New Houston Leadership Brings $800M to Market

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DALLAS – Houston will price $800 million of revenue and refunding bonds as the city's new leadership grapples with economic uncertainty and persistent pension problems.

The double-A water and sewer bonds from the Houston Combined Utility System, backed by customer revenues, are expected to appeal to a broad segment of institutional investors looking for strong credits and name recognition.

The negotiated deal is scheduled to price Tuesday through bookrunner Wells Fargo Securities and five co-managers. Wells Fargo Vice President John Young and director Desrye Morgan are lead bankers. Trey Cash, managing director at First Southwest Co., is financial advisor.

The size of the deal could go as high as $960 million if the market presents the right opportunity, officials said.

"A large chunk of this – about 75% -- is refunding, so it's a moving target," said Jennifer Olenick, deputy director of finance for the city.

Finance officials expect savings of about 10% on serial bonds maturing through 2040 and a term bond maturing in 2045. The estimated average life of the bonds is 15.7 years.

The sale comes in a heavy week with $9.1 billion of muni primary market volume, double the previous week's volume.

"While we realize there is a full calendar coming up, we are optimistic that the reception of the market for the recent [Dallas Area Rapid Transit] and San Antonio Water sales will carry over," Olenick said.

The bonds carry ratings of Aa2 from Moody's Investors Service and AA from Fitch Ratings, with stable outlooks. The ratings apply to about $5.9 billion in parity first lien bonds.

Analysts see very little risk from the city's heavy debt load, ongoing need for infrastructure and potentially weakening economy.

"The Aa2 reflects the system's near monopoly in a robust service area and the system's strong balance sheet that benefits from a closed loop flow of funds," Moody's analyst Adebola Kushimo wrote.

Fitch analyst Gabriela Gutierrez called the system "highly leveraged and expected to remain so given its large capital plan, which was developed to actively manage the system's aging infrastructure and growing service area."

Moody's has a negative outlook on the city's Aa2 general obligation bond rating, citing pension problems and economic uncertainty.

Standard & Poor's, which isn't rating the utility deal, has a stable outlook on Houston's AA-plus GO rating. The city's new leaders, including Mayor Sylvester Turner and Controller Chris Brown, have hardly enjoyed a honeymoon period in their first month in office as fiscal trend lines become increasingly worrisome.

According to audited figures for the fiscal year ended June 30, the city's unrestricted net position was a deficit of $5.98 billion after falling $3 billion in FY 2015. Under new accounting rules, the city's net pension liability increased by $4.4 billion.

In a January city council meeting, Turner decried a $16 million drop in anticipated property tax revenue in the current $2 billion budget because of appraisal challenges from commercial property owners in the city.

"When they're not successful at the appraisal districts, they go to court for relief," Turner said. "The reality is, that $16 million is a real hit to the city's budget. We cannot ask our homeowners who can least afford it to pay more."

While the $16 million is just 2.4% of the $667 million in property tax revenue for the previous fiscal year, Turner said the loss is alarming.

"This cycle is devastating to our city budget," the mayor said. "This month it is a $16 million hit.  What will it be next month? Where will we find this additional money?"

As a result of falling revenues, last year's expectation of a $126 million revenue shortfall has grown to $142 million, Turner told the council.

Property tax is the city's largest source of revenue, and fiscal year 2015 was the first year under a tax cap imposed by the city's voter-approved Proposition 1. The cap reduced property tax revenue by $57 million, according to the city controller's office.

The city also saw its first month of declining sales tax revenue in May after a long surge fueled by robust energy development in Texas. For calendar year 2015, Houston's sales tax revenues were down 2.08% from the previous year.

In an executive order shortly after taking office, Turner said he would streamline spending as the city nears a spike in debt service payments, rising pension costs and the cap on city property tax collections.

"What the credit rating agencies are asking of us is a concrete definitive plan to address our short-term and long-term financial obligations, and that's what I'm committed to doing," Turner told the council.

Under new Government Accounting Standards Board rules, Houston's pension underfunding grew to nearly $5.6 billion in an audit released Dec. 31.

Before the most recent audit, the city was required to report only the difference between the annual payment required to fully fund each pension and the lower payment it was actually making. Now, cities must report the gap between the projected cost of all employee retirement benefits and the cash the city has set aside to pay those benefits.

In a January meeting, council members asked Brown if the budget figures and liabilities indicated the city was approaching insolvency.

"In my eyes, that's not insolvent, but that's a wake-up call," Brown replied. "We have the ability to put a plan together to start to address these types of challenges. What this shows us is we're getting dangerously close to being in an uncomfortable situation, and we need to take action to reverse that course. The time to act is now."

Houston's capital improvement program through 2020 calls for $8.72 billion of enterprise and property tax supported projects. About $7.1 billion will be paid for with income generated by the self-supporting enterprise funds. The rest will be funded with tax-supported public improvement bonds approved by Houston voters.

The city's outstanding debt payable from taxes and other revenue sources totaled $13.1 billion in fiscal year 2015, according to the certified annual financial report.

In April 2010, the city council adopted a rate ordinance resulting in an average rate increase of more than 20% for retail customers of the Combined Utility System. The new rate ordinance also altered the automatic rate adjustments. Future adjustments are tied to changes in the producer price index versus the consumer price index.

The Combined Utility System serves the Houston-Sugar Land-Baytown metropolitan statistical area, the sixth largest in the U.S. and second largest in Texas, with an estimated population of  6.3 million. The system provides water to wholesale users in neighboring communities through a vast network of reservoirs, pipes and treatment facilities. Lakes Houston, Conroe and Livingston are the major sources of surface water.

Lakes are currently full after heavy rains in 2015, and total supplies are expected to meet demands through 2060.

The system's wastewater is treated through 40 treatment plants with 440 pump and lift stations and more than 6,700 miles of wastewater lines. In fiscal 2015, average daily flow was 257 million gallons a day, less than half of the system's capacity.

The system is managed by the Department of Public Works and Engineering with a staff of 3,900 and an annual budget of about $1.8 billion.

The city has capital cost sharing agreements with other cities, water authorities, water districts, and a federal joint venture to meet the groundwater reduction plans.

While Houston's pension problems are onerous and require negotiated solutions, analysts see the city in a much better position than Chicago or Detroit.

In his final report as controller, Brown's predecessor and former boss Ronald Green noted that he is often asked if Houston could go the way of Detroit, the nation's largest city ever to file bankruptcy.

"To me, that's inconceivable," Green wrote. "Detroit had its debt problems mounting over years, years in which the population (hence, the revenue source) declined substantially."

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