OREANDA-NEWS. Fitch Ratings assigns an 'AA' rating to the City of Houston, Texas' (the city) \$75 million general obligation (GO) series G-1 bank notes.

The city will be substituting the current liquidity provider effective on or around Feb. 20, 2015.

In addition, Fitch affirms the following ratings:

--\$1.36 billion public improvement bonds (PIBs) at 'AA';
--\$9.7 million certificates of obligation (COs) at 'AA';
--\$184.7 million pension obligation bonds (POBs) at 'AA';
--\$200 million TRANs outstanding at 'F1+'.

(Fitch does not rate the city's outstanding PIBs, series 2008A, 2009A, taxable 2009B, 2011A, taxable 2011B, and 2014A. Fitch also does not rate the city's taxable POBs, series 2008A and 2008B).

The Rating Outlook is Stable.

SECURITY

Banks notes associated with the commercial paper program are payable from a limited ad valorem tax levied against all taxable property in the city, on parity with outstanding PIBs and POBs. COs are secured further by a subordinate lien against certain city revenues.

KEY RATING DRIVERS

SATISFACTORY RESERVES: Operating reserves presently are sound. The combination of increasing compensation outlays, a looming charter revenue cap and a weakening energy sector may erode reserve levels unless meaningful spending adjustments occur.

LARGE BENEFIT LIABILITIES: Debt levels are manageable and the pace of amortization is above average; however, when other long-term liabilities (pension, retiree health benefits) are included, the overall burden is large. The funding level remains weak for the municipal employee pension plan, particularly when a more conservative investment assumption is used, and annual payments to both the municipal and police plans have been less than actuarially-determined annual required contributions (ARC).

LARGE, DIVERSE REGIONAL ECONOMY: The expansive regional economy has continued to show impressive gains in recent months, although the recent plunge in oil prices is expected to slow the pace of growth over the near term.

BUDGET PRESSURES TO CONTINUE: Financial challenges remain, led by increases in benefit and public safety outlays. Voter approved property tax limitations may further restrict revenue and budget flexibility as early as fiscal 2016. Fitch assumes in its rating and Stable Outlook that management will take appropriate action to address these challenges.

RATING SENSITIVITIES

WEAKENED FINANCES, GROWING OBLIGATIONS: A material reversal of recent operating gains and corresponding declines in reserves, or continued erosion of pension funding levels, would be a negative credit consideration and could lead to downward pressure on the rating.

CREDIT PROFILE

Fitch has reviewed the interest rates, cure periods and amortization schedules specified in the documents governing the bank notes. Under the terms of the credit agreement, the city is required to amortize bank notes over a period of up to five years. At present, there are no bank notes outstanding.

Fitch believes the city's current financial profile and presumed market access (to take out notes with long-term debt) largely mitigate the concern that repayment of the bank notes could pressure the city's financial performance if the entire authorization were to become bank notes for an extended period of time.

ECONOMIC PERFORMANCE BOOSTING REVENUES; PRESSURES CONTINUE

Both sales and property tax revenues recorded impressive gains over the past three fiscal years, with sales tax receipts posting a cumulative 15% increase and property taxes climbing 13% over this timeframe. These two sources combine to produce roughly three-quarters of general fund revenues.

The city recorded positive financial performance in two of the past three fiscal years, reversing a pattern of annual shortfalls from fiscal 2009-2011 that brought reserves near the city's formal minimal policy level (unassigned balance at 5% of spending). Aided by aggressive cost cutting and better than expected revenue totals, the general fund recorded a cumulative operating surplus after transfers of roughly \$108 million in fiscal 2012 and 2013. At fiscal 2013 year-end, the unrestricted general fund balance totaled \$197.8 million or 9.6% of spending and transfers out, up \$50 million from fiscal 2011.

Operating results turned negative in fiscal 2014, as continued wage and benefit pressures boosted general fund spending up 9% over the prior year. Although revenues posted a solid gain of nearly 7%, the increased spending and larger debt service transfer contributed to a net deficit after transfers of \$14 million. At \$204 million, the year-end unrestricted general fund balance was a satisfactory 9% of spending. General fund liquidity remained sound, with fiscal 2014 year-end cash and investments at \$248 million or roughly 48 days of spending.

The fiscal 2015 budget reflects continued spending pressures, led by a more than 20% increase in pension contributions and pay increases for police and municipal workers. General fund spending is slated for a 7.4% increase from the prior year budget. Revenues were budgeted for a similar 8.5% gain, with property and sales taxes projected to climb more than 12% and 5%, respectively. The adopted budget included an operating gap of \$48.5 million, but better than forecast revenue and spending totals are expected to shrink the budget gap by up to \$22 million.

Management has expressed its commitment to maintaining the unassigned general fund balance at its 7.5% of spending policy target, while acknowledging additional benefit and personnel cost pressures. The mayor's fiscal 2015 budget message also noted the possibility of 2004 voter approved property tax revenue caps limiting revenue gains in fiscal 2016, which if realized would force the city to look at additional spending reductions.

LONG-TERM LIABILITIES SIZABLE

Fitch considers Houston's overall debt levels above average at roughly \$4,880 per capita but more moderate when measured against the tax base at 4.4% of market value. The pace of tax-supported debt retirement is above average, with two-thirds retired in 10 years. The city also maintains multiple GO commercial paper programs to provide interim capital financing. The total authorized amount is \$875 million, and the amount outstanding at March 31, 2014 was \$212 million. The city's five-year general government capital improvement plan is up moderately from prior plans, with streets and drainage the largest components. The city anticipates that the majority of tax supported components of the plan will be debt funded.

The city has three single employer defined benefit pension programs--for municipal, police and fire employees. Fitch considers the large unfunded liabilities in the municipal and police plans and the pressures associated with improving and maintaining funding levels for all programs significant credit concerns.

The city's efforts in recent years to address the pension funding issue have included negotiated benefit adjustments, contribution increases, pension obligation borrowings, and in-kind contributions. In 2011, the city and the municipal employee association agreed to a multi-year agreement that included increased city contributions to the pension plan. The current police pension funding agreement expires in 2023 and also calls for increased contributions from both the city and police employees.

The firefighter pension plan is governed by state statute, which defines both benefits and the amount of required contributions. The city recently sued the firefighter pension plan, challenging the governing statute as unconstitutional. The trial judge ruled against the city, and the city has appealed this decision.

City contributions to the municipal and police plans have met the contractual requirements, but the payments have fallen short of the actuarially-determined ARCs. The city's expectation is that as the combination of benefit adjustments and increasing contributions take effect, the assets of these two systems will be sufficient to meet obligations as they come due. Fitch cautions that an inability to close these funding gaps and corresponding increases in pension liabilities would not be consistent with the current rating and likely would result in negative rating action.

The funding level for the municipal plan, when adjusted for a more conservative 7% investment return assumption, is estimated at a low 50%; the police and fire plans are in somewhat better shape at roughly 70% and 74% funded, respectively (assuming a 7% return). Other post-employment benefits (OPEB; retiree healthcare) also represent a sizable liability, but recent program changes have shaved the total liability by one-third from \$3.1 billion to \$2 billion, which equals less than 1% of fiscal 2015 market value.

Fitch views positively the plan for increased contributions over the near term, but these additional outlays likely will continue to pressure the city's operations. Evidence of this pressure is found in the high fiscal 2014 carrying cost (combined debt service, pension ARC and OPEB payment) of more than 26% of governmental spending.

OIL PRICE COLLAPSE CLOUDS OTHERWISE STRONG ECONOMIC PICTURE

The post-recession recovery of Houston's regional economy has outpaced that of many other large U.S. cities, as a robust energy sector, the Port of Houston and healthcare all contributed to recent population and employment gains. Regional employment continued to register solid gains in the latter part of 2014, posting a 3.5% increase in the 12-month period ending in December 2014; the local unemployment rate of 4.1% for the month was down from 5.5% in the same period last year and is consistent with the state average and below the U.S. rate (5.4%). The metro population continues to expand at an annual rate of roughly 2%, in line with state growth trends and double the U.S. average.

The recent plunge in oil prices will materially affect the pace of economic growth in the city over the near term. Houston is home to several thousand energy companies, ranging from large multi-national concerns to numerous mid-sized to smaller exploration, construction, engineering and service companies. While growth in other sectors (e.g. shipping, healthcare) has reduced dependence on the energy sector over the past several decades, direct employment in the sector was 4% of the 2014 regional total. Estimates of the oil and gas contribution to Houston's 2014 GDP range from 15%-20%, and when associated industries are included the share of GDP increases to 35%-40%.

A number of energy companies have announced layoffs in recent weeks, including Schlumberger, Halliburton and Baker Hughes. Total job loss estimates vary, but projections for 2015 Houston employment gains are sharply lower than the 100,000 annual increase in jobs the city has experienced recently.