Fitch Downgrades Sterling Heights, Michigan ULTGOs & LTGOs to 'AA+'

NEW YORK--()--Fitch Ratings has downgraded the following bonds of Sterling Heights, Michigan (the city):

-- $4.5 million unlimited tax general obligation (ULTGO) fire station bonds, series 2008 to 'AA+' from 'AAA';

-- $2.1 million limited tax general obligation (LTGO) bonds, series 2005 refunding to 'AA+' from 'AAA';

-- $3 million limited tax special assessment bonds, series 2008 to 'AA+' from 'AAA';

-- $5.4 million Michigan transportation fund (MTF) bonds, series 2005 refunding and series 2007 to 'AA+' from 'AAA'.

The Rating Outlook for the ULTGO bonds is Stable. Fitch has also revised the Rating Outlook for the LTGO bonds to Negative from Stable.

SECURITY

The ULTGO bonds are secured by the city's full faith and credit and its ad valorem tax pledge without limitation as to rate or amount.

The LTGO bonds are secured by the city's full faith and credit general obligation and its ad valorem tax pledge, subject to applicable charter, statutory and constitutional limitations.

The MTF bonds share the same security as the LTGO bonds. Additionally, the bonds are secured by the city's allocation of state-wide vehicle license and motor fuel taxes received from the state's transportation fund.

KEY RATING DRIVERS

DOWNGRADE REFLECTS DECLINING FLEXIBILITY: Several years of general fund operating deficits have reduced reserves. The city maintains alternate liquidity in its self-insurance fund which will be used to balance the general fund budget. That said, the current fund balance is below policy level. As such, the city will continue to experience significant budgetary pressure absent revenue enhancements.

OUTLOOK DISTINCTION: Fitch currently makes no distinction between the ULTGO and LTGO ratings due to the city's still adequate overall level of financial flexibility and satisfactory taxing margin under the statewide cap. The Negative Outlook on the LTGO bonds reflects the likelihood that a rating decision will be made over the near term if budget balancing efforts are not successful.

SUSTAINED TAX BASE CONTRACTION: Total taxable assessed value (TAV) has declined in excess of 20% over the past five years. Additionally, the corresponding decline in property tax revenues (roughly 60% of general fund revenues) has pressured the general fund despite an increase in the millage in fiscal 2011.

MIXED ECONOMY; MODERATE CONCENTRATION: Socioeconomic indicators are mixed with declining (but still above average) income levels and slightly above average unemployment. The economy is moderately concentrated in the auto-industry.

SOUND FINANCIAL MANAGEMENT ALTHOUGH PRESSURES REMAIN: The city benefits from a strong financial management team that practices conservative budgeting. The city has also taken judicious steps to reduce expenditures in light of revenue declines. However, further expenditure reductions necessary in the absence of revenue enhancements could impact core city services.

MANAGEABLE LONG-TERM LIABILITIES: The city's debt burden is low and characterized by rapid amortization. This is unlikely to change as there are no immediate plans for additional debt. Pension and other post-employment benefits (OPEB) are moderate and Fitch notes as a credit positive the city's practice of fully funding the OPEB ARC.

WHAT COULD TRIGGER A RATING ACTION

FAILURE TO ACHIEVE STRUCTURAL BALANCE: Fitch is concerned about the city's reduced financial flexibility and given significant spending cuts to date, believes a path towards structural balance will most likely come from the recovery of lost property tax revenue. Recovered revenue could come in the form of TAV growth or a possible new public-safety millage, which would allow the city to replenish general fund reserves to the 15% level by fiscal 2016 while leaving approximately $10 million in the self-insurance fund. Failure to achieve structural balance would likely cause continued reductions in overall financial cushion and a downgrade of the LTGO rating.

CREDIT PROFILE

The city is located in Macomb County, 18 miles north of Detroit. The city is one of the largest in the state with a 2011 population of 129,880.

MIXED ECONOMY; SOME AUTO CONCENTRATION

The city's local economy has traditionally been linked to the automotive industry, with both Ford and Chrysler together comprising 10% of taxable assessed value (TAV). Partially offsetting Fitch's concentration concerns are signs of some stabilization within the local economy and significant investments by both firms. Chrysler, which currently employs about 2,500 people, recently almost doubled the size of their plant. Additionally, Ford, which employs 1,400 people, is investing over $170 million it its two plants. Furthermore, the city has been experiencing improved industrial vacancy rates, with the 6.4% vacancy rate in October 2012 well below the metro Detroit area rate of 12.4%.

Unemployment levels continue to decline. The October 2012 rate of 7.9% is below the state average of 8.3% but slightly higher than the national average of 7.5%. Wealth levels are slightly above average but have come down over the last four years. The 2011 median household income reflected 115% and 105% of state and national averages, respectively. This is down from 124% and 118% in 2008.

The city has experienced considerable declines in TAV, which is indicative of regional economic pressures. TAV fell each year since 2008, with the largest decreases of 9.8% and 6.9% for fiscal 2011 and 2012, respectively, followed by another 6.9% decrease in fiscal 2013. The cumulative loss of property tax revenue is cause for concern given this revenue source accounts for over 60% of general fund revenue.

SUSTAINED STRUCTURAL IMBALANCE DESPITE PRUDENT BUDGET MANAGEMENT

Continued declines in TAV and loss of property tax revenue have resulted in multiple years of general fund operating deficits and the corresponding reduction of reserves. Audited fiscal 2012 results show a $5.7 million operating deficit (6.7% of spending) decreasing the unrestricted fund balance (the sum of committed, assigned and unassigned per GASB 54) to $4.4 million or 5.1% of spending, well below the city's 10% policy.

Property tax revenue declined 10% or $6 million over the prior year. The city's second largest revenue source, state-shared revenue (13% of general fund revenue), has also shown declines since 2002 with no increases in funding expected in the near term despite a growing population.

The city has actively worked to control costs to counter revenue softening and eliminated 59 full-time positions in 2012, including 27 layoffs. Since 2002, the city has eliminated 165 positions (25% of its full-time workforce), creating savings of approximately $12.6 million annually.

Fitch views the city's approach to programmatic changes to reduce ongoing expenditures, including greater utilization of part-time employees to replace full-time vacancies, as a credit positive. Fitch also views positively continued service sharing with surrounding communities. The city importantly achieved significant wage and benefit concessions from the majority of its labor contracts, which is expected to save approximately $6 million annually. Current contracts expire in 2015.

RESERVE DRAWS TO CONTINUE NEAR TERM

The city is planning to draw reserves down further and make expenditure cuts over the near term to balance the fiscal 2013 budget. The magnitude of the draw downs and expenditure cuts will depend on the recovery of lost property tax revenue.

The city's self-insurance fund benefitted from a one-time infusion from a settlement in 2004. The city is utilizing $4.7 million of self-insurance fund reserves to balance the general fund budget in fiscal 2013. A portion of the remaining balance will be used over the ensuing two years. This is in addition to the elimination of 59 full-time positions, saving the city $4.7 million.

The use of self-insurance reserves will eliminate the need to use general fund balance. This resulted in a projected unrestricted general fund balance of $6.4 million at the end of fiscal 2013, equal to 7.7% of spending. Combined with the self-insurance fund balance of $17.9 million, total reserves equal approximately $24.3 million or 29% of spending.

STRONG DEBT POSITION

Overall debt levels are low at $1,421 per capita and 2% of market value. Amortization is rapid with 89% retired in ten years. The debt position is not likely to change in the near-term given the city's limited future capital needs. The debt service burden is low at 5.1% of fiscal 2012 spending.

MODERATE POST-EMPLOYMENT REQUIREMENTS

The majority of city employees participate in either the General Employees' Retirement System or the Police and Fire Retirement System, which are single-employer defined benefit plans. The city consistently makes its required contribution to both plans. Although funding of both plans has declined, the General Employees' Retirement System remains well funded, at 90.9%. The Police and Fire Retirement System funding is slightly weak at 66.5% as of Dec. 31, 2011. The fiscal 2012 annual pension cost for both plans totaled $8.5 million.

The city provides other post-employment benefits (OPEB) to eligible employees through the city's retiree medical benefits trust plan. The city consistently contributes 100% of the required contribution. The current unfunded OPEB liability equals a low 1.5% of market value.

Carrying costs for debt service, pension and OPEB are moderate at 25% of total governmental funds expenditures. However this is inflated somewhat as a portion of the OPEB payment is funded by the city's water and sewer fund.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

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, and the National Association of Realtors.

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

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE.

Contacts

Fitch Ratings
Primary Analyst
Nicole Wood, +1-212-908-0735
Associate Director
One State Street Plaza, New York, NY 10004
or
Secondary Analyst
Eric Friedman, +1-212-908-9181
Director
or
Committee Chairperson
Jessalynn Moro, +1-212-908-0608
Managing Director
or
Media Relations
Elizabeth Fogerty, +1-212-908-0526 (New York)
elizabeth.fogerty@fitchratings.com