JULY 2010 BY: BOB LEMER GRAPHICS: PIPER WILLIAMSON

CITY OF HOUSTON

TOTAL

OPERATING LOSSES FISCAL YEARS 2004-2009

$$11..77 BBIILLLLIIOONN

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The City of Houston Is Teetering On The Edge Of A Fiscal Abyss

By: Bob Lemer

Executive Summary

The City of Houston is teetering on the edge of a fiscal abyss, as proven by: (a) the audited financial statements and other data

included in the City’s latest (2009) Comprehensive Annual Financial Report (CAFR); and (b) the fiscal year 2010 “actual” data

and the fiscal year 2011 “budgeted” data, both included in the City’s official budget for fiscal year 2011.

In my opinion, the City’s only hope for solving this fiscal crisis is for the business sector to immediately and assertively become

involved in the situation and help guide the City out of its frightening fiscal crisis. The business sector has a vital need to do this

because a collapse of the City’s finances would seriously harm the economy for the entire Houston metropolitan area.

The severity of the fiscal crisis is evidenced by the City’s deficit of $1.7 billion in unrestricted assets at June

30, 2009, the as of date for its latest publicly available audited financial statements. In other words, the City‟s unrestricted assets at June

30, 2009 totaled $1.7 billion less than the already recorded liabilities the unrestricted assets would have to cover.

The crisis is further evidenced by the fact that the City’s currently positive general fund balance exists solely

because the general fund balance has been wholly financed by the proceeds of long-term pension bonds. See

Exhibit G.

The $1.7 billion deficit in unrestricted assets at June 30, 2009 resulted from operating losses of $1.7 billion for fiscal years 2004-2009

(Exhibit A). The vast majority ($1.5 billion) of the $1.7 billion of losses occurred during fiscal years 2004-2008--before the current

serious economic recession. The $1.5 billion of operating losses occurred during fiscal years 2004-2008 even though each of those fiscal

years saw record levels of revenues from property taxes and sales taxes.

Houston‟s $1.7 billion of operating losses is incredibly worse than the operating results of the rest of Texas‟ 10 largest cities. But the $1.7

billion of operating losses is really staggering when compared to the operating results of the larger cities in the essentially bankrupt State

of California. And even the rotting city of Detroit had better operating results than Houston. See Exhibit B.

The $1.7 billion of Houston losses resulted primarily from overly generous and totally unsustainable pension

and other retirement benefits such as health care. The $1.7 billion is almost twice the total annual property

tax revenues of the City.

The sudden granting of overly generous pension benefits and the evidence that they are unsustainable over time are well illustrated by

these Exhibit C and Exhibit D facts: (a) Per Exhibit C, as of June 30, 2003, the pension plans had been paid practically all amounts

(except for a net $54.4 million liability) required to be accrued by generally accepted governmental accounting principles; (b) Per Exhibit

D, the City‟s contributions to the plans, as a per cent of payroll costs, rose dramatically during 2004-2009; and (c) Yet, per Exhibit C, the

City‟s pension liabilities still mushroomed to an astounding $1.2 billion at June 30, 2009.

The $1.7 billion deficit was financed by delaying payment, long-term, for $1.7 billion of liabilities for benefits already earned by

employees for pension and other retirement benefits, according to generally accepted accounting principles for governmental entities. See

Exhibit C. Almost $600 million of such currently earned debt was converted to long-term property-tax-supported public obligation

bonds, backend loaded so that future generations would have to pay for them, plus uncalled for extra interest costs.

The $1.7 billion deficit has effectively transferred financial ownership of the City from the Houston

taxpayers to City employees (see Exhibit E).

As shown by Exhibit E, in reality, the City’s deficit in unrestricted assets is more like $8.5 billion, rather

than $1.7 billion, due to many more not funded and not recorded retirement-related liabilities to the City’s

employees. The $8.5 billion is a mind-blowing more than 9 times the total annual property tax revenues of

the City.

Apparently the real elephant in the room now is the tremendous health care benefits for retired City

employees. Exhibit C reveals that the City recorded liabilities of $485.8 million as of June 30, 2009 for earned retirement benefits

other than pensions, primarily for health care.

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Very troubling, the City’s 2009 CAFR shows that the City’s un-funded actuarial liability for health care

benefits was $3.1 billion at June 30, 2008, the last actuarially determined date. That is a much greater

amount than the City’s un-funded actuarial liability of $1.9 billion for pension costs, as of the same date,

June 30, 2008. That is very scary indeed. See Exhibit E.

The City‟s slide toward fiscal disaster (on the full accrual basis of accounting) has been masked by diverting attention to the (modified

accrual basis of accounting---essentially cash basis) General Fund‟s “positive” fund balance. But that is disingenuous, for the

General Fund’s fund balance has been “positive” since fiscal 2005 only because the City has used pension

bond proceeds to cover a significant portion of annual pension funding requirements. See Exhibit G.

To the City‟s credit, its fiscal year 2011 budget does not provide for playing the pension bond issuance shell game any longer. However,

that source of funds has been replaced by planned significant (“fire”?) sales of City assets in fiscal year 2011. That is nothing but a

stopgap measure.

The City is really up against a fiscal wall regarding possible additional revenues. Property taxes and sales taxes

make up about two-thirds of the City‟s budgeted revenues for the general fund for fiscal year 2011. According to page 70 of the 2009

CAFR, there is a voter-approved $0.50/$100 cap on the portion of the property tax rate that can be used to cover City general fund

operating expenses. The City already is using close to that rate. And the City already is charging the maximum sales tax rate allowed by

the state constitution.

So Houston voters would have to approve any increase in the $0.50/$100 operations cap on property tax rates. And Texas voters would

have to approve any increase in the sales tax rate. Getting such voter approvals would be a daunting task given the hardships voters are

already experiencing in the current recession.

The California cities apparently boosted their city treasuries for the short-term by increasing revenues through dramatically raising tax

rates (see Exhibit B). But to what end? Apparently that only exacerbated the flight of businesses and high wage earners from the now

essentially bankrupt state of California. The same thing might happen to Houston if tax rates are increased here. As a matter of interest,

the City of Houston‟s long-term debt per capita already is much greater than the State of California‟s.

It seems obvious to me that the only answers to solving the City‟s fiscal crisis lie in severely reducing employee retirement benefits

(which will apparently require changing state law) and severely reducing City expenses. It is my opinion, from observing the City‟s

finances and operations for more than a quarter-century, that there is substantial fat in the City‟s operating costs.

My opinion is basically confirmed by the fact that the City‟s operating costs have risen at approximately twice the combined rate of

increase in population and inflation over the last quarter-century, and its total debt at about four times. As previously mentioned, even in

the 2004-2008 period of record revenues from property taxes and sales taxes, the City had operating losses totaling $1.5 billion.

It is evident that the City still lacks the resolve and/or ability to rein in its operating costs, even in the face of the current severe recession.

According to pages 226-227 of the 2009 CAFR, in fiscal 2009 the City increased its civilian workforce by 5.5%, even more than the 4.1%

increase in its classified workforce. The City already had the second largest workforce in Harris County, governmental or private sector.

It also seems obvious to me that solving the City‟s fiscal crisis is going to require a comprehensive understanding of the City‟s CAFR, the

only document that sets forth the necessary guiding information, but which incredibly is normally not issued until at least six months after

fiscal year end. Apparently none of our elected officials have the level of understanding of the CAFR necessary to solve the fiscal crisis.

That is understandable, in that the vast majority of CPAs probably don‟t understand governmental accounting and CAFRs either.

Mr. James Moncour, deputy director, mayor‟s office, and Mr. Craig Mason, chief pension executive, attended my July 22, 2010

presentation to the Business Issues Committee of the Greater Houston partnership on behalf of the City. My presentation handout

included only the attached exhibits, but my verbal comments covered most of the comments in these two pages.

Mr. Moncur‟s response seemed to basically center on the City‟s favorable bond ratings. I truly cannot understand how the three

municipal bond rating agencies can continue to give the City of Houston such high bond ratings on its general obligation bonds. I believe

they do so at their own peril. I suggest that the business community request that the CEOs of the three municipal bond rating agencies

respond in writing to this document.

Mr. Mason„s response seemed to exhibit little concern over the City‟s non-payment of such a large portion of the pension liabilities

recorded in accordance with generally accepted governmental accounting principles. His response seemed to be that pension funding

must be looked at over a long period of time and there is no cause for alarm at this time. I find that position impossible to reconcile with

the facts shown in this document. Particularly when the facts in this document were derived from the City‟s CAFR, budget and monthly

financial and operations documents.

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SUMMARY: The City is teetering on the edge of a fiscal abyss. The business community is our best and

last hope for guiding the City back to fiscal stability. But this cannot happen unless the business community

responds now, not later. Please see Exhibit J for some suggested possible initial actions.

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Exhibit A

Annual Operating Losses

Fiscal years Ended June 30, 2004-2009

By Bob Lemer

City had operating losses totaling $1.7 billion for the six fiscal years ending

June 30, 2009 – per page 197 of the City‟s 2009 Comprehensive Annual Financial

Report (CAFR). These numbers agree with the City‟s audited financial statements

for fiscal years 2004-2009. For example, see bottom of Total column on page 17 of the

fiscal year 2009 CAFR. See Note below regarding terminology used.

2004 ($ 312,790,000)

2005 ( 531,465,000)

2006 ( 131,893,000)

2007 ( 221,452,000)

2008 ( 281,556,000)

Total before recession ($1,479,156,000)

2009 ( 214,817,000)

TOTAL ($1,693,973,000)

Approximately $1.7 BILLION

in operating losses!

The operating losses for fiscal years 2004-2008 occurred even

though the City received record revenues from property taxes

and sales taxes each year.

Note: governmental accounting terminology for excess of expenses over revenues is

“Change In Net Assets” rather than “Net Loss” or “Operating Loss.” This is because

governmental entities are not operated for profit.

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Exhibit B

Comparison of Selected City Government Operating Results

Total for Fiscal Years 2004-2009* as Reported on Cities’ Web Sites

By Bob Lemer

$1 billion

-$1 billion

$0

-$2 billion

$2 billion

$3 billion

$4 billion

Houston −$1.7 billion

Detroit −$0.8 billion

San

Francisco $0.5 billion

San

Diego $1.2 billion

Los Angeles $3.7 billion

thru 6/30/2009

thru 6/30/2009

thru 6/30/2009

thru 6/30/2009

thru 6/30/2009

thru 9/30/2008*

*Amount for Dallas is for only five fiscal years (2004-2008). Dallas’ CAFR for fiscal year ended September

30, 2009 has not yet been publicly released.

Note: Of the ten largest Texas cities, only Houston and El Paso had cumulative operating losses for fiscal

years 2004-2009. Arlington, Austin, Corpus Christi, Dallas, Fort Worth, Lubbock, Plano and San Antonio all

had cumulative operating surpluses from operating results for fiscal years 2004-2009.

Dallas* $0.8 billion

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2003 2009 Increase

Accrued liabilities to pension plans:

Police Officers $19.2) $369.8 $350.6

Firefighters – prepaid at June 30, 2003 (57.2) 27.2 84.4

Civilians 92.4) 313.1 220.7

Total due to pension plans $54.4) $710.1 $655.7

Pension bonds payable -0-) 587.5 587.5

UNPAID PENSION COSTS $54.4) $1,297.6 $1,243.2

Unpaid recorded liabilities for health care

and other post-retirement benefits -0-) 485.8 485.8

TOTAL LIABILITIES FOR PENSIONS

AND OTHER POB

$54.4)

$1,783.4

$1,729.0

Exhibit C

How the $1.7 Billion in Operating Losses Was Financed

By Bob Lemer

Houston‟s $1.7 billion in operating losses for fiscal years 2004-2009 created a $1.7

billion deficit in unrestricted assets as of June 30, 2009. See page 15 of the 2009

CAFR.

In other words, the unrestricted assets were $1.7 billion less than the already recorded

liabilities they would need to cover.

The $1.7 billion in operating losses for fiscal years 2004-2009, and the resulting $1.7

billion deficit in unrestricted assets at June 30, 2009, were financed via the following

increases in recorded liabilities:

(In Millions of Dollars)

Balances at June 30

Per 2003 and 2009 CAFRs

EQUALS $1.7 BILLION

8

0

5

10

15

20

25

30

35

2003 2004 2005 2006 2007 2008 2009

Pension Plan Year

% o

f S

alar

ies

& W

ages

Police Officers Firefighters Civilians

Exhibit D

City’s Contributions Actually Made to Pension Plans, as a Percentage of

Salaries and Wages Paid

Fiscal Years 2003-2009

By Bob Lemer

15.4% 16.4%

18.0%

24.8% 23.7% 23.9%

29.4%

10.0%

14.7% 16.9%

16.5% 16.0%

15.7% 14.8%

12.4%

12.4% 11.3%

15.9% 15.5%

16.3%

18.7%

Firefighters Police Officers Civilians

Thus, even though the City‟s unpaid pension liabilities dramatically increased from fiscal year 2003 to fiscal

year 2009 (see Exhibit C), the City‟s actual contributions to the plans significantly increased during that

period (as a per cent of salaries and wages paid). Percentages shown were derived from the applicable year‟s

CAFR. For example, for fiscal year 2009 percentages, see page 94 of the 2009 CAFR

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−$8.5

billion?

$14 billion

$12 billion

$10 billion

$8 billion

$6 billion

$4 billion

$2 billion

−$2 billion

−$4 billion

$0

−$0.3

billion

−$1.3

billion

−$3.3

billion

−$6.5

billion

$5.0

billion

$8.6

billion

$10.6

billion

$13.8

billion

−$6 billion

−$8 billion

−$10 billion

June 30, 2003 CAFR

June 30, 2008 CAFR

June 30, 2009 CAFR

Note A Adjustment

Note B Adjustment

Exhibit E

Transfer of Wealth from Houston Taxpayers to City Employees (The Majority Of City Employees Do Not Live In The City)

By Bob Lemer

City Employees’ Net Assets

Surplus

Houston Taxpayers’ Net Assets

Deficit

Note A - Balance after adjusting for $1.9 billion of City’s unfunded pension liabilities to City employees (2009 CAFR page 121) Note B - Balance after further adjusting for $3.1 billion of City’s unfunded health and other post-retirement benefit liabilities to City employees (2009 CAFR page 122) Note C - The City’s deficit will be even greater when it has to reimburse the City employees’ pension plans for the investment losses (approximately $1.8 billion) incurred by the plans in fiscal year 2009. The City’s actuarial computations for fiscal year 2009 were based upon the actuarial report as of June 30, 2008, before the pension plans’ market losses in fiscal year 2009.

Note C Adjustment

$13.6

billion

$11.8

billion

$8.7

billion

$6.8

billion

−$1.7

billion

−$3.6

billion

−$6.7

billion

−$8.5

billion

−$1.3

billion

The City of Houston‟s deficiency in unrestricted net assets increased from -$0.3 billion at June 30, 2003 to -$1.7 billion at

June 30, 2009, while the net assets of the City employees‟ pension plans increased 72% from $5.0 billion at June 30, 2003 to

$8.6 billion at June 30, 2008, and then dropped about 20% to $6.8 billion at June 30, 2009, according to the City‟s 2003, 2008

and 2009 CAFRs. Certainly much of the increase in the value of the employees‟ pension plans was due to employee

contributions and performance of the pension plans‟ investments, but a large amount of the of the increase of the pension

plans‟ net assets, as well as most of the decrease in the City‟s net unrestricted assets, was due to ballooning costs of City

employee pension and health benefits.

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Exhibit F

Basic Reasons Why the Public Is Not

Aware of the Foregoing Financial Facts

By Bob Lemer

Apparently our elected City officials do not understand the Comprehensive Annual

Financial Report (CAFR) or its relationship to the City‟s annual budget and its

monthly financial and operations report (MFOR), or the significantly differing

accounting methods involved. See Exhibit G.

Apparently the same lack of understanding exists on the part of the municipal bond

rating agencies.

Apparently the same lack of understanding exists on the part of the media.

The CAFR is consistently not publicly released until many months (sometimes up to

about one year) after fiscal year end.

In very recent years, public release of the CAFR has been delayed by “material

weaknesses” in internal control. For fiscal year 2009, the auditors reduced their

assessment of internal controls status from “material weaknesses” to the level of a

“significant weakness” in internal controls.

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Exhibit G

Appearances vs. Actuality or

Budget and Monthly Financial Reporting vs. CAFR

By Bob Lemer

−$1.75

−$1.50

−$1.25

−$1.0

−$0.75

−$0.50

$0.25

$0.50

$0.75

$0

−$0.25

?? ??

?? ??

2003 2004 2005 2006 2007 2008 2009 2010 2011

Billions

Unrestricted (Deficit) of Governmental Activities, per CAFR for that year.

Unrestricted Fund Balance of General Fund. For fiscal years 2003-09, per page 194 of 2009 CAFR. For fiscal years 2010-11, per 2011 preliminary budget.

Governmental Activities portion of year end balance of pension bonds payable, per CAFR for that year.

— At June 30th —

Observations:

A. The General Fund shows a positive unrestricted balance (blue) each year, for budget and monthly

financial reporting purposes---under the “modified accrual” basis of accounting (essentially cash basis).

Yet the annual CAFR shows a (red) deficit in the unrestricted “Governmental Activities” (General

Fund) fund balance---using the full accrual basis of accounting.

B. For fiscal years 2005-2009, a positive Unrestricted Fund Balance in the General Fund (blue) apparently

exists due to the City having used pension bond proceeds to cover General Fund pension costs.

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Exhibit H

Can the perpetual annual operating losses be overcome by increasing assessed

revenue rates or creating new sources of revenues, without voter approval?

By Bob Lemer

GOVERNMENTAL ACTIVITIES (Core mission of the City, primarily the General Fund):

Property tax revenues (42.4% of General Fund revenues budgeted for fiscal year 2011):

According to page 70 of the fiscal 2009 CAFR, the maximum operations portion of the property

tax rate is $0.50/$100, per the City Charter. According to the preliminary fiscal year 2011 budget,

the property tax rate for fiscal year 2011 will be close to the $0.50/$100 City Charter limit yet

total property tax revenues will decrease in fiscal year 2011, due to falling property values.

Sales tax revenues (23.2% of General Fund revenues budgeted for fiscal year 2011):

The City‟s 1% sales tax rate is set by the state constitution. Sales tax revenue reached its historic

peak in fiscal year 2009, and then dipped significantly in the just completed fiscal year ended

June 30, 2010. Sales tax revenue is budgeted to increase slightly in fiscal year 2011, but not to the

level of its peak in fiscal year 2009.

Renew Houston:

I have not yet analyzed the Renew Houston proposed amendment to the City Charter. Initially, it

appears to me that a portion of this tax duplicates the portion of the City‟s water and sewer rates

that already are allocated for coverage of drainage costs by the Combined Utility System (CUS).

See CUS comments below.

BUSINESS-TYPE ACTIVITIES (Activities not within the City‟s core mission, and which the City opted

to get into):

Combined Utility System (CUS):

The CUS covers the City‟s water and sewer operations as well as drainage costs. Drainage costs

were moved from the General Fund (and voter control over drainage bond issuance thereby

stopped) to the CUS just a few years ago. Now a portion of the Renew Houston proposed

revenues appears to duplicate the portion of water and sewer rates already designed to cover

drainage costs. City council recently approved massive increases in water and sewer rates

(apparently the equivalency of a 30% hike), without voter approval. Even though the revenues

thereby derived are supposedly limited to retention in the CUS, state law apparently overrides the

City Charter and City ordinances and permits the transfer of such revenues to the General Fund.

Airport Fund:

Airport Fund revenues consist mostly of rentals, with landing fees in significant second place.

Revenues are required by federal law to remain in the Airport Fund. However, the City has

occasionally managed to transfer some General Fund costs to the Airport Fund, thereby

accomplishing the same objective as transferring revenues.

Convention and Entertainment Facilities (CEF):

The CEF revenues are principally the hotel occupancy tax, which is restricted to the CEF. The

CEF is relatively insignificant in size and has no surplus revenues to support any other Fund.

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Exhibit I

Is it wise to return to the City’s 1980s approach to increasing revenues?

By Bob Lemer

The City‟s response to the downturn in the City‟s economy (along with certain legally

mandated water and sewer improvements) in the oil-bust 1980s was to implement the

following rate increases:

Property tax rate 27%

Water rates 119%

Sewer rates 161%

Our elected City officials need to think long and hard before repeating that approach

in the face of:

The $1.5 billion operating losses incurred for fiscal years 2004-2008 (before the

recession), when the City received record revenues from property taxes and

sales taxes.

The continuing current recession.

Bear in mind:

The City already has increased water and sewer rates approximately 30%,

without voter approval.

Houstonians will vote next November on a drainage tax proposed by a

Renew Houston City Charter amendment.

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Exhibit J

Need for the Business Sector to Become a Significant Voice in the Dialogue

Needed for Solving the Financial Crisis

By Bob Lemer

Inasmuch as the elected City officials apparently lack the level of understanding of the Comprehensive

Annual Financial Report needed to solve the City‟s financial crisis, the private business sector needs to

immediately become a significant voice in the dialogue needed for solving the financial crisis. I believe that

the situation is so critical that it calls for a public oversight board.

Some of the things the City and the public oversight board may wish to consider are:

Immediately investigate this situation to make sure that it does not have the potential to be a

bankruptcy/pension plan crisis similar to the one experienced by the City of San Diego a few years

ago. There do appear to be some similarities.

Immediately freeze operating expenses in all departments, as well as all construction contracts

not yet started.

Have a qualified totally independent expert evaluate the City‟s financial exposures regarding

financial derivatives.

Go to the state legislature and get the employee pension plans converted from defined benefit to

defined contribution plans.

Correct the weaknesses in the financial accounting and reporting system, as well as any other

impediments to timely financial reporting.

Commence the practice of preparing timely and accurate quarterly financial reports using the

accrual basis of accounting.

Hire highly qualified consultants to conduct efficiency and effectiveness audits of every department,

commencing with the largest first, with no sacred cows. There are unreleased reports on the police

and fire departments that can be used as beginning reference points for those departments. Consider

using a productivity and quality control consultant to make sure that customer service is adequately

considered in the deliberations.

Conduct an in-depth inventory of the City‟s infrastructure and prioritize the discovered needs.

Have a qualified independent consultant evaluate the City employee benefit package.

Immediately commence ongoing CAFR workshops for all elected City officials.

Once the national financial crisis and the City‟s preceding self-created financial crisis are over, a permanent

oversight City audit committee should be installed, as recommended by the City‟s independent auditors in

their December 17, 2002 letter to the City, and as recommended for all state and local governments by the

Government Finance Officers Association.