Recently a concerned reader asked: “If Houston’s finances are so atrocious, then why does the City still have a credit rating of AA?” I answered him, “You should call and ask them; please let me know what they say. And, while you’re at it, why don’t you ask them how they did in the mortgage collapse?”
The question is serious; the answer requires review of three areas: what the rating agencies consider, the rating agencies’ track records, and the new dangers in municipal financial practices.
For general obligation (“GO”) bonds, the rating agencies look at the tax bases to assess if the City can pay its debts. They do not consider the cost of providing even minimal services, such as public safety or infrastructure repair. They believe that their security is their ability, in the event of default, to step in and compel a property tax increase – in Houston, sales taxes are already at the maximum rate permitted by the State). Also in Houston, it is not clear to me if they consider property tax caps contained in Prop 1 or Prop 2, which are legally binding charter amendments. So, while our tax rates could conceivably support higher debt and property tax payments, it may not be possible legally or politically to increase taxes high enough to avoid or cure default.
It also is not realistic to expect a sufficiently high percentage of revenues to be devoted to debt payments to exclude critical city services. More fundamentally, an effort to increase property taxes ironically would drive down the very property values they seek to tax further. History has shown that high property taxes cause residents to flee and new buyers choose surrounding suburban alternatives rather than paying taxes to repay indebtedness incurred to fund past services. The City of Houston, with its record levels of property and sales taxes, is already suffering population decline as its suburbs boom.
As far as the rating agencies’ history of prognostication, that is a series of sad and well-known stories. He are a few examples: On October 29, 2001, Moody’s downgraded the credit rating of Enron from Baa1 to Baa2; despite this downgrade, Enron was still considered “investment grade” by all major rating agencies. On December 2, 2001, just five weeks later, Enron filed for Chapter 11 bankruptcy protection. In March 2008, after AIG posted a $5.3 billion loss for the fourth quarter of 2007, Moody’s reaffirmed the senior unsecured debt rating of Aa2 for AIG. In the fall of 2008, AIG collapsed, precipitating a $182.3 billion government bailout. The record of other rating agencies is comparable. The US Justice Department has recently won substantial judgments against the major rating agencies, including Standard & Poors, regarding the mortgage debacle of the last decade.
To return to what the agencies consider, one thing they do not consider in a municipal context: oil prices. (Please see the HBJ article, “What Happens if Oil Prices Stay Down and Interest Rates Don’t?”) The Houston commercial and residential real estate markets are already reacting to the oil price slide. Property values and property tax revenues will soon follow. New Texas State Controller Glen Hegar recently stated in the Bond Buyer magazine that Texas sales tax revenues have begun to plateau, given the reduction in sales taxes from oil service companies’ materials purchases. Have past ratings been re-issued to reflect changes in the City’s underlying economic fundamentals, and to warn bondholders of increasing financial risks?
Despite all the attributes that comprise Houston’s great success and reputation, there is a part of Houston’s history that is troublesome – Houston has been the center of repeated financial scandals – recall Enron, Stanford, the Savings & Loan debacle. Imagine if, of all entities, the CITY of Houston became the next to join the long line of defaults.
The main consequence of Enron’s failure wasn’t just the losses suffered by investors on Wall Street, bad as this was. It was that many PEOPLE in and around Houston – employees, vendors, local shareholders and pension accounts – all of whom believed in the promise of Enron and the promises of its leadership – were hurt. Yes, Wall Street recovered, but families lost their jobs and life savings endured the pain for a long time.
The same thing will happen if and when the City of Houston defaults on its debt – whether that debt is in municipal bonds or in pension plans that cannot be paid. Two of the largest pools of the nation’s savings are municipal bonds and pension funds. When cities default on their obligations, it is PEOPLE who get hurt. When the S&L’s failed in the 1980’s, and when the 2008 financial crisis caused the subsequent banking collapse, the institutions and/or their depositors were bailed out by the federal government. But, the government has not bailed out the creditors of any bankrupt city; I don’t see the federal government bailing out the City of Houston, its pensioners or its bondholders.
Now, to come full circle to our reader’s question: Richard Ciccarone, president and CEO of Merritt Research Services, recently stated in a major three-part report receiving widespread acclaim in the municipal finance circles, “the Achilles heel for many cities remains the escalating burden of the dollars that they owe to pay existing and future retirees. In addition, many cities have deferred infrastructure financing….From that perspective, today’s high concentration of city (bond ) ratings in the upper two brackets (AAA and AA) appears to paint too rosy a picture for a number of cities whose categorical legal protections, including those associated with a general obligation bond, earn them better ratings than their fundamental characteristics deserve. Accordingly, these cities may be less motivated to significantly correct their deficiencies or resize their governments than if they were more accurately distinguished by the rating agencies or the market.” (http://www.muninetguide.com/articles/assessing-the-credit-quality-of-americas-cities–part-one–f-726) In other words…pensioners and bondholders, beware.
The parallels to past scandals – as well as the City’s irresponsible financial management and phantom regulatory protection offered by the rating agencies — are what frighten me most.
A version of this article was submitted to the Houston Business Journal in April 2015.