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In the midst of an ongoing budget crisis, Sweetwater Union High School District’s credit rating agency, Fitch, downgraded the district’s credit rating in recent days and indicated the district’s credit rating is likely to continue to slide in the future.
The announcement of Fitch’s diminished confidence comes just days before voters are being asked to invest heavily in the district. South Bay residents will decide on Election Day whether to pass Measure DD, a $403 million construction bond for Sweetwater schools.
Fitch downgraded Sweetwater – the second largest district in San Diego County with roughly 40,000 students – two spots, from an “A” to “BBB+.” It also changed the district’s outlook from “stable” to “negative,” meaning Fitch predicts the rating could continue to slide.
“The rating could come under further downward pressure if management fails to take prompt policy action to mitigate financial pressures and stabilize its financial position,” the downgrade report reads.
Credit ratings describe an organization’s ability to meet its financial obligations. They are also an indication of how much trust investors should place in that organization’s ability to manage its money. “BBB+” reflects an “adequate” ability to stay fiscally solvent. Lower credit ratings mean an organization is at risk of default.
“It’s a big deal, without a doubt,” said Graham Schnaars, a Fitch analyst on the team that rated Sweetwater. “The even bigger deal is how they are going to handle [their finances] moving forward.”
When closing its books on the last fiscal year, Sweetwater officials noticed they had overspent by upward of $30 million. That put the district in a sudden and immediate deficit for the current school year. The deficit forced officials “to make steep, immediate expenditure cuts to balance the current fiscal 2019 budget,” Fitch wrote.
In salary and benefits alone, Sweetwater overspent by roughly $16 million. Sweetwater officials have not released an explanation for how they failed to realize during the school year that they were overspending, beyond indicating that multiple software systems failed to accurately track how many workers were on staff at any one time. District officials also said they overestimated how much money would come from the state.
But the mistake actually seems to have worked in the district’s favor. Last April, Sweetwater issued $28 million in bonds to help pay for school construction. (The district was able to leverage that money because voters passed two previous school bonds in 2000 and 2006, totaling more than $800 million.) Had the true state of the district’s finances been known, it may have had to pay higher interest on its bonds.
“Conceivably they paid less [in interest] but it would probably be a very small amount,” said Matt Fabian, who researches municipal bond markets for Municipal Market Analytics. Bond investors don’t pay a great deal of attention to the underlying rating of California school districts when it comes to taxpayer-backed bonds, he said. That’s because, legally, tax money for construction bonds goes straight from homeowners to the county and into investors’ pockets. Because of California’s laws, investors and credit rating agencies see their bond investments as virtually untouchable regardless of a district’s credit rating, he said.
While the district’s credit rating went down and has a negative outlook, Fitch continues to rate the district’s taxpayer-backed bonds as “AAA,” the highest rating.
Investors may be well protected, but taxpayers less so. In extreme circumstances, bond money doesn’t necessarily have to go to school construction. If a school district is facing default, the state will require it to exhaust all its revenue streams before issuing an emergency loan. That means a district could pull bond money previously earmarked by voters for construction into its general fund to stay afloat. District residents would be on the hook to bail out a district, instead of the state in that scenario.
A question that could come up for regulators with the U.S. Securities and Exchange Commission, said Fabian, is whether anyone at the district knew of the precarious finances back in April. Regulators would want to know: “Is it a mistake or was it intentional?” Fabian said. “Even if it is a relatively small misrepresentation of information, regulators take that very seriously.” The SEC has gone after cities in New Jersey and Florida, and their chief financial officers, for financial misrepresentations, he said.
District spokesman Manny Rubio said no one knew about the district’s precarious financial position in April.
“Immediately upon discovering [our financial position] we took it to the county. Did we know? Absolutely not,” he said.
Fitch may have downgraded Sweetwater even further were it not for California’s legal framework, which allows the state or county to take full or partial control of a district in financial distress.
“Fitch expects the district to recover to flexibility because both the state Department of Education and the County Office of Education have the power to intervene to force spending adjustments if management is unable to make them on its own,” the report reads.
The County Office of Education, which has oversight authority, rejected Sweetwater’s budget in September. It has until Nov. 8 to approve millions in cuts the district proposed in October. It also has the power to appoint a fiscal adviser who would have the power to overturn decisions by Sweetwater’s Board of Trustees.