Fitch Downgrades Kalamazoo, MI LTGOs to 'A+'; Outlook to Stable

NEW YORK--()--Fitch Ratings downgrades the following Kalamazoo, Michigan (the city) ratings:

--Implied unlimited tax general obligation (ULTGO) bond rating to 'AA-' from 'AA';

--$13 million capital improvement limited tax general obligation (LTGO) bonds to 'A+' from 'AA-';

--$1.7 million downtown development LTGO bonds to 'A+' from 'AA-';

--$20.3 million Kalamazoo Building Authority LTGO bonds to 'A+' from 'AA-'.

The Rating Outlook is revised to Stable from Negative.

SECURITY

The LTGO building authority and downtown development bonds all carry the city's full faith and credit and its ad valorem tax, subject to constitutional, charter and statutory limitations.

KEY RATING DRIVERS

STRUCTURAL IMBALANCE: The downgrade reflects the city's diminished financial flexibility in the context of its restricted revenue raising environment. Fitch believes that restoration of structural balance will likely depend upon the city's ability to implement as yet unidentified expenditure cuts to avoid sizable out year budget gaps.

CHALLENGED REVENUE BASE: Approximately 40% of the city's tax base is exempt from taxation. Taxable valuation declined notably in the recent economic downturn and prospects for revenue recovery in the near term are limited by the lack of taxing margin as well as statutory restrictions on revenue growth.

REGIONAL CENTER; BELOW AVERAGE INDICES: The local economy remains highly dependent on manufacturing but is stabilized by the presence of higher education and healthcare. Per capita wealth levels are below average and the local unemployment rate is above average.

MIXED LONG-TERM LIABILITY PROFILE: The debt burden is currently modest, principal amortization is rapid, and future debt requirements appear manageable. The city's pension plan is over-funded and does not represent a source of budgetary stress, but the OPEB liability is high.

LTGO RATING DIFFERENTIAL: The rating differential between the implied ULGO rating and the LTGO bonds reflects the city's limited financial flexibility and the lack of available taxing margin for operations.

RATING SENSITIVITIES

RESTORATION OF STRUCTURAL BALANCE: The rating is sensitive to the city's ability to successfully execute its multi-year fiscal plan returning the city to structural balance while minimizing reliance upon non-recurring measures.

CREDIT PROFILE

Kalamazoo is located in the southwestern quarter of Michigan's Lower Peninsula, approximately 50 miles south of Grand Rapids. The city has experienced marginal population loss over the past decade, to an estimated 75,548 in 2013.

REGIONAL CENTER; BELOW-AVERAGE SOCIOECONOMIC INDICATORS

The city is a regional economic and population center for south-west Michigan. Pfizer Corp. has a major presence within the city, serving as both the largest taxpayer (5.6% of total assessed value) and a significant employer (4,000 personnel). Other major employers include Borgess Medical Center (4,642), Western Michigan University (2,817), and Bronson Healthcare Group (3,729 employees). The city's economy is further stabilized by Kalamazoo College and Kalamazoo Community College. Approximately 40% of the city's property is tax exempt. While the regional economy has experienced some diversification in recent years, employment within the manufacturing sector remains elevated as compared with the national average.

Socioeconomic indicators are below average, with per capita income levels at 72% and 65% of the state and national averages, respectively, although these may be marginally skewed by a large student population. The city's education levels are above average, with 32% holding a bachelor's degree, compared with 28% for the nation. The individual poverty rate is well above average at 230% of the national.

Unemployment is elevated at 9% as of June 2014, well down from the year prior (11.1%), but above the state (7.9%) and national (6.3%) averages. Positively, growth in local employment outpaced labor force gains over the prior 12 months.

ECONOMIC WEAKNESS DRIVES REVENUE PRESSURE

The city's tax base declines have moderated, with a small 0.2% loss in 2014 signaling possible stabilization. Nevertheless, the tax base has declined an aggregate 14.7% since 2008, pressuring operations as the city is at its maximum operating rate. The city is projecting minimal tax base growth for 2015 and after, which could widen the structural gap if not realized.

Multiyear projections show maintenance of the city's fund balance at the city's 13% target, with reliance upon one-time uses in 2014 as well as increasing unidentified expenditure reductions of $2.35 million in 2015, growing to $6 million 2019 (12% of projected spending). Further, Fitch believes that the city's revenue flexibility is considerably limited by little upside economic potential and a stringent revenue cap, at which the city is levying. The city has no immediate plans to seek a voter override.

CHALLENGES TO STRUCTURAL BALANCE

The city's fiscal 2013 revenue composition includes 57% from property taxes and 18% from intergovernmental sources. Fitch believes the city's ability to control spending is key to maintaining its current cushion as its revenue base is limited. Financial performance has been uneven historically, and recent years have shown operating deficits predominantly. Fiscal 2013 ended with a general fund net operating deficit after transfers of $2.2 million (equivalent to 4.2% of spending). The unrestricted general fund balance declined to $4.4 million or 9.2% of spending.

The city's 2014 budget is balanced with one-time revenues, including $4.6 million for a cell tower lease buyout program. Operational balance does not depend on realization of these revenues. According to the city's fiscal plan, the cash from these sources would be applied to discretionary payments related to the city's post-retirement liabilities. Fitch views positively the city's continued commitment to funding capital within the operating budget, estimated at 1.3% of general fund spending in 2014.

The city remains reliant upon external borrowing for cash-flow purposes. Annual liquidity borrowing has declined from $6 million in 2009 (11% of revenues) to a moderate $3 million in 2013 (6% of revenues).

MIXED CREDIT IMPACT OF OPEB BONDING

The city's OPEB liability is currently a high $187 million or 5.9% of market value. City council has recently authorized up to $100 million in OPEB borrowing, which will require state approval. Fitch estimates that debt levels under the borrowing will increase to a high 7.9% from currently moderate 4.7%, assuming full use of the city's authorization.

Fitch generally views such borrowings as credit neutral, representing the substitution of one type of long-term liability for another. Municipalities who borrow to fund post-retirement liabilities introduce market timing risk in exchange for greater predictability and/or affordability of post-retirement costs.

Under the plan, the city will adjust its 4% return assumption to 7.5%. This adjustment alone would represent a 32% decrease in the city's current UAAL, to $127 million or a still elevated 4% of market.

The city will be required to fund its annual required contribution under the state-approved plan; therefore, the city will be responsible for an anticipated $3.5 million annual required contribution in addition to a $6 million increase in debt service. Combined carrying costs for debt service, pension and OPEB would amount to approximately 24% of governmental spending, down from 31% in 2013 (the first year in which the city fully funded its ARC as calculated under a 4% rate of return).

Beginning in 2015, the city plans to fund its ARC payments from the existing balance in its OPEB funding trust, thereby plugging the budget gap. Fitch would consider this to be a non-recurring budget balancing action and would view negatively the city's decision to increase the size of its OPEB borrowing to allow for draws upon the trust fund for annual funding requirements, which have traditionally been considered an operating expense. The city is developing a 6% contingency reduction budget to implement if the OPEB borrowing and associated annual savings do not occur.

OTHER LONG-TERM OBLIGATIONS MODERATE

The current overall debt burden is slightly above average at 5.1% of market value or $2,169 per capita. Principal amortization is rapid with 77% of debt retired within 10 years; the effect that the potential OPEB borrowing may have on the rate of payout is unknown. The five-year capital improvement plan contemplates issuing a manageable $11.6 million in general obligation debt for capital purposes.

The city provides post-employment benefits through a single-employer defined benefit pension plan that was overfunded at 120% in 2012 or an estimated 113% using Fitch's 7% investment return assumption. The city anticipates making its final hold harmless contribution this year, dependent on execution of the cell tower deal, to the fund for actuarial changes due to its early retirement incentive program in years prior.

LTGO PLEDGE; DEBT REPAID FROM NON-GF SOURCES

The building authority bonds are secured by cash rentals under the lease between the authority and the city. The cash rentals constitute the city's full faith and credit and its ad valorem tax, subject to constitutional, charter and statutory limitations. Payment under the lease is not subject to annual appropriation nor setoff or abatement for any cause. Therefore, the rating is on par with the city's LTGO rating.

The downtown development bonds carry the city's LTGO pledge but are also secured by a pledge of tax increment revenues generated within the development area. Tax increment revenues are the intended source of repayment and provide at least sum sufficient debt service coverage, however, Fitch's rating is based upon the strength of the city's LTGO pledge.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from CreditScope, University Financial Associates, S&P/Case-Shiller Home Price Index, IHS Global Insight, National Association of Realtors, and Zillow.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'U.S. Local Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. Local Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685314

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=887694

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Contacts

Fitch Ratings
Primary Analyst:
Stephen Friday, +1-212-908-0384
Associate Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst:
Bernhard Fischer, +1-212-908-9167
or
Committee Chairperson:
Arlene Bohner, +1-212-908-0554
Senior Director
or
Elizabeth Fogerty, +1-212-908-0526
Media Relations, New York
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst:
Stephen Friday, +1-212-908-0384
Associate Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst:
Bernhard Fischer, +1-212-908-9167
or
Committee Chairperson:
Arlene Bohner, +1-212-908-0554
Senior Director
or
Elizabeth Fogerty, +1-212-908-0526
Media Relations, New York
elizabeth.fogerty@fitchratings.com