From: steve.hall@enron.com
To: tracy.ngo@enron.com, christian.yoder@enron.com, elizabeth.sager@enron.com, mark.haedicke@enron.com, richard.sanders@enron.com, michael.tribolet@enron.com, edward.sacks@enron.com, susan.mara@enron.com, alan.comnes@enron.com, james.steffes@enron.com, tim.belden@enron.com, robert.badeer@enron.com, jeff.richter@enron.com, ray.alvarez@enron.com
Date: 2001-05-15 12:49:00+00:00
Subject: California General Obligation Bond Rating cut to Aa2

California's GO Rating Cut To Aa3 From Aa2 By Moody's Updated: Tuesday, May 
15, 2001 12:03 PM ET 
NEW YORK, May 15, 2001 -- Moody's has lowered the rating on $19.8 billion of 
State of California General Obligation bonds to Aa3 from Aa2. In addition, we 
have lowered the rating on $5.7 billion in lease revenue bonds from Aa3 to 
A1. 
The downgrade reflects increasing financial risks associated with the 
continuing energy crisis, as well as those related to trends in the broader 
U.S. and California economies. The recent setback in securing legislation to 
provide energy purchase bridge financing threatens to compound the risks and 
cost of the energy crisis. In addition, the newly released May Revision to 
the Governor's Budget Submission confirms the substantial revenue 
deterioration that is expected to emerge over the next eighteen months due to 
the weak high technology sector and stock market. The May Revision commences 
what is likely to be a difficult budget debate. 
Delay in External Energy Financing Will Continue to Erode State Financial 
Position 
To date, the state's general fund cash advances for power purchases total 
approximately $4 billion, and these advances are likely to grow very quickly 
in the coming months. Last week, the legislature passed a bill (Senate Bill 
31) authorizing the issuance of $13.4 billion in revenue bonds to fund future 
purchases and repay the General Fund for past advances. Unfortunately, this 
law will not go into effect until late summer, thereby scuttling the state's 
planned interim loan facility which would have provided temporary funding for 
power purchases. Importantly, the bridge financing would have begun the 
process of shifting the source of cash from the state treasury to the credit 
markets, and ultimately to ratepayers. That process is now delayed, and in 
the interim, the state treasury will continue to serve as the source of funds 
for power purchases. 
Net state power purchase advances are running at the rate of over $1 billion 
per month. Moody's estimates that the state's ending cash position will be 
approximately $10 billion at June 30, 2001, including both General Fund cash 
and internal "borrowable resources", which represents cash that can be 
borrowed by the General Fund beyond the end of the fiscal year. This estimate 
takes into account expected energy purchases through June 30th. 
In July and August, an additional $3 to $4 billion could be expended from the 
state treasury to purchase power until external financing is secured, 
bringing total General Fund advances for power purchases to almost $10 
billion by mid-August. As a result, the state's cash reserves are likely to 
be significantly depleted by the time long-term financing can be secured. The 
experience of the early 1990s indicates that a substantial portion of 
borrowable resources serve as a source of liquidity. Nevertheless, Moody's 
still anticipates this weakened cash position will lead the state to seek 
external cash flow borrowing for the General Fund in the form of Revenue 
Anticipation Notes during 2002, reversing the trend over the last two fiscal 
years in which the State has not needed to borrow externally for seasonal 
cash flow purposes. The state is expected to release refined cash projections 
later this week. 
Although the state's liquidity position is clearly weakening, we do not view 
the state's current financial outlook as severe enough to lower the rating to 
the A range. And Senate Bill 31 protects the General Fund from future 
energy-related advances by stipulating that after November 15, 2001, the 
amounts required for short-term cash flow power purchases cannot exceed $500 
million in the aggregate. The enacted bill further requires that such amounts 
be repaid from the Department of Water Resources Electric Power Fund within 
180 days. These provisions provide some assurances that DWR will seek rate 
increases to fund its purchases when bond proceeds have been depleted. We are 
currently assuming the state's General Fund may not be fully reimbursed by 
the proceeds of the long-term financing, as such full reimbursement would 
reduce the amount of bond proceeds available for future power purchases, and 
require DWR to seek additional rate increases during 2001. Given the lack of 
consensus as to how to distribute the cost of power between ratepayers and 
the state treasury, it is unclear whether additional rate increases during 
2001 will be politically feasible. 
May Revision Quantifies Expected Deterioration in Revenue Forecast 
As expected, the May Revision to the Governor's Fiscal 2002 Budget Submission 
revised tax revenue forecasts downward by a substantial magnitude, reflecting 
the economic and revenue effect of the weakening economic outlook compared to 
that underlying the Governor's January proposal. In particular, the weakening 
U.S. economic outlook and stock market performance, particularly in the 
technology-oriented NASDAQ market, produce major changes to the income and 
sales tax forecasts. Over the last several years, the percentage of General 
Fund revenues attributable to capital gains and stock options has grown from 
approximately 5% in fiscal 1996 to an estimated 23% in the current fiscal 
year. Based primarily on the downturn in the high technology sector, which 
relies heavily on options in compensation packages, and the sluggish 
performance of the stock market and its adverse affect on capital gains, the 
state has reduced its tax revenue estimate for the upcoming year by 
approximately $5.4 billion, including a $2.7 downward revision in the 
personal income tax. The drop in these sources of income will also temper 
growth in sales tax collections for the upcoming year. In total, the state 
now expects revenues to decline by approximately $3.2 billion year over year 
between the current fiscal year and fiscal 2002. The state has not seen year 
over year tax revenue declines since 1992. 
A number of budgetary actions taken in recent years will aid the state in 
adapting to the weaker revenue forecast. During fiscal 2001, as well as in 
the January proposal for 2002, the budget included substantial non-recurring 
spending items. As a result the base of recurring budget demands in fiscal 
2002 and beyond is lower than it otherwise would have been. The governor has 
proposed to cancel or defer some of these items, seeking to reduce General 
Fund spending by approximately $3.2 billion as compared to the January 
proposal. Spending cuts, however, do not match the revenue decline. Fiscal 
2002 spending is slated to drop by $600 million year on year, a drop of less 
than 1%, while revenues are expected to fall by 4% during the same period. 
Although the revenue forecast is relatively cautious, the target ending 
balance, at $1.8 billion, leaves little cushion for additional bad news. 
The proposed budgetary reductions, along with proposed spending levels for 
recurring items such as education, will likely lead to prolonged budget 
debate in the coming weeks. While such budget negotiations would not 
necessarily adversely affect the timing of the issuance of the long-term 
power bonds, delay could further weaken the state's fiscal position. 
Energy Crisis Compounds Uncertainty in Economic Outlook 
The energy crisis will have economic, as well as financial, consequences that 
add further uncertainty to an already complex economic outlook. The 
Governor's economic forecast calls for the economy to slow through 2002, 
taking a similar if not more slightly pessimistic view than other economists, 
including UCLA, Economy.com, and the economists surveyed by the Western Blue 
Chip. The state posted non-farm employment gains of nearly 4% in 2000, but 
the Governor's forecast expects job growth to moderate to 2.3% in 2001, and 
grow by less than 2% in 2002. Salary and wage income growth, which drives tax 
revenues, is expected to be even weaker than employment trends. The drivers 
of the forecasts include the outlook for the high technology sector, as well 
as the important housing sector. 
None of the economic forecasts explicitly quantifies the impact of the energy 
crisis. The California economy is not heavily dependent upon energy, and 
ranks lowest among states in terms of per capita electricity consumption. The 
industries that drive the California economy are not heavy users of energy 
and it is not a major cost factor for the California industry mix. However, 
uncertainty regarding cost and availability of energy and the threat of 
unreliable power going forward have already damaged the state's business 
climate, reputation, and longer-term growth prospects. In Moody's view, the 
forecasting techniques of the major economic services tend to underestimate 
the potential impact of these difficult to quantify dimensions of the energy 
crisis. 
OUTLOOK: 
Outlook Remains Negative 
At the moment, we expect that the substantial cash resources accumulated by 
the State of California during the expansion of the last decade, in 
combination with the planned long-term energy financing will enable it to 
avert the degree of fiscal damage that would call for the rating to fall to 
the A range. If a reasonably cautious balanced budget is enacted and the 
long-term energy financing completed, the state will still have reasonable 
margins of bondholder protection on its balance sheet. However, if the state 
or US economic outlook weakens further, or if the energy financing stalls, or 
if the enacted budget is only narrowly balanced, the rating could be adjusted 
further. While we expect that the state will be able to structure a viable 
long-term energy financing over the next few months, substantial obstacles 
must be overcome to meet that goal. In addition, the state will need to enact 
a balanced budget that leaves enough cushion to accommodate the remaining 
economic uncertainty not captured in its cautious revenue forecast. Given the 
recent failure to secure the supermajority necessary to enact emergency 
bridge energy financing legislation, we expect that the budget - which also 
requires a two-thirds majority vote - will also be the subject of a difficult 
debate.