The State of New Jersey has suffered another ratings downgrade, to A1 (negative outlook) by Moody’s, due to recurring budget gaps. This time the budget gap of $875 million was due mostly to lower income tax revenues resulting from overoptimistic revenue estimates. The timing of the miss on cash flow estimates could not have been worse for New Jersey. The state has $2.6 billion in tax and revenue anticipation notes maturing at the end of June, but Moody’s reports that it has only $2.2 billion cash on hand. To generate the needed cash for the maturing debt and balance the budget, Gov. Christie has proposed cutting the yearly contribution to pensions by more than half, from $1.58 billion to $681 million. We identified New Jersey as a problem credit in our Fiscal Year 2013 State of the States study, where and it ranked just above last place Illinois. New Jersey’s current fiscal year shortfall is a near-term cyclical issue due to lingering fallout from the financial and housing recession as well as Hurricane Sandy, but the pension underfunding can be attributed to long-term structural issues. On May 15, the Wall Street Journal ran an Op-Ed by Richard Ravitch (former Lieutenant Governor of New York and current Federal Bankruptcy Court Advisor on Detroit) titled “More Detroits Are on the Way,” where he succinctly captures the underlying long-term operational issues afflicting many municipal issuers: “Everyone with a role in determining these contribution levels has an incentive to keep them as low as possible. Politicians don’t like to raise taxes to meet future obligations, while public unions would rather take the long-term risk of underfunding rather than face immediate layoffs or benefit reductions.” Identifying near-term cyclical issues can be an opportunity to add value in our client portfolios. It is the long-term structural issues we at SNWAM avoid because the rewards typically do not compensate investors for the inherent risks. In the case of select credits associated with the State of New Jersey, the near-term fiscal issues are potentially an opportunity to add value but, in this instance, they do not outweigh the long-term risk of serious pension funding mismanagement.