Lemer/farb/roberts Assessment Of City Of Houston Finances (22 October 2009)

October 22, 2009 Name, Title and Address Subject: Finances of the City of Houston Dear

:

Enclosed is our partial analysis of the very serious financial situation at the City of Houston. We would be derelict if we failed to share this financial analysis with you. This financial heads up will assist you in meeting your fiduciary responsibilities to Houston voters, taxpayers, readers, viewers or investors---as the case may be. We feel a public discussion of the City’s financial situation is necessary and firmly believe that addressing the City’s financial condition is in the best interest of the Houston economy and Houston taxpayers. We believe the sooner the City of Houston addresses the financial shortfall the better. Please bear in mind that the Houston City elections are on November 3, 2009, with early voting having commenced on October 19, 2009. Recent history has shown a large portion of voting occurs during early voting. We trust that the attached article is of significant assistance to you. We may be reached at [email protected]. Respectfully,

Bob Lemer, CPA Retired Partner Ernst & Young

Aubrey M. Farb,CPA Retired Partner Grant Thornton

Tom Roberts, CPA Retired Partner Fitts Roberts

CC: City of Houston---Incumbent Mayor, City Controller, and City Council Members City of Houston—Non-Incumbent City Candidates Greater Houston Partnership---Board Members Houston Chronicle---Editorial Board Members Houston TV Stations---CEOs Houston Business Journal---Editor Houston Community Newspapers-Editor Houston Press-Editor Municipal Bond Rating Agencies---CEOs Wall Street Journal---Editor Barron’s-Editor Investor’s Business Daily-Editor USA Today-Editor Texas Monthly---Executive Editor Deloitte & Touche LLP---Houston and New York

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City Of Houston Disturbing Financial Facts---October 2009 By: Bob Lemer, Aubrey M. Farb and Tom Roberts Executive Summary

The City of Houston is financially broke and it appears that the mayor who takes office in January 2010 may have to captain the City through bankruptcy procedures. The City’s unrestricted assets were $1.2 billion short of the already recorded corresponding liabilities these assets were needed to pay as of fiscal year end June 30, 2008, according to the City’s latest publicly available audited Comprehensive Annual Financial Report (CAFR). The $1.2 billion shortfall was a result of operating losses totaling $1.5 billion for fiscal years 2004-2008, applying the full accrual basis of accounting used in the private sector. Apparently the City has no idea as to what has transpired financially since June 30, 2008 or will transpire this fiscal year ending June 30, 2010, on the full accrual basis of accounting. But even on the modified accrual basis of accounting (essentially cash basis) followed by the City and all other municipalities, the $236.8 million fund balance in the City’s general fund as of July 1, 2009 (the beginning of this current fiscal year) would not exist except for the City having deposited the proceeds of pension obligation bonds into the City’s general fund instead of depositing them in their legally required immediate destination, the pension plans’ bank accounts. The City is in this dangerous financial position because its total spending since fiscal year 2003 has greatly outstripped its total revenues in that period. And the rate of growth in the City’s total revenues since 2003 has, in turn, greatly outstripped the City’s rate of growth in population plus inflation.

Thus the City’s problems are a result of greatly overspending and not a result of insufficient revenues. All of this occurred before the current severe recession. Now the City has the added burden of the recession. The City is in a real financial dilemma, because now its two principal sources of general fund revenues are in trouble---sales taxes and property taxes. Sales tax revenues already are dropping significantly and property tax revenues will commence dropping at an even more rapid rate after the next annual appraisal and assessment process. And the City will have to go to the voters for any contemplated rate increases in either the sales tax rate or the portion of the property tax rate allocable to operations. It appears to us that there may be no viable alternative to bankruptcy proceedings and thereby positioning the City to regain control over its overspending, through addressing structural spending problems such as overstaffing and overly generous employee benefits.

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Following are our detailed findings and observations. 1. The City incurred operating losses (“Change In Net Assets”) totaling approximately $1.5 billion for the five fiscal years ended 6/30/08--- per the latest (fiscal year 2008) publicly available audited Comprehensive Annual Financial Report (CAFR), page 199: Thousands a. (312,790) b. (531,465) c. (131,893) d. (221,452) e. (281,556) TOTAL (1,479,156) ---or--- $1.5 BILLION 2. The City’s deficiency in unrestricted assets [“Unrestricted (deficit)”] was $1.2 BILLION ($1,174,429 thousands) at June 30, 2008--- per 2008 CAFR, page 15. In other words, the City’s unrestricted assets were approximately $1.2 billion less than the already recorded liabilities that they will be required to satisfy. 3. The $1.2 billion deficiency in unrestricted assets as of June 30, 2008 (which was created essentially during fiscal years 2004-2008-see item 1) was basically financed, per page 15 of the 2008 CAFR, by: (a) the $347,728,000 collateralized note payable to the municipal employees’ pension trust; (b) the $643,413,000 combined accrued liabilities to the employees’ pension trusts (municipal-$285,462,000, police officers’-$318,567,000, and firefighters’-$39,384,000); (c) the $219,755,000 pension obligation bonds payable; and (d) the $272,941,000 accrued liability for other post employment benefits-----less, per pages 17 and 74 of the 2003 CAFR, (d) the $54,395,000 net accrued liabilities to the employees’ pension trusts at June 30, 2003 (municipal-$92,386,000, police officers’-$19,221,000, and firefighters’-asset of $57,212,000). 4. Thus, as of June 30, 2008, the City’s elected officials essentially had transferred financial ownership of the City from the taxpayers to the City’s employees, about 43.7% of who do not live in the City, according to documentation we have received from the City’s human resources department. Very troubling, 63.3% of first responders (police officers and firefighters) do not live in the City, versus just 30.0% of civilian employees, according to the City’s human resources department. 5. The City’s deficiency in unrestricted assets is so severe that in their yet to be completed audit for fiscal year 2009 the City’s independent auditors apparently will have to address the audit reporting issue as to whether the City was a “going concern” as of June 30, 2009. 6. Apparently the City has no idea yet as to what its operating loss (“change in net assets”) was for the fiscal year just ended June 30, 2009 or what its deficiency in unrestricted assets was at June 30, 2009, and has no idea as to what is in store fiscally for fiscal year 2010. That is because the City does not keep its books on the full accrual basis of accounting (fully accruing its assets and liabilities) but once a year, via the audited Comprehensive Annual Financial Report (CAFR). And the CAFR cannot be completed until the (nearly always very substantial) annual audit adjustments are booked. 7. In recent years, the City has been taking up to almost a year to issue its annual CAFR. See Exhibit A. In comparison, the SEC requires that large publicly-held companies, who 3

normally have worldwide operations and much more complex operating and financial reporting problems than the City, to file their annual complex SEC reports within 75 days after fiscal year end. 8. The annual delays in issuing the CAFR are due to material weaknesses in internal control (over the City’s financial accounting and reporting system) that are so severe that the City’s independent auditors have been issuing professionally required special warning letters thereon for the last few years. See Exhibit A. The auditors finally discontinued even bothering to test the City’s system of internal control relative to the last completed annual audit (fiscal year 2008). This inability to test and thereby partially rely upon the City’s system of internal control during their audit undeniably causes the City’s outside audit firm to expand their other “substantive” type audit procedures, at untold extra expense to the taxpayers. 9. The city controller advised city council in an open meeting in January 2007 that the internal control weaknesses delaying completion of the fiscal year 2006 CAFR “appear to be due to a lack of basic accounting knowledge at the departmental level---.” In a meeting Mr. Lemer had with her, the city controller advised him that City civil service requirements prohibited terminating those inadequate employees and thus they would have to be retrained. It seems obvious that one or more of the following situations exist: (a) the existing job specifications were inadequate; (b) the employees in question did not meet the job specifications when hired; (c) the employees in question did not tell the truth on their applications, in which case they should be fired; (d) incompetent management and supervision exists at the departmental level and perhaps all the way to the mayoral level. The controller’s comments pertained to the fiscal year 2006 CAFR. Yet the City still continued to receive annual “material weaknesses in internal control” letters through the latest (fiscal year 2008) completed and publicly reported upon audit. 10.

Neither the mayor nor the city controller have revealed to the public the extremely serious matters set forth in items 1 through 9. These issues are not addressed in the city controller’s cover letter in the 2008 CAFR (pages vii-xiii). Nor are they actually addressed in the “Management’s Discussion and Analysis” section of the 2008 CAFR (pages 3-13).

11.

The annual audit reports since fiscal year 2003 by the City’s independent audit firm make no mention whatsoever of: (a) the City’s serious financial condition; (b) the City’s material weaknesses in internal control; or (c) the exceptionally long delays in the City’s issuance of its annual CAFR.

12.

The municipal bond rating agencies appear to be unaware of, or at least unwilling to acknowledge and react to accordingly, regarding the serious matters raised in items 1 through 9. According to page i of the 2008 CAFR, both Standard and Poors and Moody’s Investor’s Services maintained their AA ratings for the City.

13.

Although the current mayor, city controller, and each city council member have been advised by Mr. Lemer of the City’s very serious financial situation, including most of the preceding information, apparently not one of these individuals has taken steps to advise Houstonians of the seriousness of the situation, let alone what they intend to do about it.

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14.

There is no excuse for the mayor and the city controller not to be fully aware of and fully comprehend the entire information in this article. They both sign off on the CAFR and the city controller’s department prepares the CAFR.

15.

Giving the other current elected City officials the benefit of possible lack of knowledge of the existence of the audited annual CAFR, or at least a lack of ability to understand the CAFR, one can see where their focus has been upon the annual budget and the monthly financial and operations report (MFOR).

16.

The financial picture presented by the 2008 CAFR is greatly more severe than the picture painted by the City’s annual budgets and the MFOR. That is because the annual budgets and the MFOR are prepared based upon the modified accrual basis of accounting (essentially cash basis) prescribed by the accounting oversight body for governmental entities, while the CAFR is prepared on the full accrual basis of accounting used in the private sector, wherein all incurred assets and liabilities are accrued and recorded.

17.

For example, Exhibit B demonstrates how it was possible for the City to actually show an audited surplus of $19,891,000 from operations in the general fund (which is the focus of the annual budget and the MFOR) for fiscal year 2008 when, in reality, the City had an audited Citywide operations deficit of $281,556,000 for fiscal year 2008.

18.

Exhibit B is difficult to comprehend for a person not trained in governmental accounting, even for a CPA. But the two most significant reasons for the difference between the $19,891,000 general fund surplus from 2008 operations and the $281,556,000 deficit from 2008 Citywide operations are: (a) the ever-growing accrued liabilities to employees for pension plans and other post retirement benefits; and (b) the commenced practice of financing current pension plan expenses with backend loaded pension obligation long-term bonds.

19.

Once one understands Exhibit B, or at least items 18(a) and 18(b), it becomes obvious that the City’s fiscal 2010 general fund budget is an illusion, for two reasons. First, it is calculated on the modified accrual basis of accounting (essentially cash basis) and therefore ignores the ever-growing and enormous accrued liabilities for employee pensions and other post retirement benefits. Secondly, it is dependent upon continued payment of some of the pension expenses with issuance of long-term backend loaded pension obligation bonds.

20.

In fact, the $236.8 million beginning fund balance of the general fund for fiscal year 2010 is wholly the result of the $587.5 million of pension bond debt issued for fiscal years 2004-2009 and deposited into the City’s general fund to meet current operating expenses.

21.

The whole pension bond situation is very disturbing, for a number of reasons: a. In late 2003, the Texas state legislature amended the Texas Local Government Code in order to permit municipalities to reduce unfunded pension liabilities through issuing pension obligation bonds. This timing basically coincided with the redrawing of considerably more liberal pension plans approved by the City’s previous mayoral administration and the City’s three pension plans’ boards, which at that time totally consisted of City employees. b. The Texas Local Government Code (Title 4. Finances. Section 107.003.a) now provides that “A municipality may issue obligations to fund all or any part of an 5

unfunded liability.” There appears to be no cap on the amount of bonds that can be issued, other than the preexisting total unfunded liability, nor any apparent requirement for voter approval. c. Section 107.004 of the Code now states “The municipality shall deposit the net proceeds of obligations issued under Section 107.003 to the credit of the public pension fund. The amount deposited under this section becomes part of the public pension fund’s assets.” However, the City has been depositing proceeds of pension bonds directly into the City’s general fund and commingling the bond proceeds with other general fund receipts. Apparently the City is then using the pension bond proceeds to pay current, rather than past, service costs owed to the pension plans. d. About 91% of the $587,525,000 principal on the City’s pension bond debt will not come due until 2021 or later. This backend loading will cause the interest expense to be $678,568,690 (an exceptionally large 115% of the principal amount) over the life of the bonds. 22.

The commencement of the use of pension bond debt in fiscal 2004 and its rapid increase in amount has caused the City’s total tax-supported debt to increase 55% from January 1, 2004 until August 31, 2009, date of the City’s last monthly financial report.

23.

At June 30, 2008 (date of the City’s last audited financial statements), the City’s total Citywide debt per capita of $5,338 was over twice the $2,528 debt per capita of the now bankrupt State of California.

24.

An enormous swelling in annual pension costs has caused a like swelling in the accrued unfunded pension liabilities since June 30, 2003. See Exhibit C. Exhibit C shows that the pension plans were basically fully funded at June 30, 2002 and still were underfunded less than $55 million at June 30, 2003, before the financial effect of the rewritten pension plans kicked in.

25.

As shown by Exhibit D, the City has not decreased its rate of actual contributions (as a per cent of payroll). The City has maintained about the same rate of actual funding for the police officers’ plan, while greatly increasing the rates of actual contributions for the firefighters’ and municipal employees’ plans. Thus the very significant increases in the plan benefits are the obvious cause of the enormous increase in the accrued pension liabilities shown in Exhibit C. The accrued pension plan liabilities would be even greater had not funding been accomplished in part by issuance of pension obligation bonds (thereby making the debt permanent, since it is now owed to outsiders and thus no longer possibly negotiable with the employees).

26.

Pension expenses have been a very major cause of the increase in the City’s total expenses even after the pension plans were revised under the current mayoral administration.

27.

During the fiscal years 2004-2008 period, when the City incurred the $1.5 billion of operating losses, the City’s total operating expenses increased 44.9% from $2,708,668,000 in fiscal 2003 to $3,923,811,000 in fiscal 2008, according to 2008 CAFR page 198.

28. When evaluating the appropriateness of the 44.9% increase in operating expenses, one should take into account that the City is essentially a service organization. Thus the increase should be viewed in the context of the 29.4% increase in population plus inflation, the two principal 6

drivers in need for increased City services. See item 29. Obviously, total operating expenses increased at a rate greatly in excess of the rate of growth in population plus inflation. 29. The below increase in population for fiscal years 2004-2008 was computed based upon population numbers on 2008 CAFR page 223. The inflation for fiscal years 2004-2008 was computed based upon the CPI for the Houston SMSA from June 2003-2008. 10.3% Population, including Katrina influx 19.1% Inflation 29.4% Population plus inflation 37.7% Total revenues (See item 30) 44.9% Total expenditures (See items 27 and 28) 30. The City’s revenues (program plus general) increased a very generous 37.7% from $2,645,899,000 in fiscal 2003 to $3,642,255,000 in fiscal 2008 according to 2008 CAFR pages 198 and 199. The 37.7% was well in excess of the 29.4% increase in population plus inflation. 31. Thus it is apparent that the problem lies with excessive operating expenses rather than insufficient revenues. 32. The following conditions make the future of continuing operating deficits exceedingly more serious: a. The City already had accumulated a $1.2 billion deficiency in unrestricted assets at June 30, 2008. b. Apparently the City does not know what its deficiency in unrestricted assets was at June 30, 2009 or what it is now or what it will be at June 30, 2010. c. The City’s financial accounting and reporting system has such material weaknesses in internal control that it cannot be relied upon to produce either accurate or timely financial statements using full accrual accounting, as followed in the private sector. d. The City already has the second largest workforce in Harris County, governmental or private. Yet, in the face of the current deep economic recession, the City increased its civilian workforce by 7.1% in fiscal year 2009 and expects to increase that another 3.6% in fiscal year 2010. Meanwhile the City increased its police officer and firefighter workforces just a combined 3.7% in fiscal 2009 and expects to increase that just 1.2% more in fiscal year 2010. See 2010 budget pages 14-15. e. Incidentally, page 198 of the 2008 CAFR indicates that public safety expenses increased about 75% from 2003 to 2008. That is contradictory to the 9.2% decrease in the combined number of police officers and cadets and the 1.2% decrease in the number of firefighters and cadets from 2003 to 2008, per 2008 CAFR pages 228-229. Certainly overtime pay cannot account for the disparity from these two fact sources in the same CAFR. f. The City has the following liabilities that were not yet recorded on the City’s June 30, 2008 balance sheet: • Unfunded pension liabilities, $2 billion as of July 1, 2007, per 2008 CAFR page 123. • Unfunded health and other post-retirement benefit liabilities to employees, $3.2 billion as of September 30, 2008, per 2008 CAFR page xii.

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Investment losses by the City employees’ pension plans since the start of the current recession, which apparently will have to be made up for by the City and may be in the range of $2 billion. g. The City is just now beginning to really feel the deep financial recession. Sales tax revenues are dropping and property tax revenues will probably drop significantly more after the next annual appraisals. h. The City’s property tax rate already is more than 90% of the $0.50/$100 cap set by the City charter relative to property tax revenues that may be used to cover general fund operations. And the City cannot increase its current sales tax rate without a state constitution amendment. So there is little leeway to cover the current excessive expenses, let alone increases in or new expenses. 33. Therefore, it appears to us that the next City administration may have to deal very soon with the very real specter of financial bankruptcy.

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Exhibit A Evaluating The Financial Reporting Stewardship Of Houston's Mayors, City Controllers, And City Council Members Historical Data Regarding Timeliness Of Completing The City's Comprehensive Annual Financial Report (CAFR) And City's Receipt Of "Control Deficiency" Letters From The City's Independent Audit Firm By: Bob Lemer

Per City's Comprehensive Annual Financial Report Fiscal Year Date Of Audit Ended 6/30 Auditor's Report Firm 2009 Not Yet Issued Deloitte 2008 12/19/08 Deloitte 2007 6/30/08 Deloitte 2006 6/6/07 Deloitte 2005 3/6/06 Deloitte 2004 12/23/04 Deloitte 2003 12/23/03 Deloitte 2002 12/17/02 KPMG 2001 11/30/01 KPMG 2000 11/14/00 KPMG 1999 11/30/99 KPMG 1998 10/30/98 KPMG 1997 11/14/97 KPMG 1996 10/31/96 KPMG 1995 11/17/95 KPMG 1994 10/28/94 KPMG 1993 11/15/93 Coopers Lybrand 1992 11/18/92 Coopers Lybrand 1991 12/12/91 Coopers Lybrand 1990 12/03/98 Coopers Lybrand 1989 12/05/89 Coopers Lybrand Key:

Office Holder At FYE Mayor Controller White Parker White Parker White Parker White Parker White Parker White Parker Brown Gray-Johnson Brown Garcia Brown Garcia Brown Garcia Brown Garcia Brown Garcia Lanier Kelly Lanier Kelly Lanier Greanias Lanier Greanias Lanier Greanias Lanier Greanias Whitmire Greanias Whitmire Greanias Whitmire Greanias

Per Correspomdence From Audit Firm Type Of Year End Letter From Audit Firm (See Definitions Below) Control Significant Material Deficiency Deficiency Weakness ? Yes Yes Yes Yes Yes

Only years that the (then state legally required) 4 month due date was met.

Definitions , per US Auditing Standards Board: Control deficiency---A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. Significant deficiency---A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the entity's ability to initiate, authorize, record, process, or report financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the entity's financial statements that is more than inconsequential will not be prevented or detected. Material weakness---A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected.

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Exhibit B City of Houston Reconciliation of Budgeted "General Fund" Results of Operation to City-wide Results of Operation Fiscal Year Ended June 30, 2008 Per 2008 Audited "Comprehensive Annual Financial Report" ("CAFR") -- Thousands of Dollars Actual Over/(Under) Budget Budgeted "General Fund" Performance: Revenues-page 117 Other financing sources-page 117 Expenditures-page 120 Other financing uses, transfers out-page 120 Net annual surplus (deficit) of the Budgeted "General Fund" Non-budgeted "General Funds"-Page 121: Revenues Expenditures Interest on pooled investments Proceeds from issuance of debt Transfers in

55,493 477 12,414 181 68,565

Budget

Actual

1,706,244 49,745 (1,540,885) (263,778) (48,674)

1,761,737 50,222 (1,528,471) (263,597) 19,891

1,627 (71,300) 1,670 95,623 5,896

Net annual surplus from all "General Funds"- page 20

53,407

Net annual surplus from other "Governmental Funds": Debt Service-page 20 Capital Projects-page 20 Grants-page 21 Non-major-page 21

21,816 18,447 164 25,444

Net annual surplus from all "Governmental Funds", on the "modified accrual basis of accounting"-pages 21 & 22 Conversion from "modified accrual basis of accounting" to "full accrual basis of accounting"-page 22: Add purchase of capital assets, treated as expenditures Deduct depreciation expense Revenues that will be collected more than 60 days after FYE Previous year 60 day deferred revenues collected this year Net effect of reversing "Governmental Funds" handling of these items: (a) bond proceeds as "other resources", (b) repayment of debt principal as expenditures, and (c) expensing bond issuance costs, premiums and discounts when incurred Net effect of having deferred non-current liabilities at beginning and end of year Net non-reimbursed expense of the internal service funds Net annual operating deficit for the "Governmental Activities"pages 22 and 17 Net annual operating deficit for "Business-Type Activities"-page 17 Net City-wide operating deficit-page 17

119,278

363,687 (167,630) 79,546 (97,762)

(199,406) (359,706) (524)

(262,517) (19,039) (281,556)

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Exhibit C City Of Houston Annual Pension Costs, Contributions Made, And Reported Liabilities Activity For Fiscal Years Ended June 30, 2003-2008 Per Audited Comprehensive Annual Financial Reports (CAFRs)For Fiscal Years 2003-2008 Dollars In Thousands Summary Of Activity For Fiscal Years 2003-2008:

Balance at 6/30/02 Annual pension costs Contributions made Balance at 6/30/08

Total Firefighters' Municipal (1,243) 51,892 (56,320) (1,556,962) (343,372) (609,832) 914,791 252,096 380,689 (643,414) (39,384) (285,463)

Police Officers' 3,185 (603,758) 282,006 (318,567)

Activity By Fiscal Year 2003-2008:

Balance 6/30/02 Annual pension cost Contribution made Balance 6/30/03 Annual pension cost Contribution made Balance 6/30/04 Annual pension cost Contribution made Balance 6/30/05 Annual pension cost Contribution made Balance 6/30/06 Annual pension cost Contribution made Balance 6/30/07 Annual pension cost Contribution made Balance 6/30/08

Total Firefighters' Municipal (1,243) 51,892 (56,320) (156,479) (22,669) (76,688) 103,327 27,989 40,622 (54,395) 57,212 (92,386) (243,649) (36,272) (133,456) 123,031 28,325 58,061 (175,013) 49,265 (167,781) (287,484) (52,222) (129,369) 135,350 32,699 66,006 (327,147) 29,742 (231,144) (259,662) (90,827) (62,169) 178,238 56,238 69,000 (408,571) (4,847) (224,313) (316,721) (74,683) (111,405) 182,864 52,864 72,000 (542,428) (26,666) (263,718) (292,967) (66,699) (96,745) 191,981 53,981 75,000 (643,414) (39,384) (285,463)

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Police Officers' 3,185 (57,122) 34,716 (19,221) (73,921) 36,645 (56,497) (105,893) 36,645 (125,745) (106,666) 53,000 (179,411) (130,633) 58,000 (252,044) (129,523) 63,000 (318,567)

Exhibit D City Of Houston Pension Plans City's Actual Contribution RatesAs A Per Cent Of Payroll Per City's Comprehensive Annual Financial Reports For Fiscal Years 1998-2008 Fiscal Year 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998

Firefighters Municipal 23.9 15.7 23.7 16.0 24.8 16.5 18.0 16.9 16.4 14.7 15.4 10.0 15.4 10.0 15.4 10.0 15.4 9.3 15.4 9.1 15.4 8.9

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Police 16.3 15.5 15.9 11.3 12.4 12.4 16.3 16.3 16.3 16.2 16.2