenue forecasting process enables the state to identify budget gaps that may arise.

What would change the rating up?

• Rebuilding and maintenance of strong reserve levels.

• Broader economic diversification, sustained job growth, and reduced vulnerability to the tourism industry.

• Maintenance of structural budget balance.

• Annual funding of pension and OPEB annual required contributions.

What would change the rating down?

• Economic weakening leading to employment erosion.

• Further deterioration of revenue trends leading to budget imbalance, liquidity pressure, and narrowing of financial position.

• Increased use of non-recurring solutions to balance budget.

• Failure to adopt a plan to cover expenditures once federal stimulus monies are no longer available

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Nicole Johnson, Analyst with the Public Finance Group of Moody's Investors Service and Nicholas Samuels, Backup Analyst with the Public Finance Group of Moody's Investors Service prepared this report

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