OREANDA-NEWS. Fitch Ratings assigns the following ratings to the Michigan Finance Authority, MI (the authority) local government loan program revenue bonds issued on behalf of the city of Detroit (the city) for the Detroit Water and Sewerage Department (DWSD):

--Approximately $156 million DWSD sewage disposal system revenue refunding second lien local project bonds, series 2015C 'BBB-';
--Approximately $89.9 million DWSD water supply system revenue refunding senior lien local project bonds, series 2015D-1 'BBB';
--Approximately $38.8 million DWSD water supply system revenue refunding second lien local project bonds, series 2015D-2 'BBB-'.

The bonds are scheduled to price the week of Nov. 30 via negotiation. Proceeds will be used to refund certain DWSD sewer system and water system (the systems) debt for interest savings and pay costs of issuance. Purchasers of the authority bonds are deemed to be consenting to the assumption of DWSD's bonds by Great Lakes Water Authority (GLWA)-subject to certain conditions precedent-which would be responsible for the repayment of DWSD's bonds.

At this time, Fitch also affirms the following city and authority bonds issued on behalf of DWSD:

--$1.2 billion in senior lien water revenue bonds at 'BBB';
--$585 million in second lien water revenue bonds at 'BBB-';
--$1.8 billion in senior lien sewer revenue bonds at 'BBB';
--$698 million in second lien sewer revenue bonds at 'BBB-'.

The Rating Outlook is Stable.

SECURITY

Senior lien water and sewer bonds are separately secured by a first lien on net revenues of each respective system. Second lien bonds are separately secured by a second lien on the net revenues of each respective system after payment of senior lien bonds.

KEY RATING DRIVERS

ADEQUATE FINANCIALS ON OPERATIONAL IMPROVEMENT: Ongoing actions by DWSD have led to stabilized and improved financial results from prior years. Further gains are forecasted over the coming years.

LEASE REINFORCES SEPARATE OPERATIONS: All system funds and accounts are separate and distinct from other city funds including the city's general fund. The planned lease of the systems by GLWA provides further assurance that system operations will remain independent of the city.

HIGHLY LEVERAGED DEBT PROFILE: The systems' debt load is expected to remain elevated for the foreseeable future as a result of legacy issuances and ongoing borrowings. Over the longer term, it is envisioned a greater use of pay-go capital funding will alleviate debt pressures to some degree.

EXPANSIVE SERVICE TERRITORY: The systems provide essential services to a broad area. The water system covers almost 40% of Michigan's population, with over 75% of operating revenues coming from wealthier suburban customers. The sewer system includes around 30% of Michigan's population, with over 50% of operating revenues coming from suburban customers.

STRONG RATE-ADJUSTMENT HISTORY: The governing bodies have instituted virtually annual rate hikes in support of financial and capital needs. Continued annual adjustments are included in the forecast but the pace of growth should be less than in prior years.

RATING SENSITIVITIES

CONTINUED FINANCIAL AND OPERATING GAINS: Demonstration of consistent and steady improvement in the financial and operating profiles of the respective water and sewer systems could lead to upward rating movement over time.

CREDIT PROFILE

ADEQUATE FINANCIALS ON IMPROVING OPERATIONS

Unaudited 2015 financial results point to total debt service coverage (DSC) for the water system of just under 1.1x (as adjusted by Fitch to include non-operating pension and pension certificate payments to the city), close to previous forecasts despite an 8% reduction in water sales during the year from an extremely wet spring/summer. For the same period total sewer DSC was nearly 1.2x.

Financial results have stabilized over the last couple of years from previously poor levels, including years where total DSC for both systems was below 1.0x. Improvement in financial results is attributable to DWSD's efforts both to enhance revenues and cut operating costs.

On the revenue front, DWSD has been working extensively to reduce retail delinquencies, which has included stepping up outreach to customers. As a result, current collections have improved, and since May 2015 customers scheduled for shut-offs have declined from 26,000 to 6,000 while customers with payments plans have increased from 24,000 to 42,000.

DWSD also adopted changes with its wholesale water customers beginning in fiscal 2016 to revise purchase estimates and shift to an increasing amount of fixed monthly charge recovery. These changes are similar to the implementation of a rate simplification initiative for wholesale sewer customers effective for fiscal 2015 that identifies each customer's proportionate costs based on historical average shares, with such shares billed monthly and locked in for three years before being subject to recalculation.

On the expense front, management continues to implement its organizational optimization, which has entailed cutting the number of job classifications in recent years and reducing by nearly 40% DWSD's workforce from 2011 to 2015 as well as leading to increased automation, with some additional gains possible in the future. As a result, operating expenses have trended downward over the last several years, although the systems will face cost escalation over the next several years (fiscals 2015-2023) in light of $409 million in costs associated with the DWSD's share of the city's prior general retirement system negotiated as part of the city's bankruptcy process.

A major credit concern in recent years has been DWSD's poor financial results and inability to meet its forecasts which in turn led to uncertainty as to ongoing minimum performance levels. Recognizing these projection issues, management last year undertook a systematic reevaluation of underlying forecast assumptions. For the most part assumptions were revised to more conservative levels, particularly with regard to sales and bad debts and also included certain costs related to the city's bankruptcy plan of adjustment, particularly those surrounding pension costs.

The assumption changes resulted in lower forecasted margins but appear to provide a greater measure of certainty as to baseline results and the ability to absorb negative budget variances. DWSD's latest projections (as adjusted by Fitch to include non-operating and pension certificate payments) point to water DSC of 1.3x for fiscal 2016, rising gradually each year to 1.5x through the fiscal 2020 forecast period. Similarly, total sewer DSC (per Fitch's adjustment for non-operating and pension certificate payments) is 1.2x in fiscal 2016, climbing to 1.4x by fiscal 2020. Assuming DWSD is able to continue meeting or exceeding these figures positive credit action could ensue.

ASSET LEASE REINFORCES SEPARATION

The newly-created GLWA entered into 40-year leases of DWSD's respective water and sewer systems as well as a water and sewer services agreement with the city in June 2015. The leases become effective after completion of certain conditions, including consent by the majority of bondholders, receipt of various legal opinions, contract assignments, permit transfers, and the adoption of a master bond ordinance relating to the respective systems' debt. The estimated completion of the conditions is Jan. 1, 2016.

Fitch views the transition of systems to GLWA control as detailed in the agreements and supporting documents as a credit positive for bondholders, principally because it codifies the legal separation between the systems. DWSD has operated with increasing independence from the city in recent years (including a separation of staff and financial accounts) and Fitch expects this would continue without the leases becoming effective. However, despite DWSD's operating independence from the city, DWSD was still included as part of the city's recent bankruptcy proceedings which cost the systems around $28 million in professional and insurance fees during fiscal 2015 alone as well as requiring significant staff efforts. With the leases, all DWSD regional assets will be conveyed to GLWA along with a right and title to all system revenues thereby insulating the system from being included in any future city bankruptcy proceedings, if one were to occur.

Key terms of the agreements, which are embedded in the financial projections associated with this sale, include a $50 million annual lease payment to the city, although such monies may only be used at the city's option to fund pay-go capital improvements related to the city's local water and sewer systems or debt service related to the city's local systems and/or GLWA. A $4.5 million assistance program will also be funded and replenished annually as part of GLWA's budget for low-income customers throughout GLWA's service territory. In addition, a budget stabilization fund will be funded from city retail customers (initially over a three-year period) to ensure monies are available to meet the city's portion of GLWA's annual revenue requirement. Deposits required to fund the lease payment and other created accounts like the assistance account will occur subsequent to payment of debt service, although these are added costs that ratepayers will absorb.

SYSTEM LEVERAGE REMAINS HIGH

Fitch expects leverage for both systems to remain high for the foreseeable future. DWSD's system long-term debt per capita totaled a high $1,158 for sewer and moderately high $618 for water for audited fiscal 2014. Principal payout is relatively typical for sector credits at around 80% over 20 years for both water and sewer.

The systems' 2016-2020 current estimated capital improvement plans (CIPs) have increased from last year's estimates to $796 million (an 18% increase) on water and $594 million on sewer (7%). Along with these increases, additional borrowings are also expected, although transition to more pay-go funding is expected over time. For water, planned borrowings through the CIP period are estimated at $520 million while sewer borrowings are anticipated to total around $161 million.

The rise in projected water capital costs and borrowings stem from the recent completion of the updated water master plan, the first since 2004. One major consideration of the update was to evaluate the feasibility of reducing or repurposing certain water treatment plants as well as distribution mains in order to more actively match asset capacity to needs over the next 20 years. The updated master plan results in significant near-term investment but these costs are expected to moderate over time. These additional capital costs are factored into DWSD's projections.

BROAD SERVICE AREA ENHANCES SYSTEM STABILITY

The water system is a regional provider serving around 3.8 million people or almost 40% of Michigan's population, including the city's population of around 680,000. The system serves the city on a retail basis and 127 communities through 83 wholesale contracts. The service territory consists of 138 square miles in Detroit and 981 square miles in eight counties.

The sewer system is a regional provider serving around 2.8 million people or around 30% of Michigan's population, including the city. The system serves the city on a retail basis and 76 communities through 18 wholesale contracts. The service territory consists of 138 square miles in Detroit and 850 square miles in three counties.

Population and customer growth for both systems have experienced modest annual declines for a number of years. Detroit's population in particular has experienced continuous decline, but suburban areas have picked up most of the migration.