NEW YORK NEW YORK--(BUSINESS WIRE)--Fitch Ratings takes the following action on the U.S. Virgin Islands (USVI) as part of its continuous surveillance effort:

--$0.6 million USVI general obligation (GO) bonds, series 1999A, downgraded to 'BB' from 'BBB-';

--$556.2 million Virgin Islands Public Finance Authority (VIPFA) revenue bonds (Virgin Islands gross receipts taxes loan note), affirmed at 'BBB-'.

The Rating Outlook is Stable.

RATING RATIONALE:

--The downgrade of the USVI GO rating reflects the USVI's extreme revenue weakness in the context of already constrained fiscal flexibility. Bonds issued by VIPFA and secured by gross receipts taxes are insulated from general fund operations and debt service coverage remains adequate.

--The territory's longstanding fiscal challenges have worsened in the current downturn given sharp cyclical revenue declines, prolonged, unresolved property tax litigation, high fixed cost burdens, and difficulty in reducing expenditures. The territory has returned to borrowing to close its operating gap and maintain liquidity.

--Net tax supported debt is extremely high, and revenues dedicated to debt service reduce fiscal flexibility.

--Other liabilities for pensions and unpaid retroactive salaries further weigh on the territory's limited resources, although anticipated matching fund revenues may provide future relief.

--Recent years have brought demonstrated, though incomplete, progress in financial management and reporting. Historically, financial management shortcomings have been widespread and material, leading to external oversight, and qualified and delayed audits.

--Stability is provided by the U.S. legal and regulatory environment, although as a territory the USVI enjoys less flexibility in fiscal matters than U.S. states.

--The economy is limited, dependent on tourism and vulnerable to disruption from natural disasters.

KEY RATING DRIVERS:

--Ability to control spending pressure and curb borrowing for operations.

--Ability to limit growth of debt and other liabilities.

SECURITY:

The bonds are general obligations secured by the USVI's full faith and credit and taxing powers. In addition, the gross receipts tax revenue bonds issued by VIPFA are secured by a pledge of gross receipts tax collections from the USVI deposited to the trustee for bondholders prior to their use for general purposes.

CREDIT SUMMARY:

The downgrade of the USVI's GO rating to 'BB' from 'BBB-' is due to the severe erosion of the territory's finances in fiscal years (FY) 2009 and 2010, with deep cyclical revenue losses and the delayed resolution of longstanding property tax litigation reducing already limited resources. Given constraints posed by its high fixed costs and very high liabilities, the USVI has returned to borrowing to cover operating gaps in the form of a $250 million line of credit for FY 2009 and 2010, about $100 million of which has been drawn to date. The borrowing adds further to the burden of the USVI's liabilities, including outstanding debt and unaddressed employee and retiree obligations. Although fiscal management has improved over the last decade, the rapid expansion of expenditures has absorbed revenue growth and limited the USVI's flexibility to address its liabilities or confront the downturn. The Stable Outlook at this rating level incorporates Fitch's view that the USVI will be able to manage in the near term within the context of severe fiscal stress, albeit not without recourse to actions that delay the USVI's prospects for longer-term recovery. Longer-term prospects for matching fund revenue growth tied to expanded rum distillation may provide fiscal stabilization in the coming years, although only with progress toward structural balance.

The affirmation of the gross receipts tax (GRT) bonds at 'BBB-' and Stable Outlook reflect the structure's legal protections and the sufficient coverage of debt service by pledged revenues. GRT bonds are secured by the trust estate, which includes the USVI's pledge of GRT revenues received or to be received. All such collections are deposited daily to a special escrow account; with the exception of a small required payment for housing, all revenues are allocated daily to the trustee for the benefit of bondholders, after which remaining receipts are available for general purposes. Security features include an additional bonds test requiring 1.5 times (x) coverage by historical and prospective revenues, a debt service reserve funded at maximum annual debt service, and covenants precluding tax rate reductions or the granting of excessive tax incentives. Like states, the USVI and VIPFA are ineligible to file for protection under the U.S. Bankruptcy Code. Coverage of the bonds remains satisfactory, at 2.36x in fiscal 2010 despite projected revenue declines. The priority claim of bondholders to GRT collections and other structural protections insulates bondholders from the USVI's broader fiscal stress and support a rating level that is higher than the GO rating. However, Fitch believes there is some linkage between the general credit of the USVI, as expressed in the GO rating, and the rating on the GRT bonds.

The USVI is an organized, unincorporated territory of the U.S. about 40 miles east of the Commonwealth of Puerto Rico. The economy is small, narrow and subject to considerable volatility, although some diversification is underway. Tourism and related industries comprise approximately 80% of economic activity, although other activities, notably rum distillation and the HOVENSA oil refinery are also prominent. After a strong tourism recovery in the last decade following the events of September 11, tourism plummeted in late 2008 with steep declines in cruise ship passenger and air visitor arrivals. Despite some recent stabilization, tourism indicators remain well below prior peaks and recovery will be linked to broader economic recovery in the U.S., from which the majority of USVI visitors originate. USVI employment peaked in 2007 and remained flat in 2008, compared to a U.S. decline of 0.4%; December 2009 employment is down 1.1% year-over-year, compared to a U.S. decline of 3% for the same period. After a 24.2% decline in 2008, construction employment has flattened, with several development projects on St. Croix supporting employment. The USVI government provides virtually all public services and employs nearly 27% of the labor force, a level unchanged in recent years.

USVI tax collections are subject to significant volatility; after several years of robust growth, net tax collections have plummeted in the recession. FY 2009 collections, which were initially forecast to grow 17% from FY 2008, to $854 million, instead fell 36%, to $470 million. Weakness was led by a 24% decline in individual income taxes and a 71% decline in corporate income taxes, the latter tied to performance at HOVENSA. Delayed resolution of property tax litigation also lowered collections to $30 million, from $103 million assumed in the budget. Revenue weakness continues in FY 2010, with the USVI now forecasting net tax collections of $487 million, down nearly 20% from the $606 million forecast in June 2009. Year-to-date collections for FY 2010, which began Oct. 1, show declines moderating through January 2010, with general fund tax collections down 6% compared to the same period last year. Individual income taxes are down 2%, corporate income taxes are down 29%, and gross receipts taxes are down 10%.

Revenue growth prior to the recession was largely absorbed by base spending increases, particularly for personnel and fringe benefits. FY 2008 appropriations, at $873 million, were 19% over the level two years earlier and $77 million higher than available resources. Appropriations remained at $849 million in FY 2009 despite plunging revenues, with the USVI relying mainly on $100 million of a $250 million line of credit, $43 million in transfers and other internal cash resources to cover spending needs. FY 2010 appropriations, projected at about $858 million, are approximately $300 million higher than available resources; the gap is expected to be closed by accessing the remaining $150 million line of credit, $93 million in monetization of property tax collections tied up in litigation, $57 million in federal stimulus, and further allotment cuts. Interest on the line of credit is secured by gross receipts taxes, with repayment linked to future revenue gains from matching funds tied to the expansion of rum distilling on St. Croix.

Financial mismanagement and devastating hurricane strikes weakened finances in the 1990s and led to considerable borrowing for operations. Thereafter substantial progress was made in fiscal management under federal oversight, leading to spending and debt control, upgraded internal systems, and progress in financial reporting. Annual financial reports and other financial data are timelier and more reliable, although annual reports remain qualified. Past management weaknesses continue to materially affect results; for example, property taxes continue to be levied at 1998 valuations pending court approvals of reforms to appraisal and appeal processes, restricting revenue growth.

The USVI's liabilities are extremely high. Tax-supported debt totals about $1.5 billion as of Dec. 1, 2009, equivalent to 60% of personal income; this includes $100 million drawn on the line of credit to date. About $669 million is GRT bonds and subordinate notes issued by VIPFA, which also carry a USVI GO pledge; all USVI-issued GO bonds without the GRT pledge mature this year. Another $828 million is backed by matching funds from federal excise taxes levied on USVI-distilled rum. (For further information, refer to Fitch's rating action commentary 'Fitch Rates Virgin Islands' Cruzan Matching Fund Bonds' dated Dec. 1, 2009.) Debt service including matching funds bonds totals $107 million in FY 2010, equal to 5.3% of revenues including matching funds. Amortization is slow, with 32% maturing in 10 years. Persistent underfunding has led to a large pension liability, with an estimated FY 2008 funding ratio of 53.6%; this $1.5 billion shortfall equates to 62% of personal income. Other liabilities include negotiated but unpaid salary increases over the last two decades, the burden of which has been estimated at $272 million. The governor has proposed directing future growth in matching fund receipts to begin addressing long-term liabilities.

Applicable criteria available on Fitch's website at www.fitchratings.com:

--'Tax-Supported Rating Criteria' (Dec. 21, 2009);

--'U.S. State Government Tax-Supported Rating Criteria' (Dec. 28, 2009).

Additional information is available at 'www.fitchratings.com'.

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