U.S. PUBLIC FINANCE

SECTOR IN-DEPTH02 DECEMBER 2014

ANALYST CONTACTS

Josellyn Yousef 212-553-4854AVP-Analyst250 Greenwich Streetjosellyn.yousef@moodys.com

Julie Beglin 212-553-4648VP-Sr Credit Officer/Manager250 Greenwich Streetjulie.beglin@moodys.com

Naomi Richman 212-553-0014MD-Public Finance250 Greenwich Streetnaomi.richman@moodys.com

New Jersey Local Governments

New Jersey Cities and CountiesRemain Resilient Despite State's CreditChallengesSummaryNew Jersey local government credit strength will be stable in 2015 despite the laggingeconomic recovery and the State of New Jersey's (A1 negative) ongoing fiscal challenges.Local governments in the state benefit from relatively well-funded pensions, stablerevenues that are not highly economically sensitive and a strong institutional framework.These factors will help local governments to remain resilient in the face of the state'sgrowing budget imbalance, persistent revenue shortfalls, rapidly growing unfundedpension liabilities and weak liquidity.

New Jersey local governments have a median rating of Aa3, the same as the nationalmedian. In contrast, the state's A1 is well below the national Aa1 median for states andfalls just shy of last place, before Illinois (A3 negative). Although cities and countiesshare the same economy as the state, local governments benefit from a number offactors, including:

» Local governments don’t have the same pension problem as the state. The localgovernment portion of New Jersey's pension plans are funded at a much higherlevel.

» Local governments rely primarily on property taxes, which have remainedrelatively stable. Conversely, New Jersey's state budget relies almost entirely onvolatile sales and income tax revenue.

» State aid is not a major revenue source for local governments. Local governmentsare not overly reliant on state aid.

» Local governments benefit from a strong institutional framework. Strong stateoversight helps local governments to control expenditures and provides additionalsupport to troubled cities.

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This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

Local governments do not have the same pension problems as the stateThe local portion of the state-administered pension plans are funded at a much higher level than the overall state plan. Whilethe state has underfunded its Annual Required Contribution (ARC) every year since 1996 and even took pension holidays byskipping its contributions between 2001 and 2004, local governments continued to fund near the ARC, at a level set by statestatute, leaving the local pension systems on much better footing.

Cities and counties participate in two plans together with the state — Public Employees' Retirement System (PERS) and thePolice and Firemen's Retirement System (PFRS). While the local and state pension programs are combined into one system,local asset liabilities and contributions are accounted for separately from those of the state. Local governments are responsible forfunding the portion of the plan dedicated to local employees and the state is responsible for state employees.

As a result, local government pensions currently are not affected by the state's severe pension underfunding problem. On areported basis, the divergence between state funding levels and the local portion is acute. As seen in Exhibit 1 local funding forPERS and PFRS is much higher at 74% and 77%, respectively. Similarly, the PERS Unfunded Actuarially Accrued Liability as apercentage of covered payroll is much better at the local level at 212%, compared to a higher, and worse 422% for the state (seeExhibit 2).

Exhibit 1

Local Portion of PERS and PFRS Better Funded

Source: Public Employees’ Retirement System of New Jersey Fifty-Ninth Annual Report of the Actuary, prepared as of July 1, 2013

The Police And Firemen’s Retirement System Of New Jersey Annual Report Of The Actuary, prepared as of July 1, 2013

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3 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

Exhibit 2

State PERS and PFRS UAAL as a % of Covered Payroll Higher than Local Portion

Source: Public Employees’ Retirement System of New Jersey Fifty-Ninth Annual Report of the Actuary, prepared as of July 1, 2013; The Police And Firemen’s Retirement System Of New JerseyAnnual Report Of The Actuary, prepared as of July 1, 2013

New Jersey's 2013 Moody's adjusted total net pension liability of 180% of state governmental revenues ranked as the fourthhighest among the fifty states, behind Kentucky (193%; Aa2 stable), Connecticut (236%; Aa3 stable) and Illinois (268%; A3negative). In contrast, the total Moody's adjusted net pension liability for New Jersey was a lower 123% of all county revenuesin 2013. We currently calculate Moody's adjusted net pension liabilities by using a market-based discount rate, uniformduration assumption and a fair market value of assets instead of a smoothed value of assets.

The new GASB 67 disclosure further reveals a significant divergence between the financial health of state and local shares oftwo New Jersey plans, PERS and PFRS. Assets in the state’s share of PERS are projected to be depleted by 2024, while the localshare is not projected to ever deplete its assets. The historical difference between local and state employer contributions relativeto actuarial requirements is the root cause behind this divergence.

Cities and counties have historically contributed to PERS and PFRS at much higher rates than the state. These localgovernments' annual rates determined contributions, determined by state statute, have ranged from 84% to 92% of ARC inrecent years, versus the state's very low 4% to 28%. (see Exhibit 3). Given these higher rates of contributions, locals will not facethe same budgetary pressure from ramping up contributions as the state. Still, it is important to note that the failure of cities andcounties to fund their full ARC is contributing to growing unfunded pension liabilities.

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4 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

Exhibit 3

Locals Fund Near the ARC for PERS and PFRS

Source: Public Employees’ Retirement System of New Jersey Fifty-Ninth Annual Report of the Actuary, prepared as of July 1, 2013; The Police And Firemen’s Retirement System Of New JerseyAnnual Report Of The Actuary, prepared as of July 1, 2013

Rapidly increasing pension contributions will continue to limit the state's budget flexibility. In 2011, the state adoptedlegislation laying out a plan to escalate its pension contribution annually over seven years to reach the full ARC by 2018. Duringfiscal 2015, the state decided to fund less than was statutorily promised in the 2011 funding plan. It paid just 30.3% of the$2.25 billion combined required contribution under pension reform legislation, including on-behalf Teachers Pension AnnuityFund payments.

Some states have decided to push their pension problems down to their local governments in some form. Through legislativeaction, the state of New Jersey could choose to do the same by combining the funds' assets or requiring school districts tocontribute toward teacher pensions. Either of these cost shifts from the state to its localities would be very challenging politicallyand thus far there has been no indication that these options are under consideration.

Local government revenues are less economically sensitiveNew Jersey local governments rely primarily on property tax revenue, which is a relatively stable revenue source (see Exhibit4). Conversely, the state budget relies heavily on very economically sensitive sales and income tax revenue. Cities receivedapproximately 60% of revenues in 2013 from property taxes and counties received 65%. As a percentage of total municipalrevenues, property tax collections have remained consistent (see Exhibit 4). In 2013, the state received 64% of its revenues fromsales and use taxes and gross income tax. Local governments do not collect sales or income taxes, with the exception of a fewcities designated as urban economic zones, which receive a portion of sales taxes collected by the state.

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5 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

Exhibit 4Property Tax as % of Revenues Largest Revenue Source for Cities and Counties

Data based on Moody's rated local governments

Source: Moody's Investors Service

The predictability of property taxes lends to a greater degree of financial stability for local governments. Property tax revenuehas remained very stable for New Jersey local governments while income and sales tax contracted significantly following thefinancial crisis (see Exhibit 5). Propery taxes for cities and counties even increased steadily during the economic downturn aslocal governments raised property tax rates during the housing market downturn while economically sensitive revenues suffered.Although the property tax levy is capped at 2% over the prior year's levy, New Jersey cities and counties have managed byimplementing incremental increases that are more easily absorbed by constituents. Property tax revenue also benefits from avery high collection rate for cities and a 100% collection rate for counties, which have the cities serving as their property taxcollection agencies.

Exhibit 5

Local Government Property Tax Revenue More Predictable than State Income and Sales TaxesProperty tax revenue is historically a more consistent tax revenue stream

Data based on Moody's rated local governments

Source: US Census and New Jersey Division of Local Government Services

Higher home values in New Jersey than the rest of the country will continue to foster stable property tax revenues. Property taxvalues are still very high in New Jersey compared to the nation, despite the sluggish economic recovery. The New Jersey medianfor full value per capita for cities is 149% of the national median. Housing completions are projected to continue to outpace theUS (see Exhibit 6). Notably northern New Jersey is performing better than southern New Jersey as it benefits from the spillover

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6 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

effect of rapidly rising values in New York City (Aa2 stable). New Jersey does continue to face a higher foreclosure rate than thenational average. If foreclosures are cleared faster than expected, New Jersey home values are expected to benefit.

Exhibit 6

New Jersey Housing Completions Outpace the United StatesUsing 2005 as a Benchmark Year, New Jersey has Recovered Faster than the United States

Source: US Census Bureau & Moody's Analytics Forecast

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7 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

State aid is not a major revenue source for local governmentsNew Jersey cities and counties rely only modestly on aid from the state, which can be subject to cuts or delays. State aid for citiescontributes to about 12% of total municipal revenues, and counties do not collect aid from the state outside of grant funding.School districts rely more heavily on state aid at about 20% of revenues, and as a result they are more exposed to the state'sfinancial problems. New Jersey has not cut aid for cities since 2010 and reports claim that state officials chose to reduce pensionfunding in fiscal 2015 instead of cutting aid. This approach has kept municipalities protected to date from the state's financialtroubles trickling down to the local level. Going forward, cities do have some exposure to the possibility of cuts in state aid, butas a relatively small portion of total revenues most cities would be able to manage over time as they did following cuts in 2010(see Exhibit 7).

Exhibit 7

New Jersey Local governments not overly reliant on state aid

Source: The State of New Jersey Audit

Local government have strong institutional frameworksNew Jersey state oversight of local governments is exceptionally strong. In 2013, we designated New Jersey as one of six stateswith strong oversight of their local governments (see Exhibit 8). The Division of Local Government Services (DLGS) at theState Department of Community Affairs serves as a regulatory oversight body for all 565 municipalities and 21 counties,overseeing their financial condition. The DLGS requires timely fiscal reporting, reviews and approves municipal budgets,and licenses CFOs, clerks, tax collectors, and procurement officials. The DLGS can place a troubled city under formal statesupervision and appoint a comptroller to oversee the city's financial decisions. It can also force a municipality to increase itsproperty tax levy in order to adopt a balanced budget. Importantly, n o local government can file bankruptcy without approvalfrom the DLGS, and none have filed since the Great Depression.

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8 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

Exhibit 8

New Jersey is One of Six States with “Strong” State Oversight of Cities and Counties

Source: Moody's Investors Service

There have been numerous examples over the last few years of the DLGS helping municipalities from falling into financialdistress. In 2010, the division set a tax rate for Trenton (A3 stable) just before the end of the fiscal year. In 2011, the DLGSlent$4.8 million to Paterson (Baa2 negative) when it struggled with weak cash balances. Following Superstorm Sandy, theDLGS director reached out to the investment community assuring potential note purchasers that the state would provideliquidity assistance to municipalities should they have trouble repaying the lender. This helped many Sandy-affected issuersreceive the financing needed to quickly begin clean-up efforts quickly.

New Jersey's local governments also benefit from a strong regulatory and legal framework that equips municipalities with thetools to control expenditures. The 2% cap on police and firefighter arbitration agreements allows cities and counties to controlcosts associated with employee salaries because it limits any salary creases arrived at through arbitration to no more than 2%.This cap provides an invaluable degree of predictability to the largest expenditure line item.

In addition, the DLGS recently changed its budget disclosure requirements for public authorities affiliated with localgovernments, dramatically improving disclosure. Greater disclosure of authority financial operations will enhance accountabilityand lead to better cost controls.

Lastly, cities and counties in New Jersey present their audited financial results under a mode of accounting that is unique toNew Jersey. The state's statutory accounting presentation fosters generally more conservative picture of cities’ and counties’available reserves than the Generally Accepted Accounting Principles used by most local governments in other states. New Jerseystatutory accounting is a cash basis of accounting that excludes accounts receivable in fund balance, which GAAP includes. As aresult, New Jersey fund balance amount are primarily cash funded.

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9 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES

School districts are more exposed to state troublesSeveral factors expose school districts much more to the state's financial troubles than cities and counties. Schooldistricts have a pension plan, the Teachers' Pension Annuity Fund, that is as poorly funded as the state's pensions at57.1% and is funded by the state through on-behalf payments. Furthermore the state currently funds only 52.3% ofthe ARC, whereas cities and counties fund at approximately 90%. We have seen a number of states choose to reducetheir on-behalf payments for teachers, forcing the unexpected cost onto school budgets, although this has not beenactively discussed in New Jersey.

Additionally, schools are more exposed to state aid cuts or payment delays than cities or counties, because they are morereliant upon aid as a revenue source, at an average of 20% of revenues. State aid for schools makes up 36% of the state'sbudget, including on behalf pension payments, which could make this line-item expenditure a source of state budgetcuts.

Another smaller factor setting school districts apart is the lack of a similarly strong legal framework that benefits citiesand counties. While schools have a similar level of state oversight, they are not protected by the 2% arbitration cap andfinancial reporting is done on a GAAP basis, rather than the more conservative, New Jersey statutory accounting.

Moody's Related ResearchDrivers of New Jersey’s Downgrade to A1 from Aa3 (170747)

US Local Government GO Focus: Debt Security Pledge Summaries Across 50 States (171780)

State of New Jersey November 21, 2014 General Obligation Update Report

Adjusted Net Pension Liabilities Show Improvement (1000056)

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AUTHORJoselyn Yousef

ASSOCIATE ANALYSTAndrew Pfluger

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11 02 DECEMBER 2014 NEW JERSEY LOCAL GOVERNMENTS NEW JERSEY CITIES AND COUNTIES REMAIN RESILIENT DESPITE STATE'S CREDIT CHALLENGES