Fitch Rates Houston, TX $65MM POBs 'AA-'; Outlook Revised to Stable.

AUSTIN, Texas -- Fitch assigns an 'AA-' rating to the $65 million taxable pension obligation bonds, series 2007A of Houston, Texas. Additionally, Fitch affirms the 'AA-' rating on the city's $1.9 billion in general obligation bonds, $81.3 million in certificates of obligation and $2.3 million in tax notes outstanding. The Rating Outlook is revised to Stable from Negative.

Proceeds will fund a portion of the annual contribution to the pension systems for municipal employees and classified police officers of the city. The bonds are scheduled for a negotiated sale through a group led by Goldman, Sachs & Co. on or about Feb. 6.

The revision in Outlook to Stable from Negative results from voter passage of Proposition G in November 2006, which eases revenue restrictions approved by voters two years earlier. With Proposition G the city now will exclude enterprise fund revenues from the previously approved charter revenue limitations. Proposition 1 was a city council initiative and targets only ad valorem tax revenue and water and sewer system rates. Proposition 2, which was a citizen initiative, is much broader, covering combined revenues of essentially all city operations and has the potential to more severely restrict revenue growth.

Propositions 1 and 2 are conflicting, and litigation is ongoing to resolve the inconsistencies. A district court ruled in January, 2006 that the city must implement both Proposition 1 and Proposition 2, despite a city attorney opinion that only Proposition 1 is legally binding since it received the larger number of votes in the 2004 election. The city has appealed the court's final ruling. Houston continues to budget in compliance with both measures.

Fitch believes the approval by voters of Proposition G removes the most onerous component of Proposition 2 by excluding enterprise system revenues from the revenue limitations; this component had the potential for reductions in basic services if enterprise system revenues increased significantly. In addition, the approval in November 2006 of another ballot measure-Proposition H-adds $90 million in public safety spending for fiscal 2007 and boosts the base revenue amount for subsequent years, thereby reducing the impact of another restrictive component of Proposition 2. A voter has filed suit challenging both Proposition G and Proposition H, claiming that both measures violate state law. The city disputes this, and both measures presently are in effect.

Fitch notes that the outcome of the appeals process relating to Propositions 1 and 2 may require the city to operate under both limitations. However, with Propositions G and H, Fitch believes the financial flexibility of the city has been measurably enhanced. Fitch will continue to monitor the litigation proceedings for all propositions.

The 'AA-' rating reflects positive credit considerations which include a broad and strengthening economy, a moderate direct debt burden, and satisfactory general fund reserves. In addition to the revenue limitation measures, another negative credit factor is the city's large unfunded pension liabilities that are expected to increase over the near term.

Despite recently agreed upon program changes and funding commitments that have reduced the $1.8 billion unfunded actuarial accrued liability (UAAL) of the city's municipal employee pension system by an estimated one-half, that program and the police officers' and firefighters' pension plans all face potentially sizeable increases in UAAL over the near term. In addition, Fitch views the city's decision to make pension contributions at less than the actuarially required amount as an indication of financial stress.

The impact of pension-related borrowing as currently envisioned is expected to have a minimal effect both on the city's capital improvement plan and projected debt service tax rates. The city's debt ratios, both on a per capita basis and as a percentage of taxable assessed valuation (TAV) are moderate; the pace of repayment on the city's tax-supported debt is average.

The general fund has reported healthy net income in three of the past four fiscal years, and reserves have increased as a result. Fiscal 2005 ended with net income of $34.4 million, and the unreserved fund balance of $142.7 million or 9.3% of spending and transfers out was up sharply from the prior year. Preliminary results for fiscal 2006 anticipate a modest operating loss and an increase in general fund reserves of roughly $60 million. The fund balance gains in both fiscal 2005 and 2006 were aided by proceeds from offerings of pension obligation bonds. Liquidity levels also have improved markedly over the past three fiscal years; the fiscal 2005 general fund cash and investments total was $111.7 million, compared to $27.7 million in fiscal 2002.

Houston's healthy local economy is evidenced by various measures, including sales tax revenue collections and TAV growth. Sales tax receipts grew 7.9% and 6.5% in fiscal 2004 and fiscal 2005, respectively, after declining in fiscal 2003. Preliminary results suggest a robust 14% increase in receipts for fiscal 2006, and year-to-date totals for fiscal 2007 are running ahead of budget projections. The city's fiscal 2007 TAV climbed a healthy 9.7% to $122 billion. This gain followed a 5.4% increase in fiscal 2006.

Local unemployment rates also are down from recent recessionary highs; the city's November 2006 rate of 4.9% is significantly below the 2003 average (8.3%). Single family building permits issued in the Houston metropolitan area in 2006 reached an all-time high, and the estimate for 2006 Port of Houston tonnage also was at a record high.

Completion of the city's fiscal 2006 audited financial statements has been delayed, which city officials attribute to implementation of a new financial management system. Completion of the audit is expected by mid-February 2007, and staff has expressed its confidence that the audited results will be in line with current preliminary totals.

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