City of Dallas, TX. Update: Moody's Confirms Dallas, TX A1 GOLT, DCCHDC Downgraded to Baa1, Related Ratings Confirmed; Outlook Negative

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2 CREDIT OPINION Update City of Dallas, TX Update: Moody's Confirms Dallas, TX A1 GOLT, DCCHDC Downgraded to Baa1, Related Ratings Confirmed; Outlook Negative Summary Rating Rationale Contacts Denise Rappmund VP-Senior Analyst Gera M. McGuire VP-Sr Credit Officer/ Mgr Adebola Kushimo VP-Senior Analyst Moody's Investors Service has confirmed the A1 rating on the city of Dallas, TX's outstanding general obligation limited tax (GOLT) debt. The rating confirmation applies to $1.6 billion of Moody's rated debt. Concurrently, Moody's has affirmed the General Obligation Commercial Paper Notes at P-1, and downgraded the Dallas Convention Center Hotel Development Corporation to Baa1 from A3, which affects $476 million of debt. Finally, we have confirmed the Aa1 rating on $1.6 billion of Moody's rated Waterworks and Sewer bonds, and the contract revenue bonds issued through the Tarrant Regional Water District, the A2 rating on $67 million of the Downtown Dallas Development Authority's Tax Increment debt, and the A1 rating on $303 million of Dallas Civic Center Convention Complex debt. We are also affirming the Waterworks and Sewer Commercial Paper rating at P-1. The outlook is negative on all of the listed Dallas securities. The review for all Dallas ratings is now concluded. The confirmation of the A1 rating on the GOLT debt continues to consider the city s ongoing challenges surrounding its poorly funded public safety pension plan while recognizing two developments over the course of our review period: the stabilization of the asset position through temporarily halting lump sum DROP withdrawals and claims that a bill drafted by state representatives is near complete and expected to be filed by the March 1 deadline. Moody s continues to have concerns over implementation risk surrounding the proposed reforms to date, as well as the challenges that have plagued the negotiation process, and the questions surrounding the legal ability to limit lump sum withdrawals from the Dallas police and fire pension fund. The A1 rating incorporates the strong underlying economy which translates to annually increasing property and sales taxes, an adequate financial position on a reported basis, and manageable direct debt; the rating also reflects the very high Moody s adjusted net pension liability (ANPL) and the high level of fixed costs, placing Dallas as an outlier relative to peers on these metrics.

3 Exhibit 1 City's ANPL for Combined Pension Plans Continues to Increase with Poor Asset Performance and Caps to Annual Contributions Source: Moody's Investors Service; city audited financial reports The confirmation of the Waterworks and Sewer Enterprise rating, and the Tarrant Regional Water District (Dallas Project), both at Aa1, considers the credit fundamentals of the system as well as the broad service area that is nearly double the size of the city and the strict separation of accounts and assets from the general fund per the city's charter. The downgrade to Baa1 from A3 on the Dallas Hotel Convention Center Development Corporation 2009A-C debt is based on the a three notch rating differential for less essential assets with a city moral obligation under current methodology. The confirmation of the Dallas Downtown Development Authority 2006 and 2007 debt considers the moral obligation pledge of the city, but notes the strengths of the project area under Moody s Tax Increment Debt methodology. Credit considerations include the large project area, healthy debt service coverage, strong AV growth expected to continue and favorable location in central Dallas; while also recognizing the high taxpayer concentration and weak volatility ratio. Finally, the confirmation of the Civic Center Complex debt at A1 similarly reflects the credit fundamentals of the pledge, including the strong debt service coverage, stable operations and adequate legal provisions. The P-1 ratings are based upon (i) Moody s short-term counterparty risk assessments (CR Assessment) of the Banks; and (ii) Moody's assessment of the likelihood of termination of the applicable Liquidity Facility without payment at maturity of the applicable Notes. Events which could cause the Liquidity Facilities to terminate without payment at maturity of the Notes, are directly related to the credit quality of the city and the waterworks and sewer system, respectively. Credit Strengths Large, growing and diverse tax base that anchors the Dallas/Fort Worth metroplex Population and employment growth that surpass national averages Five consecutive years of operating surpluses on a reported basis; growth in operating reserves Ample legal flexibility to raise revenues or cut expenditures Credit Challenges Outsized unfunded pension liability expected to translate to budgetary pressure in the near to medium term absent reform Short term liquidity concerns in the Dallas police and fire pension fund Additional debt burden pressure stemming from significant infrastructure needs Ongoing legal battle related to back-pay referendum that may result in an outsized city liability This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2

4 Rating Outlook The negative outlooks on the related credits reflects the high degree of uncertainty surrounding meaningful progress towards pension reform while incorporating operating pressures for competitive police pay, the back-pay lawsuit and ongoing capital needs. Factors that Could Lead to an Upgrade Material improvement to annual pension funding, through meaningful reform and contribution commitments, reducing the Moody's Adjusted Net Pension Liability (ANPL) over the medium term Significant increase to operating reserves and liquidity Demonstrated balanced operations inclusive of pension funding at actuarially determined levels Reduction to fixed costs and balance sheet leverage relative to the size of the budget Factors that Could Lead to a Downgrade Minimal to no pension reform demonstrating near to medium-term police and fire plan insolvency Lack of swift and meaningful progress with respect to legislative action surrounding pension reforms and sovereign immunity A considerable judgment regarding pending back-pay litigation Reduction in operating reserves to a level inconsistent with the rating category Protracted trend of significant tax base contraction without offsetting rate adjustment Key Indicators Exhibit 2 Source: Moody's Investors Service; city audited financial reports Recent Developments Credit related events continue to surface since Moody s rating actions in October and December 2016, and a high degree of uncertainty remains surrounding a resolution to the Dallas police and fire pension (DPFP) solvency concerns. Since December, members voted down benefit reductions put forth by the pension board, lawsuits have been filed challenging and protecting limitations to lump sum withdrawals, and negotiations have resulted in no clear movement towards resolution between the city and the pension board. Favorably, state and city representatives have said that a state-drafted bill is expected to the filed by the March 1 legislation deadline. 3

5 In a positive development, benefit reforms approved in 2014 by the pension board have been given the approval by the Texas appeals court. Following three years of litigation challenging the constitutionality of prospectively reducing guaranteed DROP interest, the case was resolved December 13, 2016 in favor of the pension board. With this court ruling, the plan document schedule of gradually reduced guaranteed interest holds and will aid in slowing the growth of pension liabilities. The DPFP plan as of September 8, 2016 includes a reduction in the guaranteed earnings rate on DROP accounts to 6% effective October 2016, then 5% beginning October 2017, and after October 2018 earnings will be tied to the reported funded ratio of the plan, with a rate of 0% if the funded ratio is less than 55%. A city proposed plan to reduce the long term liabilities of the DPFP would include retroactively reducing accrued DROP interest, in part based on the legal precedence of this case, however, it is not explicitly clear that retroactively reducing interest is legally defensible. More than $500 million in lump sum withdrawals from August to November 2016 were halted by the pension board in mid-december, bringing the net asset position to approximately $2.2 billion and liquid assets down to approximately $837 million or 37% of the asset position. While small monthly distributions have since been allowed to pensioners, a lawsuit has been filed challenging the legality of restricting pensioners full access to DROP account balances, which currently total $1.06 billion. A subsequent lawsuit was filed by representatives of the city to protect the board amendments restricting withdrawals in order to preserve the liquidity and viability of the fund. The board s withdrawal restrictions are in effect until March 31, The remaining liquid assets are less than the DROP account balances, leaving the fund vulnerable to required sale of real assets if lump sum withdrawals recommence. Exhibit 3 Asset Position Decrease Accelerated Over Past Two Years With Write-Downs and Lump Sum DROP Withdrawals Source: Moody's Investors Service; Dallas Police and Fire Pension Fund investment reports Detailed Rating Considerations Economy and Tax Base: Strong Economic Indicators and Tax Base Growth to Continue Over Near to Medium Term Dallas, and the broader metro area, have been characterized by positive employment, demographic, and other economic trends over the past several years which will continue through the near to medium term due to continued job and population growth. Located in north Texas, Dallas is the ninth largest city in the United States, and third largest in Texas after Houston (Aa3 negative) and San Antonio (Aaa stable). Residents in the metropolitan area enjoy a diverse economic base with employment opportunities in the information technology (IT), banking, commerce, medical, transportation, government and logistics sectors, among many others. The city s population is large at 1.26 million, as of Population growth is among the highest relative to other large cities nationally, and has increased by approximately 8.5% since the 2010 census. Dallas retains its position as having the largest job base in the metropolitan area, serving as home to several fortune 500 companies, also reflected by a daytime population that swells by over 20% relative to the resident population. As such, Dallas is a regional economic center for the metro area with thousands of people commuting to the city for work. With strong job growth in the city that continues to outpace the nation, the labor force has continued to increase while unemployment remains low. As of December 2016, unemployment in the city was 3.7%, below the state and national rates of 4.6% at the same period. 4

6 A strong regional economy in the DFW metroplex has resulted in positive taxable value growth for the city, driven by property value appreciation and construction. Taxable values have shown four years of growth through fiscal 2016, with an increase of approximately 10% for fiscal 2017, bringing the city s tax base to over $110 billion. Major taxpayer concentration is minimal with the top ten accounting for 5.3% of AV as of fiscal Exhibit 4 Dallas' Tax Base Demonstrates Accelerating Growth Coming Out of Recession; Increasing Property Tax Revenues Source: Moody's Investors Service; city audited financial reports Financial Operations and Reserves: Operating Funds' Trend Marked by Reported Positive Operating Performance; Tempered by Pension Funding Shortfalls Driven by Statutory Limitations The city s financial profile will be challenged to maintain structural balance over the near to medium term largely due to the necessitated increases to pension funding which exceed the growth in projected revenues. Positively the city has posted five consecutive years of General Fund surpluses. However, the structural balance is muted when considering severe pension underfunding in the past few years, largely attributable to statutory caps to contributions and exacerbated by asset losses. Pension funding aside, past General Fund surpluses were generated through management s willingness and ability to make expenditure cuts and increase the property tax levy post-recession. Prudent financial management over the last five years has annually added to General Fund reserves over this period, growing the available balance from a relatively low $64.7 million (6.5% of General Fund revenues) in fiscal 2010 to $181.7 million in fiscal 2015, representing a more healthy 15.6% of General Fund revenues. Inclusive of the Debt Service Fund, available operating funds balance totaled $195.5 million as of fiscal 2015, or 14.2% of operating revenues. Similar to past years, fiscal 2016 General Fund unaudited fiscal year-end estimates indicate a surplus of just under $5 million. The fiscal 2017 budget was passed in September and contemplates the use of a modest $2.6 million of reserves for mosquito abatement and election expenses. However, based on actual results year to date, the city projects ending the fiscal year $1.5 million ahead of budget. The majority of 2015 operating revenues (General and Debt Service Funds) were derived from property taxes at 51.2%, followed by sales taxes at 20% and service to others at 14%. The city remains well under the statutory maximum for property taxes ($25/$1000 of AV) and has levied a combined rate of $7.97/$1000 since 2011, when it increased the rate from $7.48/$1000 amid declining assessed values. In fiscal 2017, the city is decreasing the levy to $7.81/$1000, primarily due to the fact that taxable value growth has been so strong that maintenance of the $7.97/$1000 tax rate would have exceeded the effective 8% yield control and trigger rollback tax rate elections. The city does not have the ability currently to seek voter approval for additional sales taxes, though it does maintain the ability to adjust various fees for services. LIQUIDITY As of fiscal 2015, the city s General Fund maintained a healthy cash position of $185.4 million, 15.9% of General Fund revenues. Inclusive of the Debt Service Fund, total operating funds cash was $198.8 million, or 14.4% of operating revenues. 5

7 Debt and Pensions: Slightly Elevated Debt Burden Relative to Peers Typical for High Growth City; Outsized Pension Liability With considerable infrastructure needs, we expect the city s debt to increase in the near term. However, given the growth in taxable value, the infrastructure debt as a percent of the tax base (debt burden) is not expected to materially increase over the next few years. The city maintains a debt policy which stipulates a maximum debt burden of 4% of the estimated market value of taxable property in the city. The city has typically had a debt burden consistent with the nation and around 2% of the full assessed valuation. Material movement in the debt burden could occur based on the needs of the Dallas police and fire pension (DPFP) system though no debt plans have been disclosed. Presently, the city s outstanding general obligation debt totals $1.77 billion, approximately $1.6 billion of which is rated by Moody's. This includes $198 million in pension obligation bonds which are invested in the Employee Retirement Fund (ERF) assets. The city has $437.3 million of authorized but unissued debt, and may seek voter approval for another bond package in the $600-$800 million range within the next 12 months. The city s fixed costs for debt, pensions and retiree health care benefits relative to operating revenues were elevated at 30% in fiscal Due to statutory caps on the city's pension contribution, however, its contributions fall well below the tread water benchmark of covering current year benefit accruals plus interest on reported unfunded liabilities. If the city had contributed at tread water (based on the 2015 funding assumptions rather than the city's more lagged GASB reporting), its fixed costs would have been 41% of its operating revenues. The tread water cost is a calculation of the amount an employer must contribute that, when combined with employee contributions, is equal to current year service cost plus interest on the unfunded pension liability as of the beginning of the year, using each plan's assumed discount rate as the interest rate. The city funds its retiree medical benefits on a pay as you go basis. In fiscal 2015, the city s OPEB contribution was $14.4 million. DEBT STRUCTURE All of the city s debt is fixed rate. Principal repayment is comparable to national medians with approximately 75% retired within ten years. Debt service costs as of fiscal 2015 were $250 million, representing a hefty 18.2% of 2015 operating revenues. Debt service as a percent of revenues has been decreasing slightly over the past five years from 22.4% in fiscal 2010, but could increase again depending on future debt plans as discussed. With the growth in the tax base and the strong likelihood of the city to issue additional debt for ongoing capital needs, we believe the annual debt service costs as a percent of operating revenues would remain in line with historic levels. DEBT-RELATED DERIVATIVES The city is not a party to any derivative agreements. PENSIONS AND OPEB The city s growing unfunded pension liabilities and potential plan insolvency over the medium term, particularly associated with the Dallas Police and Fire Pension (DPFP), represent the primary weakness of the credit. In addition to multiple years of underfunding the actuarially determined contribution due to statutory maximums, poor investment returns and asset write-downs in the city s DPFP system, and additional pension system liquidity challenges rooted in the Deferred Retirement Option Plan ( DROP ) have exacerbated the city s pension challenge. The city participates in three single-employer systems: the Employees Retirement Fund (ERF), the Dallas Police and Fire Pension Fund (DPFP) and the Supplemental Police and Fire Pension Plan. Contribution rates for the systems are set by ordinances or statutes. The ERF and the DPFP are managed by separate boards, and DPFP has minority representation from the city. Absent major reforms, cash, or both, the DPFP actuaries project the plan will be insolvent by 2030; sooner if investment returns are not improved. Moody's projects that based on the asset position of the DPFP as of December 2016, insolvency is brought in to approximately eight years. If the DPFP were to become insolvent, Moody's opinion is that the impact to the budget would be significant. Favorably, judicial precedent in Texas suggests that issuers have legal flexibility to implement reforms, specifically with respect to future benefits of current employees and cost-of-living adjustments. The ERF maintains a better funded position, but contribution caps and poor returns mean the unfunded liability is not being amortized. City voters approved ERF pension benefit changes for new employees starting January The new tier of benefits will reduce the pace at which future pension liabilities are accrued. Moody s Adjusted Net Pension Liability ( ANPL ) for the city s combined plans, net of support from the water utility, is $7.6 billion, or 5.5 times 2015 operating revenues, and 6.8% of the most recent fiscal 2017 assessed value. Nearly 75% of the ANPL is associated 6

8 with the public safety plan. The ANPL of the city is significantly elevated relative to peers. Moody s ANPL reflects certain adjustments we make to improve the comparability of reported pension liabilities. The adjustments are not intended to replace the city s reported contribution information, or the reported liability information of the plans, but to improve comparability with other rated entities. Management and Governance Texas cities have an institutional framework score of Aa, or strong. Cities rely on stable property taxes for 30%-40% of their operating revenues, while 25%-35% comes from economically sensitive sales taxes, resulting in moderate predictability overall. Cities maintain moderate flexibility under the state-mandated cap ($25 per $1,000 of AV, with no more than $15 for debt) to raise property taxes as most cities are well below the cap. Expenditures primarily consist of personnel costs, which are highly predictable. Cities have high flexibility to reduce expenditures given no union presence. The city of Dallas is managed by a sophisticated team that has produced strong operating results for the city within legal limitations, most notably as it relates to caps to contributions to the city's pension plans. The city has been, and continues to, experience senior level management changes, including a new Chief Financial Officer, retirement of the Police Chief, and the City Manager in early Dallas is among few large cities operated under a council-manager form of government, as opposed to a strong mayor form of government that is seen in many large cities nationally. Legal Security The general obligation limited tax bonds constitute direct and general obligations of the city, payable from the levy and collection of a direct and continuing annual ad valorem tax, within the limits prescribed by law, on all taxable property located within the city. Use of Proceeds Not applicable. Obligor Profile The city of Dallas is the ninth largest city in the US and third largest in Texas behind Houston and San Antonio. The city serves as the anchor city to the DFW metroplex. The current population in Dallas is approximately 1.26 million. Methodology The principal methodology used in the general obligation debt was US Local Government General Obligation Debt published in December The principal methodology used in the lease backed rating was Lease, Appropriation, Moral Obligation and Comparable Debt of US State and Local Governments published in July The principal methodology used in the waterworks and contract revenue bonds rating was US Municipal Utility Revenue Debt published in December The principal methodology used in the special tax rating was US Public Finance Special Tax Methodology published in January The principal methodology used in the tax increment rating was Tax Increment Debt published in June The methodologies used in the general obligation commercial paper debt were Variable Rate Instruments Supported by Conditional Liquidity Facilities published in March 2015 and US Local Government General Obligation Debt published in December The methodologies used in the waterworks commercial paper debt were Variable Rate Instruments Supported by Conditional Liquidity Facilities published in March 2015 and US Municipal Utility Revenue Debt published in December Please see the Rating Methodologies page on for a copy of these methodologies. 7

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10 Contacts 9 CLIENT SERVICES Denise Rappmund VP-Senior Analyst denise.rappmund@moodys.com Adebola Kushimo VP-Senior Analyst adebola.kushimo@moodys.com Gera M. McGuire VP-Sr Credit Officer/Mgr gera.mcguire@moodys.com Americas Asia Pacific Japan EMEA