Happy New Year from the City of Houston: We’re Insolvent!

     It has become standard bill of fare for the City of Houston to hold the release of its annual audit until sometime between Christmas and New Year’s Day, hoping that the awful news normally contained therein will go unnoticed by the local media, which it normally does.
     Holding true to form this year, the City dropped its audit for the fiscal year ended June 30, 2016 on the internet late in the day on Friday, December 30, notwithstanding that the auditors signed off on the report a month earlier on November 30.  You may recall that last year the City released its audit, which had been completed on December 2, at 4:00PM New Year’s Eve, which was also conveniently after the December 12 City run-off elections.
     The headline news from the report is that the City is now officially technically insolvent, that is, the City’s liabilities exceed its assets.  According to the report the deficit is a little under $100 million, although the real number is much larger (more on that in a moment).  The fact that the City was, for the first time in its history, insolvent was timely reported by the Chronicle.  [click here]  But unfortunately, the story also included the swill from Turner and our financial watch-dog turned lap-dog, Chris Brown, that the City going insolvent really was not that big of deal and that the solution to the City’s fiscal woes is to double down – for another 30 years — on the defined benefit pension system that got us into this mess.
     Turner was quoted as assuring everyone that the City had $2.5 billion of cash on hand, plenty to pay all its bills.  That is, of course, if you don’t count the $8 billion of pension bills the City has accumulated in the last fifteen years.  Nor does he mention that about 90% of that money is tied up in restricted accounts that are not available for regular expenses.
     There are hundreds of pages in the report, so there is much yet to be unpacked.  But here are some of the things that jumped out at me in the few days we have had to examine the reports.
     1. Are we insolvent by $100 million or $2 billion?  One of the more bizarre and deeply troubling aspects of these reports is that they continue to assume that our pension plans will earn an 8-8.5% rate of return indefinitely.  Of course, these assumptions are absurdly unrealistic.  Last year the plans, on average, lost about 2%.  It appears that the fire fighter plan assumption of 8.5% is the highest in the country and the only plan to continue to perpetuate this fantasy.  None of the other 10 largest cities in the country used a rate of 8% or higher in their most recent audits.  Even Turner has admitted as much by proposing lowering the rate to 7% in his new pension plan.  The police pension plan dropped its rate assumption last year to 7% and then arbitrarily raised it back this year to 8% notwithstanding it lost over 3% last year.
     The difference is not trivial.  Buried deep in the notes to the report is a schedule that shows the effect of lowering the plans’ assumption by a mere 1% on the city pension debt.  That small change balloons the pension debt from $6 billion to about $7.8 billion.  If the auditors had used Turner’s new numbers, the pension liability would have swollen to over $8 billion.  In other words, if the auditors had used the new assumptions proposed by Turner, the City would have been insolvent by over $2 billion instead of the $100 million it has officially reported.
     This kind of cherry-picking assumptions out of thin air allows the City to manipulate its audit results.  It is difficult to understand what the auditors were thinking about when they signed off on these absurd assumption.  Generally speaking, auditors are supposed refuse to issue a “clean opinion”if their client’s assumptions are patently unsupportable.  In their transmittal letter, the auditors specifically state: “Government Auditing Standards . . . require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.”  How is understating the amount of the City’s insolvency by 20-fold by using assumptions everyone agrees are not realistic not a “material misstatement” of the City’s financial condition?
     2. “Elite” Club of Bankrupts.  One of the City’s other favorite propaganda lines is to suggest that its financial woes are typical of other cities around the country.  Well, not so much.  I have looked at the latest financial reports for the 30 largest cities in the country.  While it is hard to compare the financial statements of one city to another, all must report their “net asset” position.  I have only found six others which are technically insolvent (New York, Chicago, Philadelphia, Jacksonville, Indianapolis, and Boston).  To be fair Baltimore has not issued an audit on the internet for over two years and is almost certainly insolvent.  Also, Dallas and El Paso will probably join the list when their reports are issued later this year as both are struggling with crippling pension debts as well.
     However, many other cities like Los Angeles, Charlotte, Seattle, Phoenix, San Antonio and San Francisco are still very much solvent notwithstanding their own pension issues.  So, while it is true that virtually every large city in the country today is struggling with financial issues to one degree or another, Houston’s predicament places it among those with the most grave fiscal challenges.
     3.  The Police Pension $676 Million Flip-Flop.  One truly amazing entry on the City’s books this year is a write-down, that is reduction, of the City’s debt to the police pension plan by $676 million due to “assumption changes.”  It appears that this is the result of police pension changing its investment assumption for 8% to 7% last year and then going back to 8% this year.
     Now just think about this for minute.  The amount that taxpayers supposedly owe just one of the pension funds changed by $676 million in one year purely on the whim of some nameless actuaries and a pension board which is mostly elected by the pension members.  By the way, that change is equal to more than half the property taxes collected by the City last year and about 15% of the total pension liability for that plan. And the taxpayers, rank-and-file police officers and even City Council had absolutely no say in the matter.
There cannot be a clearer example of the vagaries of the costs and debt associated with defined benefit pensions and the utter hubris that we can predict investment returns and demographics that will ultimately determine the true cost of these plans over the next 30 years.  This is why Turner’s plan to double down on defined benefit plans for another 30 years is such a dangerous idea.
     4.  Other Metrics
Here are a few other comparisons to the previous year noted in the report:
Total Revenues: Up 3.4%.
Total Expenses: Up 5.6%.
Amount Expenses exceeded Revenues: $288 million or 6%.
Increase in Total Debt: $820 million (larger than any bond issue ever approved by City voters).  Had it not been for the police pension’s flip-flop on its rate assumption, the increase would have been $1.5 billion.
Miles of Streets Resurfaced: Down by 42 (152 vs. 194, 28% decline).
Tons of asphalt used for pothole repairs: Down by 2,842 (13,130 vs 15,972, an 18% decline).
I expect to have more to say about the annual reports for the City and its pension plans after I have had more time to study them.  Till then . . . .