Rating Update: Moody's affirms City of Houston's, TX Aa2 GOLT; revises outlookto negative

Global Credit Research - 02 Jul 2015

$3 Billion in debt outstanding

HOUSTON (CITY OF) TXCities (including Towns, Villages and Townships)TX

NEW YORK, July 02, 2015 --Moody's Investors Service has affirmed the Aa2 on the City of Houston's, TXgeneral obligation limited tax debt. The outlook has been revised to negative. The city has a total of $3 billion indebt.

SUMMARY RATING RATIONALE

The Aa2 rating continues to reflect a large tax base benefitting from a robust Houston economy that serves as theworld's capital for oil and gas. Despite the recent downturn in oil prices, Houston's economy continues tobenefitting from other key sectors including the healthcare, transportation (port), education and downstreamenergy. Although, the city's fiscal health remains challenged by rising expenditures from increased demand forservices, and fixed costs (pension, OPEB, and debt), the rating incorporates recent positive General Fundperformance which have improved the reserve position. Also considered is the current overall manageable debtprofile.

OUTLOOK

The outlook revision to negative reflects the challenges the city faces from growing pensions costs and liabilities,which are compounded by significantly limited revenue raising flexibility, and projected structural imbalance. Infiscal year 2014, fixed costs (pension, OPEB and debt) equaled about 30% of the budget. In the city's threepensions systems, the total unfunded liability, as reported, equaled $3.2 billion, at fiscal year end 2014; nearlydouble the liability reported five years ago. Current forecasts indicate increased pension costs, which could furtherweaken the city's financial position which include budget gaps in the five year projection. A sustainable plan tomanage the costs, while balancing the budgets, and meeting full required contributions will be key creditconsiderations going forward.

WHAT COULD MAKE THE RATING GO UP/Revised outlook to stable

-Improved financial position that incorporates controlled expenditure growth and ability to raise revenues

-Managed pension obligations that do not threaten the city's fiscal health; structurally balanced operations with fullrequired pension contribution

-A trend of increased reserves

WHAT COULD MAKE THE RATING GO DOWN

-Failure to address projected deficits either through improved revenue flexibility, reduced spending or acombination thereof

-Sustained trend of imbalanced operations depleting reserves

-Significant economic loss related to a softening labor market

STRENGTHS

-Robust economy; regional economic center with global leadership in oil and gas that supports professional andtechnical jobs

-Significant trade and export links, owing to location on Texas Gulf Coast

-Positive economic and demographic trends driving growth in tax base and sales tax

-Recently adopted financial ordinance improves minimum GF levels, sets expectation regarding unbudgetedrevenues flowing to fund balance, to improve overall liquidity

CHALLENGES

-Cost structure includes rising fixed obligations expected to increase over the medium term

-Significantly limited revenue raising flexibility with restrictions imposed by Propositions 1 and H offsetting effect ofpositive taxable value trends

-Economic exposure to volatile oil and gas industry retraction

-Population growth drives increased service demands

-Continued reliance on tax anticipation and revenue notes (TRANs)

RECENT DEVELOPMENTS

Fiscal year 2015 is expected to result in an increase in the General Fund based on the April Monthly FinancialReport.

DETAILED RATING RATIONALE

ECONOMY AND TAX BASE; LOCAL ECONOMY SHOWS GROWTH AT A SLOWER PACE

The City of Houston is the largest city in the state, and the fourth largest city by population in the U.S.. Located inHarris County (Aaa, stable outlook), the city serves as the global leadership center for oil and gas. Othereconomic drivers include the healthcare and port industries. The recent and prolonged decreases in gas priceshas had a negative impact on the local economy. Although overall growth is continuing, the pace has softened,and uncertainty remains about the growth trajectory as long as oil prices remain low. Houston is not an oilproducer, but it serves as home for thousands of corporatejobs in the oil industry. Following overall positive trendsin monthly change in employment in 2013, and 2014, the Bureau of Labor Statistics reported relatively flat tomodestly negative (less than 0.5%) growth in employment through April 2015. On the positive note, Houstoncontinues to experience strong petrochemical activity in the gulf, a consequence of low natural gas prices, withcurrent projects estimated at over $30 billion. Moody's Analytics reported in March 2015 that sharply lower oilprices will limit growth in the Houston metropolitan area. However, the area is expected to avoid an outrightdownturn due to gains in nonresidential construction, transportation, housing, healthcare and local government.Over the longer term, above average population growth and expansion in energy, housing and distribution isexpected to propel above-average gains for the metropolitan area.

Historically strong population growth has fueled demand for residential construction. Population grew 7.5% to 2.1million in 2010 from 2000, following the almost 20% increase in the prior Census. The growth, coupled withcommercial development, has resulted in growth in taxable values, parallel to the boom experienced in the localeconomy. Over the past five years, taxable values grew an increase of 4.6% annually with substantial increasesof 10.2%, and 11.8% in fiscal years 2014 and 2015 respectively, to reach a total of $187.9 billion. Preliminaryvalues for fiscal year 2016 reflect growth, but moderated at over 6%. Major taxpayer concentration within the cityis modest, with the top 10 accounting for less than 5% of the total values in fiscal year 2015. The city's March2015 unemployment rate of 3.9%, was less than both the state's 4.2%, and the nation's 5.6% taken during thesame time period. Per the 2010 American Community Survey, the city's median family and per capita incomeswere 74.8%, and 94.9% of national levels.

FINANCIAL OPERATIONS AND RESERVES; RECENT GF INCREASES STRENTHENS LIQUIDITY,FINANCIAL PROFILE IS CHALLENGED BY RISING FIXED COSTS AND LIMITS ON REVENUE RAISINGABILITY

The city's financial position has improved with year over year surpluses growing the General Fund balance,following several years of deficits. Prior to fiscal year 2012, weak property and sales tax revenues driven by theeconomic downturn, as well as rising obligations, resulted in multiple years of poor financial performance. Betweenfiscal years 2009 and 2011, the General Fund balance reported a draw of $163.1 million on the aggregate,

reducing the balance to a limited $168.6 million (8.4% of revenues). Since then, a strong recovery in revenues, aswell as significant expenditure reductions including layoffs, resulted in strong operating performance. Moody'snotes expenditures reductions have not been sufficient to cover the entire portion of the annual requiredcontribution and the city has underfunded the pension plans by a total of $247.4 million between fiscal years 2012and 2014. A total surplus of $107.7 million grew the fund balance to $276.3 million (an adequate 13% of revenues)at fiscal year end 2013. In fiscal year 2014, the General Fund as reported, reflected a $14.1 million deficit, reducingthe balance to $262.3 million (11.8% of revenues), with an unassigned of $200.7 million (9.2%). This level is abovethe recently (November 2014) adopted codified policy of 7.5%, up from the previous 5%. Total operating funds,including the General and Debt Service funds, was $338.8 million (15.4% of operating revenues).

The General Fund as reported in the audit includes several other sub funds. The true General Fund, "GeneralFund 1000", is the main operating fund of the city, reported a total balance of almost $220 million (9.9% ofrevenues) at fiscal year end 2014. The increase is more positive than the $33.3 million budget draw for staffingneeds, and contractual compensation increases adopted at the start of the fiscal year. The General Fund 1000numbers are unaudited and reported based on financial reports available on the city's website. Fiscal year 2015continues the positive operating performance trend with an increase to $240 million expected in the General Fund1000. Current reserve levels are above the city's codified policy, which was recently (November 2014) increasedto 7.5% from the previous 5%. The city's recent improvement in its financial position is a strength, and key to therating affirmation.

Despite recent improvement in the financial profile, the city's financial position is significantly hindered by limitedrevenue raising flexibility, and challenged by rising fixed obligations. Although a growing economy is drivingtaxable value increases, the city's revenue potential is restricted by Proposition 1 and H. Proposition 1 limitsrevenue increases to the lesser of population growth plus inflation, or 4.5%. Proposition H allows the city to raiserevenues by $90 million above the Proposition 1 limit for public safety issues. The fiscal year 2016 budget reflectsan $85.9 million gap as contractual increases in pay and pension contributions continue to drive up expenditures.Near to medium term projections (FY 2017 to 2020) reflect gaps that average $121.2 million annually during theperiod as increases in financial obligations continue; the lowest draw of $103.1 million is in 2019, and the largestdraw is $148.6 million in 2018. The projections also reflect a maintenance of approximately $154 million (7.5% fundbalance policy requirement), and about $21 million (1% budget stabilization fund), with the assumption that the gapis eliminated in each fiscal year. Although the forecast outlines some strategies including a ballot initiative toalleviate revenue limitations, and pension reform, consistent draws and the inability to eliminate the budget gapsare credit weaknesses that could result in downward rating action.

Liquidity

At fiscal year end 2014, the General Fund as reflected in the audit, reported total cash and investments of $248.3million (11.2% of revenues). Total operating cash, including the General and Debt Service funds, was $352.9million (16.1% of revenues), also at fiscal year end.

DEBT AND PENSIONS; PENSION OBLIGATIONS ARE LARGE AND GROWING, PRESSURING THECREDIT PROFILE

The city's debt profile is manageable with a direct debt burden of 1.7% (5.4% overall), on a fiscal year 2015valuation. The overall debt burden is elevated given a large number of cities, school districts, and municipal utilitydistricts. The direct debt incorporates the city's $2.5 billion in general obligation limited tax obligations, about $600million in pension obligations, with $60 million self supporting from the utility system, $111.9 million in generalcommercial paper obligations, and $16.4 million in certificates of obligations. Payout is below national medians with66.3% of principal retired in 10 years. The city's proposed capital improvement plan (CIP) calls for $628.5 millionfor the public improvement program; 33% of which is expected to be cash funded. The debt profile is expected toremain manageable given our expectation of continued albeit slower, taxable value growth over the medium term.

Debt Structure

The city's debt service schedule calls for an increase in debt service through fiscal year 2018, before descendingannually until final maturity in 2043.

As mentioned above, the city utilizes a commercial paper program ($111.9 million of the $835 million outstandingas of April 30, 2015) for capital purposes, in anticipation of periodic long term bond issues. External liquidity for theprogram is provided by external liquidity with eight banks, all of which have P-1 short-term ratings. The city has nogeneral government swap exposure.

The city issues a tax and revenue anticipation note (TRAN) annually for cash flow purposes given that a majorityof the revenues are derived from property taxes generally received by February 1st, and cash begins to runnarrow by the summer. In fiscal year 2014, the city issued $180 million on July 2, 2013, which was repaid on June30, 2014. Officials expect annual issuance of TRANS will continue in the near to medium term.

Debt-Related Derivatives

The city is not party to any derivative agreements.

Pensions and OPEB

The city maintains three pension plans: Houston Municipal Employees Pension System, Houston's Police OfficerPension System, and Houston's Firefighters Relef and Retirement Fund. Budgetary pressure relating tounderfunding of the city's three pension systems is expected to increase and remain a challenge for the city,particularly in light of statutory revenue limitations. The city's contributions to the municipal employee and policeofficer systems are dictated by "Meet and Confer" agreements. Over the past five years, the contractually requiredamounts have been paid for the Municipal and Police systems. However, these amounts fall short of the annualrequired contribution (ARC). For the Firefighter System, state law requires the city's contribution to be the greaterof two times the firefighters' contribution, or a rate determined actuarially once every three years with no flexibilityfor negotiation. The city has historically contributed over 100% of the ARC, with the exception of fiscal year 2013.Near to medium term projections reflect increases in pension obligation for several reasons including: 1.) TheFirefighter plan includes an increase of 2% annually in contributions, 2.) the Police plan mandates additionalcontributions to the plan in any year the funded ratio dips below 80% to restore it to that threshold (historicalexpectations are this will occur in FY 2017, with each 1% equally $50 million), 3.) a repayment of a $25 milliondeferred payment to the police plan, and 4.) generally rising obligations. While the city maintains its ability toreduce expenditures or increase revenues as necessary, viable revenue raising flexibility is weak givenconstraints imposed by the propositions.

As reported, the city's unfunded actuarial accrued liability (UAAL) for the Municipal, Police and Fire systems were$1.7 billion, $939 million, and $532.7 million respectively, for a total of approximately $3.2 billion at fiscal year end2014, not considering any self supporting contributions from enterprise systems. Also as reported, the fundedratios were 57.7%, 81.2%, and 86.6% respectively. This liability has almost doubled from the $1.8 billion at fiscalyear end 2010. Current projections reflect an increase in contribution. However, total contribution for all three plansremain below the total required amount, potentially causing an escalation in liabilities. As mentioned above, theinability to raise meaningful revenues, and an acceleration in costs are credit challenges reflected in the negativeoutlook.

Moody's adjusted net pension liability (ANPL) for the city, under our methodology for adjusting reported pensiondata, is a total of $10.7 billion in fiscal year 2014, not considering any self supporting contribution. This liability is anelevated 4.86 times of operating revenues, including the General and Debt Service funds. The ratio is also a high6.35% of the city's valuation. Moody's ANPL reflects certain adjustments we make to improve comparability ofreported pension liabilities. The adjustments are not intended to replace the city's reported contribution information,or the reported liability information of the statewide cost-sharing plans, but to improve comparability with otherrated entities. For more information on Moody's insights on employee pensions and the related credit impact oncompanies, governments, and other entities across the globe please visit Moody's on Pensions atwww.moodys.com/pensions.

The city offers other post employment benefits (OPEB) to its employees and the benefits are currently funded on apay as you go basis. In fiscal year 2014, the city paid 18.6% of the annual OPEB cost. At fiscal year end, theunfunded OPEB liability was $2.1 Billion.

MANAGEMENT AND GOVERNANCE

Texas cities have an institutional framework score of "Aa" or strong. Cities rely on moderately stable propertytaxes (30% - 40%) as well as economically sensitive sales taxes (25% -35%) for their operating revenues,however cities maintain ample flexibility under the state mandated cap to raise property taxes. Expenditures arelargely predictable and cities do have great flexibility in reducing expenditures given no union presence.

KEY STATISTICS

-FY 2015 Full Value: $187.9 Billion

-FY 2015 Full Value Per Capita: $89,519

-2010 ACS Median Family Income as a % of the US: 74.8%

-FY 2014 Operating Fund Balance as a % of Operating Revenues: 15.44%

-5 year Dollar Change in Fund Balance as a % Operating Revenues: -4.73%

-FY 2014 Operating Cash Balance as a % of Operating Revenues: 16.09%

-5 year Dollar Change in Cash Balance as a % of Operating Revenues: -2.19%

-Institutional Framework: Aa

-5 Year Average of Operating Revenues/Operating Expenditures: 0.98x

-Net Direct Debt/Full Value: 1.73%

-Net Direct Debt/Operating Revenues: 1.48x

-3 year Average of Moody's Adjusted Net Pension Liability/Full Value: 4.76%

-3 year Average of Moody's Adjusted Net Pension Liability/Operating Revenues: 4.08x

OBLIGOR PROFILE

The City of Houston is the largest city in Texas, and fourth largest city in the United States with a populationestimate of 2.2 million people in 2014. Some of its main economic drivers include energy and resources,healthcare, and port activity.

LEGAL SECURITY

The bonds are secured by a direct and continuing annual ad valorem tax, levied against all taxable property in thecity, within the limits prescribed by law.

USE OF PROCEEDS

N/A

PRINCIPAL METHODOLOGY

The principal methodology used in this rating was US Local Government General Obligation Debt published inJanuary 2014. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatorydisclosures in relation to each rating of a subsequently issued bond or note of the same series or category/classof debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordancewith Moody's rating practices. For ratings issued on a support provider, this announcement provides certainregulatory disclosures in relation to the rating action on the support provider and in relation to each particular ratingaction for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings,this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and inrelation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case wherethe transaction structure and terms have not changed prior to the assignment of the definitive rating in a mannerthat would have affected the rating. For further information please see the ratings tab on the issuer/entity page forthe respective issuer on www.moodys.com.

The following information supplements Disclosure 10 ("Information Relating to Conflicts of Interest as required byParagraph (a)(1)(ii)(J) of SEC Rule 17g-7") in the regulatory disclosures made at the ratings tab on theissuer/entity page on www.moodys.com for each credit rating:

Moody's was not paid for services other than determining a credit rating in the most recently ended fiscal year bythe person that paid Moody's to determine this credit rating.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating

outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legalentity that has issued the rating.

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Analysts

Adebola KushimoLead AnalystPublic Finance GroupMoody's Investors Service

Nathan PhelpsBackup AnalystPublic Finance GroupMoody's Investors Service

Gera M. McGuireAdditional ContactPublic Finance GroupMoody's Investors Service

Contacts

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