Tapping into reserves and special funds such as the state's hurricane relief or rainy-day funds to help balance the state budget could contribute to a lowering of Hawai'i's bond rating, Moody's Investors Services said.

The credit rating agency yesterday warned it may lower the state's bond ratings if Hawai'i's financial woes aren't resolved, something that potentially could cost the state millions of dollars in higher interest paid on the bonds it issues.

Moody's lowered Hawai'i's ratings outlook to negative from stable, though it left the ratings themselves at Aa2, or the third-best level out of 21 levels Moody's maintains for long-term bonds.

The lowering of the outlook doesn't carry as serious financial implications for the state as does a ratings downgrade, but signals one could occur over the next two years. The lowering underscores the state's budget problems and uncertainty about the economy, and the critical nature of the state's response to the predicament.

Moody's noted the state is staring down a $1.2 billion budget gap for the biennium and may have to increase use of one-time solutions to balance the books.

Several legislators have suggested dipping into special funds to help solve the teacher furlough situation or make health care payments as they grapple with how to cover budget shortfalls. Georgina Kawamura, state budget director, said Gov. Linda Lingle's administration has avoided raiding special funds and will quote Moody's concerns in testifying against such measures.

"I absolutely hope they take note of it (the Moody's report) and take note of our strengths as well as our weaknesses," Kawamura said.

The bond ratings and outlooks are used by investors to make decisions on whether they should purchase a certain state, city or corporation's bonds or debt obligations. Moody's analyst Nicole Johnson said many states are struggling with revenue shortfalls.

"It's not like they're the only one," said Johnson, who said other states with negative outlooks include Ohio, Pennsylvania, Kentucky, Florida and Washington.

"It's been a rough time for states."

The report by Johnson and analyst Nicholas Samuels said Hawai'i's reserves were 8 percent of the general fund revenues at the end of fiscal year 2008 but are projected to fall to 2.4 percent at the end of the 2010 fiscal year in June.

The reserves are expected to remain under 2 percent in future years due to the use of one-time actions, including applying federal stimulus funds to balance the budget, the report said.

"Strong reserve levels are important for Hawai'i given the state's heightened vulnerability to national and international shifts in its essential tourism-based economy," the report said.

"The currently low reserve levels leave Hawai'i with reduced flexibility to address additional shortfalls that may emerge."

$534M BOND ISSUE

The Moody's report comes as the state readies to issue $534 million of bonds next week. Standard & Poor's Ratings Services and Fitch Ratings also have assigned their third-highest ratings to the bond issue while S&P has maintained a "stable" outlook for the bonds.

Fitch maintained its negative outlook for Hawai'i's debt, having lowered it in June. At the time it said Hawai'i's revenue picture continued to weaken and thin reserve levels could limit the state's financial flexibility.

State Rep. Marcus Oshiro, D-39th (Wahiawā), the chairman of the House Finance Committee, said he had yet to see the Moody's report, but said it was disconcerting news.

"It is disappointing because it may make it more difficult to issue bonds at lower interest rates and that has an impact on balancing the budget," Oshiro said.

Louis D'Avanzo, manager of the Hawaii Municipal Fund, a bond fund that concentrates on tax-free municipal bonds for Hawai'i investors, said he believed the negative outlook could add 0.01 percentage points to the interest rate cost of Hawai'i's upcoming bond issue.

That might translate into $50,000 more in interest costs annually, he said. Still, the bond sale should attract many interested buyers because part of the issue will be conducted under a program known as Build America Bonds.

The program allows states to issue bonds that draw a wider audience, because the interest rate is equivalent to those paid by corporations. But the cost to states and municipalities is the same as issuing a lower interest rate tax-exempt bond because the federal government subsidizes the issue.

Kawamura said the state expects to draw interest for the upcoming bond sale from foreign investors because of the interest rate and because of the high credit rating. For that reason, along with vagaries of the bond market, she said it was difficult to say how much Moody's negative outlook might affect the pricing.

"I'm still feeling positive that we'll get the investors and interest rates that we want," Kawamura said.

About $222 million of the bonds will go to replace bonds issued earlier at higher interest rates. The Moody's report said this will save $16 million this fiscal year and $72 million next year as the state postpones payment of principal to later years.

"All they've done is push the problem out," said Moody's Johnson, who explained Hawai'i and other states are using such tactics to delay expenditures in the hope that their economies will be stronger in the years ahead.

But that contributes to the negative outlook and uncertainty over what will happen should tourism take longer to recover at a time when state reserves are low. The report said a ratings downgrade could also be triggered by other actions, including a weakening economy that leads to more unemployment and further state budget problems.

Moody's report also noted Hawai'i has many pluses, including a history of being fairly conservative about its fiscal policies. The state's current Aa2 rating is a measure of that, having been at a lower Aa3 rating up until 2005 and at a still-lower A1 until 2000.

Moody's also called attention to the state's centralized government creating a heavy debt burden ranking among states. The 2009 debt per capita of $3,675 was third-highest in the country, it said.